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Recently I discussed the financial themes that I believe are driving consolidation in the industry. Specifically I discussed why a low cost of capital combined with multiple arbitrage is driving investment and consolidation in the collision industry. (Editor’s note: It is not only the collision industry undergoing profound transformation. Keep an eye out for upcoming articles discussing other adjacent industries that are undergoing rapid consolidation as well).
This week I thought it was important to spend some time explaining the financial mechanics of the cost of capital, and how a low rate environment impacts the entire financial ecosystem. Be warned, this delves into the realm of financial geekdom but has significant implications for your business which we will discuss later in the article.
The Cost of Capital
The cost of capital in its most simple form can be thought of as the interest rate. An interest rate is the compensation the market demands for bearing the risk of an investment. Capital is the financial resources available for use by a company and are primarily debt or equity. In business school they taught us that everything has a cost and they taught us the financial models that are used to derive the cost of just about anything, including both debt and equity.
While there are complex models to determine the appropriate cost of debt, the simplest way to determine your specific cost of debt is to call up your banker and ask what the interest rate would be on a 10 year loan. That is it – I told you it was complicated. But in all seriousness, essentially the interest rate that she quotes is based off the risk free rate (i.e. government bond rate) plus a spread, or markup the bank charges to compensate it for the risk of lending to your business.
The cost of equity is a bit more difficult to establish. Whereas we are accustomed to paying the cost of debt on a monthly basis, the cost of equity is much more esoteric. The cost of equity can be thought of an opportunity cost, or the cost of forgoing the next best investment. Determining the cost of equity essentially uses the same mechanics as determining the cost of debt.
The cost of equity is derived using a very specific formula called the Capital Asset Pricing Model, or CAPM. The most simplistic way to think about CAPM is that the cost of equity is a blend of the overall economic risk free rate (i.e. 10 year government debt) and a specific equity risk premium that incorporates the risk of an underlying asset, i.e. your business. Similar to the way the bank combines the risk free rate plus the spread, CAPM combines the risk free rate plus company specific risk (which is much higher than the banks spread).
How the Cost of Capital Affects the Economy and Your Business
The reason understanding how to calculate the cost of capital is important is because it drives the pricing of assets throughout the financial world, including your individual business. As previously discussed, private equity has entered the collision industry more as a result of the low cost of capital rather than any structural change in the industry. The industry has seen collision repair businesses acquired by private equity groups for what were previously unthinkable multiples of EBITDA. Many people refer to the rapid pace of acquisitions as a “feeding frenzy” and while there are legitimate strategic reasons acquisitions are picking up in pace it is important to understand the structural reasons increased consolidation makes financial sense.
A significant reason the industry has seen overall investment in the industry increase at such a rapid rate is a result of the low cost of capital as a result of years of zero interest rate policy enacted by the Fed. This is important because a key part in determining the price of a business is understanding a company’s Weighted Average Cost of Capital, or WACC.
Because companies are financed through a combination of debt and equity, WACC looks at a company’s borrowing costs as well as a company’s equity cost to find an average cost of capital for the business. This cost of capital is used when building a valuation model (for specifics, shoot me an email).
In general, the lower the average cost of capital, the more valuable a company. This is intuitive – if a company can lower its financing costs, it can raise capital at a lower cost and reinvest in similar projects as its competitors and realize a higher return.
But understanding the underlying mathematics mechanics is important as well. Understanding how WACC impacts the value of a company is straightforward (if slightly mathematic). WACC is expressed in terms of a percentage, just like an interest rate. Algebra tells us that when any number is divided by a decimal the result is a large number. Therefore as the weighted average cost of capital decreases the overall value of any asset increases. Numerically, you can fact check me. 10 ÷ 0.10 = 100 and 10 ÷ 0.01 = 1000.
For many years the fed has kept the risk free rate low, essentially zero. Because the risk free rate is the building block in determining both the cost of debt and the cost of equity, the result of low rates is that the WACC for many companies has dropped substantially over the past few years. Thus we have seen an increase in asset values across the financial world. Both the stock market (equity) and the bond market (debt) are at record highs. Real estate has surged in many parts of the country and the world. Inflation though tame domestically is rampant in most of the developing economies outside the U.S. and Europe.
If you made it this far through the article (and I congratulate you if you did – I barely made it this far), I would not be surprised if you wonder, “What does this have to do with my business?”
The thing about consolidation is that it is not unique to the collision industry. In fact, a number of industries around the collision industry are in the midst of consolidation. Those industries are consolidating for many of the same financial reasons that are present in the collision industry.
The federal fund rates, and interest rates in general are not constant. As rates begin to rise (or normalized, depending on your perspective) what will the impact be on your business?
If you are looking to grow and expand and need to take on outside capital, whether that be through raising debt or taking on an equity partner, as rates begin to rise, how will that impact your ability to raise capital? As the cost of debt rises, does taking on an equity partner become more attractive? If so, will a future equity partner expect greater returns in a higher rate environment?
How will rising rates impact equity funds themselves. As their cost of capital rises, will they continue to invest in the collision space or pare back investments to seek out targets with different growth, risk, or profitability profiles?
If I am an owner considering a sale now, how will a rising rate environment impact the valuation of my company? If I am an owner who recently sold and am carrying paper (financing part of the transaction), how will a rising rate environment impact the business I sold? Will my note to the company be adequately protected in the event of a negative event?
How will a changing rate environment impact the investment decisions of largest players in the market? As the cost of acquisitions increases, do brownfields and greenfield begin to make more sense? How does a rising rate environment impact the projected rate of return for a brownfield relative to an acquisition?
These are just a few questions to consider. There are additional strategic and operational questions to consider as well, like how will my vendors react in a new rate environment? Will my customers change payment terms? The questions are endless. The financial landscape is in constant change and there are a lot of factors to consider when planning for the future.
What do you think? How will a changing rate environment impact your business? I am very curious to know.
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As always, if you would like to discuss the strategies available to you in more depth please feel free to send me a note on my contact page. I find all of this fascinating. All communication is kept extremely confidential.
Feeding Frenzy High Impact Reserves Definition
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Until next week.
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