Yellowstone Cattle Bank (YBC) Essay

Introduction

If I were Tad O'Malley, I would recommend that EIG purchases Yellowstone Cattle Bank since it offers the most benefits considering the cost, among other factors. YCB is a privately-held company providing payment processing services to small and medium-sized merchants and home businesses which accepted credit. This deal is a venture capital transaction since EIG will not automatically acquire 100% of the YCB since only 40% of YCB's stock is available.

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Pros or Merits of the Transaction

YCB is a suitable transaction since the company's profitability is high. YCB's operating income was $10.1 million in 2004 implying that it operating activities were profitable. Besides, its earnings growth rate is high. Its earnings grew by 48% from $6.8 million in 2003 to $10.1 million in 2004. That was a steady growth in income considering that its break-even was just in 1999. Based on the analysis by O'Malley, YCB's incomes are expected to increase at 20% annually for the next four years if EIG acquires it. The net income is also expected to grow at 20% for the next four years. Strong positive growth in earnings is vital in a leveraged buyout (Pilger, 2012). This is because a high earnings growth rate increases the value of the company (Pilger, 2012). As a private equity company, the most important thing is the appreciation in the value of the acquired company (Baker, Filbeck & Kiymaz, 2015). This will ensure that EIG sells the company at a profit hence improved its performance in leveraged buyouts and other transactions.

Secondly, YCB has a strong customer base that is growing at a favorable rate. In previous five years, YCB's customers increased from 12,000 to 40,000. This represented an annual growth of 27%. The customer base is also expected to rise to 77,000 going forward. The strong customer growth numbers indicate that the company has a high potential for growth and profitability. Private equity funds primarily focus on companies and businesses with strong growth potential (Stowell, 2010). They invest capital and expertise to exploit the growth potential of the acquired businesses to increase their enterprise values. With such high customer growth rates, the value of YCB can only increase implying that EIG can make substantial profits from the transaction (Ross, Westerfield & Jaffe, 2008). If the growth in customer numbers continue, EIG would be sure of selling the company at a higher price than the purchase price.

Besides, the growth of YCB's earnings and customer base is attributed to industry-wide factors. The overall growth of the payment services industry contributed to the growth of YCB over the last five years. In the past five years, credit card dollar volume rose by 74% while the use of credit cards also increased from 15% to 20%. It is expected that this industry growth will continue since the contributing factors are likely to persist. More developing nations are adopting non-cash payment methods hence the payment services industry is expected to continue its rapid growth. This will increase the performance of YCB thereby benefiting EIG and its shareholders. The potential of the sector of a target firm is one of the most critical considerations in private equity transactions (Lerner, Leamon & Hardymon, 2012). Private equity should acquire a target that operates in an industry with a high potential for growth and profitability. Even if a firm is growing at a rapid rate, the growth will most likely fall if the overall industry is slowing down Demaria, 2013).

The transaction will also be beneficial to EIG since YCB is undervalued. The value of YCB was expected to be $75 million which is 50% of the comparable public market valuation. In the last one year, similar companies sold for 30.1x while YCB has a multiple of 12.6x. This indicates that the company is undervalued hence it is a good buy. When selecting investments, a private equity firm or any other investor should consider undervalued stocks (Franke, 2015). This is because undervalued stocks tend to rise towards to the intrinsic value thereby generating profits for the investor. However, the value of overvalued firms usually declines towards the intrinsic value in the long-run thus leading to losses to the investor (Povaly, 2007). Considering the situation at EIG, YCB is a good investment. Empire's strategy is to buy cheaply, leverage highly and sell at high prices through IPOs and other exit strategies (Povaly, 2007). It also had a 'resource problem' implying that it needed to control purchase costs. YCB is going at a multiple of 12.6x while other comparable firms were selling at 30.1x. This means that Empire would acquire YCB at a cheaper cost.

Cons and Risks Associated with YCB Transaction

A passive investor privately owns 60% of YCB hence it is not a typical leveraged-buyout transaction. Empire will not be able to have significant control of the YCB. The influence is likely to be limited to the extent specified by the shareholder's agreement. This will limit the ability of EIG to transform YCB to improve profitability. In a typical leveraged-buyout, the private equity fund has a significant influence on the operations of the target entity (Cumming & Johan, 2014).

YCB does not have an effective management. It has a strong-willed CEO who frustrates his second-in-command. Although he has posted strong performances over the past years, such management style may derail the success of the target. A thriving private equity-acquired firm needs an effective management to ensure steady growth in earnings. This will be important since EIG will not have absolute control over the management of YCB since it will acquire only 40% of YCB's stock.

Besides, the acquisition of YCB will improve EIG's international presence. EIG's objectives are to do business overseas. YCB is in the US where EIG already has a strong presence. The two other investment alternatives are located in Germany and UK. Diversification of markets is essential to spread risks and increase revenues.

Lessons from the Assignment

The assignment has enhanced my understanding of the considerations made when evaluating private equity transactions. A private equity fund must consider the current and expected earnings of the target firm to determine its potential for growth. It should take into account factors contributing to growth and determine whether they are temporary or persistent. I have also learned that it is better to buy undervalued companies since their values tend to rise in the long-run, unlike overvalued firms that lead to losses when their values fall towards the intrinsic value in the long-run. Besides, I now appreciate the importance of qualitative factors in private equity transactions. Although financial implications are critical, a firm must consider the qualitative impacts including the availability of PE partners, objectives of the firm, among other factors. For instance, if the firm aims at international expansion, targets from foreign countries are more preferable to domestic targets.

References

Baker, H., Filbeck, G., & Kiymaz, H. (2015). Private Equity: Opportunities and Risks. New York: Oxford University Press.

Cumming, D., & Johan, S. (2014). Venture capital and private equity contracting. London: Elsevier.Demaria, C. (2013). Introduction to private equity. Chichester, West Sussex, U.K.: Wiley.

Franke, A. (2015). Private Equity Minority Investments: An Attractive Financing Alternative for Family Firms. Cengage Learning.

Lerner, J., Leamon, A., & Hardymon, G. (2012). Venture capital, private equity, and the financing of entrepreneurship. Hoboken, NJ: J. Wiley & Sons.

Pilger, D. (2012). Leveraged Buyouts: A Practical Introductory Guide to LBOs. Harriman House.

Povaly, S. (2007). Private equity exits. Berlin: Springer.

Ross, S., Westerfield, R., & Jaffe, J. (2008). Corporate finance. Boston: McGraw-Hill/Irwin.

Stowell, D. (2010). An introduction to investment banks, hedge funds, and private equity. Burlington, MA: Academic Press/Elsevier.