How Does Multiple Arbitrage Create Value in HOA/Condo Management?

In various pieces we have covered the state of the HOA/condo management industry consolidation. In this piece we will specifically focus on private investors' most prized value driver: EBITDA multiple arbitrage.

What is EBITDA Multiple Arbitrage?

EBITDA multiple arbitrage implies that the value of a purchased business, when integrated in to a larger platform, is then inherently raised. Let's do an example. Private Investor Z has purchased an HOA management company ("Platform Z") for 12.0x $5.0M EBITDA or $60.0M, which for illustrative purposes we will assume is the going price for an HOA management company of that size or larger. Platform Z invests in Local Management Company, a business generating $500k of EBITDA. Platform Z pays 5.0x EBITDA or $3.0M for Local Management Company. The combined company (Platform Z after the transaction) generates $5.5M of EBITDA ($5.0M plus $500k). What is the multiple arbitrage generated by the purchase? If we assume the platform is worth 12.0x EBITDA, Private Investor Z's multiple arbitrage is (12.0x - 5.0x) * $500k or approximately $3.5M. In other words, while Platform Z paid $2.5M to acquire Local Management Co, the earnings associated with Local Management Company are worth $6.0M when integrated into Platform Z.  The $3.5M of value creation is owned by the investors in Platform Z, which may include individuals, executives, and others.

This math has driven the consolidation of many industries, and HOA/condo management is the newest forefront. Private investors are interested in consolidating quickly before there is more competition for assets, thereby driving up the price for businesses like Local Management Company. An increase in the price of Local Management Company is a 1:1 decrease in Private Investor Z value creation under the consolidation method.

The math itself is simple, but many consolidations do go wrong. Typical reasons include (1) inability of platform team to manage and integrate acquired businesses, (2) misalignment of compensation incentives, (3) acquired business' owners inability to work for a larger organization, and (4) capital structure mis-management creating strain on the ability to execute acquisitions.

Why are Larger Businesses Worth More On An EBITDA Multiple Basis?

Above, we mentioned that Platform Z was inherently more valuable than Local Management Company on a multiple basis due to its larger size. Markets do typically value larger businesses higher for a number of reasons, the most important of which are:

- Lower perceived business risk: Larger companies typically have more established operations, diversified revenue streams, and stronger market positions. These factors reduce the risk of business failure, making them more attractive to investors. We would include the likelihood of a strong management team in this category as well. Strong management teams enhance the possibility of a successful consolidation strategy.

- Better financing terms: Larger businesses can access capital at lower costs due to better credit ratings and established lender relationships. Better financing terms create a more attractive asset for private equity transactions.

- Exit options: Larger businesses command a premium in the investor market purely as a function of asset allocation. The private equity industry in the US features a "bulge" in the middle market bracket, or funds from $500M - $5BN. Because that marketplace is heavily competitive, it creates bidding tension for transactions that fit the bill.

Aggregated Multiple Arbitrage

Picking up from our example earlier, let's say Platform Z acquires 10 local management companies, worth a total of $10.0M in EBITDA, for 6.0x EBITDA or $60.0M. The math for Platform Z is: 

- Initial investment: 12.0x $5.0M EBITDA = $60.0M

- Aggregated add-on investment: 6.0x $10.0M EBITDA = $60.0M

- Total Platform Z size at exit (assumes no growth, for simplicity): 12.0x $15.0M = $180.0M.

- Total aggregated multiple arbitrage: (12.0x - 6.0x) * $10.0M = $60.0M!

This group of private investors created $60.0M of value for themselves by successfully consolidating the businesses into Platform Z.

Summary

While not foolproof (particularly for management deficiencies) EBITDA multiple arbitrage is a powerful tool and one of the predominant value creation strategies in private investing.

For more information on the HOA management industry, valuation metrics, or other questions, please contact contact@camadvisors.co or visit camadvisors.co.