One of my favourite modules on my MBA course was Financial Engineering. A more accurate name for this module would have been ‘making profits from thin air’. I am convinced that employees from Enron were required to excel on this course! One of the great techniques I learnt about was boot strapping!
For a variety of reasons, different businesses often get rated on different multiples. A mature business with good management which is listed may for example be trading on a multiple of ten of annual profits. A new entrant which is up and coming on the other hand may have a multiple of twenty (as the growth prospects are better). Bootstrapping occurs when a company with a higher multiple takes over a company with a lower multiple and benefits from the entire new company getting re-rated with the higher multiple.
Company A makes profits of £1m and is rated at 10x profits and therefore has a valuation of £10m.
Company B makes a profit of £0.5m but has a multiple of 20x profits and therefore also has a valuation of £10m.
Both companies are worth £10m each and you would therefore think that if they were merged (ignoring any cost savings and other synergies etc) the new company would be worth £20m.
But if company B was to buy company A, the new company may get rated on the same multiple as company B before the merger. Therefore the new company B will be rated at 20x profits of £1.5m which is £30m.
Bootstrapping has thus ‘created’ £10m of additional value simply through re-rating the prospects. Some of you will no doubt argue that I have simplified this very complicated area. Of course, it is a bit more complicated than this, but the end result is the same.
In the 1980s companies like Hanson trust were able to build themselves into huge empires by acquiring companies which had lowly rated earnings, but then apply a higher multiple. This made Hanson shares expensive – which allowed them to continue to buy other companies. Tomkins also did the same thing before it suffered a severe bout of indigestion having bought RHM (incidentally, my first employer). RHM was simply too big for them to manage effectively.
Start ups are often valued at a multiple of turnover. Hence many start ups do try to buy other companies with turnover. This is especially true in cases where you can buy a company for cheap because it has run into trouble.
This is a brave strategy. The key thing to bear in mind is management ‘bandwidth’ Many companies, especially start ups simply do not have the room to manage another business.
Given the climate we are in though. I would not be surprised if someone did come along to buy many businesses on the cheap with a view to bolting them all on to get a higher multiple.
You heard it here first!