The Days of Cheap Capital Are Gone for Good
I've always believed that you can learn a lot more from failure than from success, and my most recent failure is no exception. I'm referring, of course, to my abortive attempt to sell the records-storage and document-destruction business that I've spent almost half my life building. Had I succeeded, it would have been the second sale of the business in two years. In the spring of 2007, that same business had attracted so many potential acquirers that I'd had to lock myself in a room with my partner Sam and stop all phone calls until we decided what we wanted to do. We eventually sold a majority stake to Allied Capital for a lot of money and thought we were home free. Then, last winter, the financial crisis forced Allied to change its plans and ours. It asked us to help look for a new owner for CitiStorage. We agreed and gave it our best shot but couldn't find one. So why not?
Looking back now, I can see the reason clearly enough. The business has certain risk factors that scared off all the potential acquirers. The most important of these has to do with the status of our land. Four years ago, the city of New York rezoned the area, with the intention of creating a park along the Brooklyn waterfront. (See "Let the (Political) Games Begin," June 2005.) As a result, the city can take our land whenever it wants to, which would create a major, and potentially expensive, disruption of the business. From that perspective, it's not surprising that potential buyers might think twice before putting in a bid.
But that just raises the real question: Why was everyone so willing to ignore these risks in 2007 and yet today people find them insurmountable obstacles to doing a deal? The answer, in a nutshell, is that no one was thinking much about risk back then. People were too focused on finding places to invest all the cheap capital they had.
It was, of course, the Federal Reserve that had decided capital should be cheap and plentiful, and -- although I wasn't really thinking about it at the time -- that decision had a huge effect on the value of companies like mine. Why? Because it fostered intense competition for good acquisitions among potential buyers and made it possible for them to structure deals based on higher multiples of EBITDA (earnings before interest, taxes, depreciation, and amortization) than would otherwise have been the case.
In our industry, the potential buyers included private equity firms, which had lots of capital they needed to invest. Records-storage businesses have certain characteristics that are very appealing to those firms, including guaranteed cash flow. We rent space to boxes, and those boxes keep paying rent no matter what is going on in the economy. In addition, we have an unusually "sticky" relationship with our customers, all of whom agree to pay a permanent-removal fee (typically two years' rental income per box) if they decide to store their boxes somewhere else.
Then, too, private equity firms like to do highly leveraged transactions. When you buy a company using mainly debt, you get a much bigger bang for your buck as the company grows, because the value of your equity increases much faster than it does when you use mainly equity. Assume, for example, that a business has $10 million in sales, 50 percent gross margins, and EBITDA of $1 million, and you're acquiring it for 10 times EBITDA, or $10 million. You can do the math yourself. But let's say you use $8 million in debt and $2 million in equity to buy the business: The value of your equity will increase exponentially -- I'm talking about 20 times -- when the company doubles in size (assuming the multiple doesn't change). If you buy it with equity alone, your equity value will increase about four times when revenue doubles.
The ability to do a highly leveraged transaction depends, however, on the availability of cheap debt, especially senior debt -- that is, the debt that gets paid off first in a liquidation and thus comes with a lower interest rate (because of lower risk) than junior debt. Prior to the financial crisis, Fed policy made senior debt both widely available and inexpensive. Banks were eager to lend five or five and a half "turns" of EBITDA as part of a private equity deal. The senior debt could then be combined with junior debt, so that 80 percent of a deal's financing would come from debt of one sort or another.
This combination of factors led to a feeding frenzy in our industry. In the last months of the bubble, just about any medium-size records-storage company could command nearly double-digit multiples of EBITDA -- even companies with sloppy financials, mediocre growth prospects, weak management, and other vulnerabilities. Acquirers were so anxious to do deals that they were willing to overlook risk of almost any kind, or maybe they were simply blind to the dangers. Either way, they were snapping up records-storage companies right and left, as if the days of inexpensive and abundant capital would never end. It was ridiculous, and it was a direct result of Fed policy.
All that changed when the bubble burst. Suddenly, everyone became acutely aware of risk as the financial crisis unfolded. Even though the Fed kept interest rates low and the liquidity pump open, banks became much more cautious. In leveraged deals, they would put up only two turns of EBITDA, instead of five and a half, for senior debt, and they'd put a cap on the total amount of debt allowed. They've since eased up a bit, but banks remain extremely cautious -- which is normal. And that's the point. What's happening now is not an aberration. The aberration was what was happening then, at least as far as valuations are concerned.
That said, it will take some time for people to adjust to the new reality. If your neighbor's house, identical to yours, sold for $300,000 three years ago and now the best offer you can get is $200,000, there's a natural tendency to think, It's really worth $300,000. I'll just wait until home values come back. You don't want to accept that your neighbor simply got lucky and the market value of your house is going to be closer to $200,000 than to $300,000 for years to come.
I'm that lucky neighbor. When I sold CitiStorage and my other two businesses in December 2007, I was even luckier than I realized. I knew then that our timing couldn't have been better. We'd wrapped up the deal within weeks, if not days, of the bubble's bursting. But I didn't fully appreciate how much the bubble had distorted the selling process, both by greatly inflating multiples and by causing potential acquirers to minimize the risks. In the next few years, multiples may rise above the current level, but not by much. I doubt we'll see valuations of 10 times EBITDA again for a very long time, if ever -- at least not in my industry and probably not in yours, either.
And eventually people will get used to that idea. They'll realize that the offers they're receiving are the best they'll get for a while, and life can't wait. You need to make decisions and plans based on what's available now, not on what was available a few years ago or what might be available five or 10 years in the future.
Meanwhile, I have my work cut out for me. If the real estate issue is the main obstacle to selling the company, I have no choice but to resolve it. Given the latest news, the sooner I do so, the better: At the end of October, Allied Capital announced it was being acquired by another firm, Ares Capital. I have no idea just yet how that will change life at CitiStorage, but you can bet it's going to change. And when it does, I want to be ready.
Norm Brodsky is a veteran entrepreneur. His co-author is editor-at-large Bo Burlingham. Their book, The Knack, was named the best book on entrepreneurship of 2008 by 800-CEO-READ.
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