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Evaluation of EBITDA as a primary valuation tool for

Sandbar Investments

Specification:

Topic 1: “A case study of the strategy of an owner-managed family business in

Australia located at a single location”

Business: Sandbar Investments

Industry: Private Equity

Website: http://www.sandbarinvestments.com.au

Employees: 26

Address: Level 4, 2 Grosvenor St, Bondi Junction, New South Wales 2022
i I i

Description: Sandbar Investments is a single-location and owner-managed

family (Smorgon’s) business situated in Sydney that controls
investment portfolios for Sandra and Barry Smorgon. Sandbar usually
seeks to buy significant stakes in prosperous, growing firms that operate
in stable, non-cyclical industries and are long-term oriented. Sandbar
often seeks start-ups with enterprise valuations ranging from $5 to $50
million.

Strategy: Sandbar evaluates the potential investees using an EBITDA tool in the
range of AUD 2-8 million1 and then attempts to sell these
opportunistically.

1
http://new.sandbarinvestments.com.au/wp-content/uploads/2021/10/Family-offices-set-to-play-bigger-role-in-
Australian-MA-driven-by-diversification-higher-returns-_-Mergermarket.pdf
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 Motivations

UBS' 2021 Global Family Report2, which surveyed 121 of the world's top family offices,
exposed that more than 66% of family offices globally consider PE (private equity) as a
major driver of returns, with 35% of their investments now devoted to alternative
investment asset classes, including 16% in PE. This report further revealed that 9% of
the cash allocated to PE was invested directly, while 7% was invested through funds.
However, it is difficult to derive reliable statistics about Australian family offices because
most operate under the radar, however international data may be applied to the best
family offices in Australia. Though it took more than a week for us to decide on the
topic, the moment our group agreed to pursue topic 1, PE was our collective and
convenient choice owing to its attractive returns as compared to other asset classes
and also due to our comprehension developed through previously studied business
courses.

2
https://www.ubs.com/global/en/global-family-office/reports/gfo-client-report.html

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 Preliminary Context

PE firms are sort of investment companies that provide funding to private businesses

that are not publicly traded on the stock exchange, though there are instances where
the focus of PE firms has more recently switched to the acquisition of solely public
corporations as a means of achieving greater expansion.

Private equity investments frequently concentrate on established businesses in

conventional sectors and provide a percentage of stock or ownership in return. PE's
usual approach of purchasing businesses and then selling them after guiding them
through a transition of fast performance improvement is the primary factor driving the
industry's development and strong profits (Gompers et al. 2016, p2(2)). The success of
private equity rests on this approach, which combines business and investment
portfolio management.

To sell the company at a better price and generate a financial gain, PE companies are
interested in enhancing the company's value throughout the investment. The
institutional operators join different partners' pools of funds to form a private equity fund
(Holloway et al. 2016, p3(1)). After the target firm has received the funds raised and the
fundraising objective has been met, the private equity fund is closed. The simplified
private equity structure is depicted below.

Figure 1: PE business model. (Source: https://doi.org/10.1007/978-3-031-07630-5)

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Consequently, the three primary players in PE firms are

 PE management firms, also known as General Partners (GPs)

 Limited Partners (LPs)
 Investee or portfolio firms (Dawson 2011, p3(2))

PE investors find their ventures appealing due to the possibility of outperformance.

Since 2008, PE funds have regularly outperformed not just other asset classes in the
private market across all quartiles, but also their corresponding investments in the
public market (McKinsey, 2022, p23(3)). This is also the cause of the net value for PE
assets' (NAV) 14-fold increase since 2000, which has greatly outpaced the public
market's fourfold increase as in the following figure.

Figure 2: The net value of PE assets outdone the total market capitalization of listed companies.

PEs promote quick corporate restructuring, increasing efficiency by concentrating on

underperforming businesses that may be improved and then re-floated. As every
potential acquirer puts a valuation on every target firm. The idealized auction for control
is awarded to the PE firm with the highest valuation, which also offers the highest price
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for the target (Wood & Wright 2009, p3(1)). Different transaction costs associated with
maintaining a portfolio of companies, a firm's capacity to produce value, and unique
match-specific synergies all contribute to differing valuations between PE firms.

There are several approaches for valuing a business, including the discounted cash
flow, the comparables, the precedent, the asset-based, and the book value
approaches.

Every approach has benefits and drawbacks of its own. For instance, the comparables
strategy for stock valuation uses publicly available information from comparable firms.
The entity being compared must have comparable firms, and those comparable
companies must have information that is available to the public. It might be challenging,
if not impossible, to adequately compile comparables data if either of those
requirements is not met. (Tappeiner et al. 2012, p2(3))

As a result, valuation turns out to be a science and an art as well, which makes it more
beneficial to settle on a value range than stressing over the exact dollar valuation of a
business. For instance, a company is probably a good value if it trades near or below
the lower end of a predetermined range. At the high end, the reverse may be true and
might point to a shorting opportunity.

As our selected business, Sandbar investments pursues the strategy to evaluate the
potential investees using EBITDA, this case study will focus on the appropriateness of
this approach.

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 Research Problem

Though valuation is frequently not the beginning point for a PE’s investment decision
and the decision to engage with a firm begins well before "valuation".  Still, the PE
firm's decision to pursue a deal or not is still heavily influenced by the valuation
estimate since it has a direct impact on the price paid for the company's shares and,
ultimately, the profitability of the investment. The entire lifecycle of PE investment
revolves around the subject of values, despite the fact that it is notoriously difficult to
get them right in non-listed businesses. (Gompers et al. 2016, p2(2))

EBITDA's success as a metric for valuation has fuelled a boom in PE firms. Most PE
firms use it as their primary metric of value and push portfolio company executives to
raise it. EBITDA is now often being used by publicly traded companies to discuss
performance with investors and even as a foundation for incentive compensation,
following in the footsteps of PE firms. Hence, there is a need to substantiate that
placing so much focus on a 50-year-old metric EBITDA is still justifiable in the presence
of high computational capability.

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 Research Question

Q1: Is EBITDA the most effective metric for an investee’s valuation?

Many family offices of owner-managed private equity (PE) firms, including Sandbar Investments (i.e.,
our target business), consider EBITDA as the best approach to estimate the value of their target
businesses. The deals pursued by these family offices are strongly influenced by the valuation estimates,
which determine the purchase price of the PE investors’ stake in the target company and, in consequence,
the return on the PE investors’ capital. Although it is notoriously difficult to get these valuations right
especially for non-listed businesses, these valuations are crucial to the entire PE investment lifecycle of
these family firms (Gompers et al, 2016, p2(2)). There are very limited empirical studies to quantitatively
examine the influencing variables on business performance of family offices, though there are few
quantitative empirical studies that examined how family successors influence firm performance in the
years following the founder's departure (Ahrens et al, 2019, p3(2)).
The speed and complexity with which business is evolving around the globe demand creative responses.
Now more than ever, adapting to new circumstances and developments is essential for businesses to
thrive (Robinson, 2008, p272(1)). Hence, it becomes important to examine the justification of why it is
appropriate to continue putting so much weight on EBITDA by the family offices PE firms for their
potential investee valuations, on a measure that is already 50 years old comparing the seriously
developed computing capabilities in the last decades.
It is not uncommon for family businesses to stick to the same old approach year after year since they
were found to stick with what worked best for them once. As any generic strategy may not always be
adequate, especially when significant strategic change is eventually required to keep up with the
competitiveness of the market environment considering new technologies. The existing paradigms of
strategy formulation must be abandoned in favour of the methods that allow for the firm's strengths to be
leveraged to take advantage of potential market opportunities (Robinson, 2007, p2(2)).

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Many family offices of owner-managed private equity (PE) firms, including Sandbar
Investments (i.e., the target business), consider EBITDA as the best approach to
estimate the value of their potential investees3. The deals pursued by these family
offices are strongly influenced by the valuation estimates, which determine the
purchase price of the PE investors’ stake in the target company and, in consequence,
the return on the PE investors’ capital. Although it is notoriously difficult to get these
valuations right especially for non-listed businesses, these valuations are crucial to the
entire PE investment lifecycle of these family firms (Gompers et al, 2016, p2(2)). There
are very limited empirical studies to quantitatively examine the influencing variables on
business performance of PE family offices, though there are few quantitative empirical
studies that examined how successors of a family business influence firm performance
in the years following the founder's departure (Ahrens et al, 2019, p3(2)).

The speed and complexity with which business is evolving around the globe demand
creative responses. Now more than ever, adapting to new circumstances and
developments is essential for businesses to thrive (Robinson, 2008, p272(1)). Hence, it
becomes important to examine the justification of why it is appropriate to continue
putting so much weight on EBITDA by the family offices of PE firms for their potential
investee valuations, on a measure that is already 50 years old comparing the seriously
developed computing capabilities in the last decades. Hence, this study explores the
following research question:

Should EBITDA be worked as the main predictor of a target investee’s valuation

for PE firms?

It is not uncommon for family businesses to stick to the same old approach year after
year since they were found to stick with what worked best for them once. As any
generic strategy may not always be adequate, especially when significant strategic
change is eventually required to keep up with the competitiveness of the market
environment considering new technologies. The existing paradigms of strategic choices

3
http://new.sandbarinvestments.com.au/wp-content/uploads/2021/10/Family-offices-set-to-play-bigger-role-in-
Australian-MA-driven-by-diversification-higher-returns-_-Mergermarket.pdf

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must be abandoned in favour of the methods that allow for the firm's strengths to be
leveraged to take advantage of potential market opportunities (Robinson, 2007, p2(2)).

The collaborating members of the research group in this study, while sharing their
academic backgrounds in economics, commerce, and finance, were able to identify
during the preliminary assessment about their target firm’s reliance on a crucial
measure that was prone to biases and misinterpretations and had a lower correlation to
market value than was generally perceived by PE firms. All the collaborating members
contend that there are superior measures for the investee’s valuation that PE firms in
general and the target firm in particular should consider adopting to replace EBITDA or,
at the very least, to supplement it.

Firstly, this study highlights some of the major demerits of EBITDA as a primary
valuation metric used by PE firms. Secondly, this study explores the other available
techniques claiming to offer robust results for valuation. Thirdly, this study will perform
the correlations and regressions on the valuation figures offered by the previously
identified valuation tools as applied on the data of sample companies in the selected
sectors. Fourthly, this study will comparatively discuss the findings of the correlation
and regression models. Finally, this study will advise about the suitable technique of
valuation for PE firms.

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 References

Dawson, A 2011, ‘Private equity investment decisions in family firms’, Journal of Business
Venturing, vol. 26, no. 2, https://doi.org/10.1016/j.jbusvent.2009.05.004
Gompers, P, Kaplan, SN, & Mukharlyamov, V 2016, ‘What do private equity firms say they
do?’, Journal of Financial Economics, vol. 121, no. 3,
https://doi.org/10.1016/j.jfineco.2016.06.003
Holloway, I, Lee, HS, & Shen, T 2016, ‘Private equity firm heterogeneity and cross-border
acquisitions’, International Review of Economics and Finance, vol. 44,
https://doi.org/10.1016/j.iref.2016.04.001
McKinsey, 2022. Private markets rally to new heights - Annual Report 2021. [online] McKinsey,
https://www.mckinsey.com/~/media/mckinsey/industries/private%20equity%20and%20principal
%20investors/our%20insights/mckinseys%20private%20markets%20annual%20review/2022/mckinseys-
private-markets-annual-review-private-markets-rally-to-new-heights-vf.pdf

Tappeiner, F et al. 2012, ‘Demand for private equity minority investments: A study of large
family firms’, Journal of Family Business Strategy, vol. 3, no. 1,
https://doi.org/10.1016/j.jfbs.2012.01.001

Wood, G & Wright, M 2009, ‘Private equity: A review and synthesis’, International Journal of
Management Reviews, vol. 11, no. 4, https://doi.org/10.1111/j.1468-2370.2009.00264.x
 

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