Multiple expansion is a form of arbitrage that employs the purchase of a security at a lower valuation multiple and selling a security at a higher valuation multiple. Generally, companies with lower valuation multiples are smaller and with higher investment risk compared to companies with higher valuation multiples.
In addition, the concept of “multiple expansion” can be used to describe any increase in the company’s valuation multiple.
Multiple Expansion in Private Equity
Although multiple expansion can be related to any type of purchase, this concept is widely used in private equity deals. It is utilized along with leverage and deal structure.
It is difficult to predict a company’s multiple expansion. However, private equity firms apply special techniques to achieve the following objectives:
Monitor the current valuation multiples and M&A activities in the market.
Proactively seek the best exit time of the investment at the highest valuation multiple.
Example of Multiple Expansion
Private equity firm PE Partners has decided to acquire Startup Inc. PE Partners is willing to employ multiple expansion to profit from its investment in Startup Inc. Currently, Startup Inc. has an Enterprise Value (EV) of $10 million and an EBITDA of $5 million. PE Partners has determined that EV/EBITDA is the most appropriate valuation multiple for the multiple expansion indications. The initial EV/EBITDA multiple is 2x.
In order to achieve the expansion, PE Partners plans to drive the operational efficiency of Startup Inc. by boosting production and eliminating some costs.
After three years, the company’s EV reaches $100 million and EBITDA becomes $20 million. Thus, the company’s EV/EBITDA is 5x. In three years, Startup Inc.’s multiple has expanded by 2.5 times. PE Partners then decides to sell Startup Inc. to profit from its initial investment.
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