We are often asked why smaller companies trade for lower multiples than larger companies.

There have been many textbooks written on the subject, most delving into sophisticated mathematical equations to explain the issue. I can recall lectures in graduate school, during which esteemed faculty members would write long equations on blackboards providing proofs that explained this capital market phenomenon – in minute detail. Some 35 years later, I have come to appreciate that my professors were right in their conclusions. While market players do not use blackboards and mathematical proofs to negotiate prices in M&A transactions in the aerospace and defense industry, their overall action proves without any doubt that size matters in M&A.

Over the past 23 years, since the founding of Alderman & Company, we have learned what truly drives buyer behavior. What we have seen time and again is that buyers of smaller companies are concerned about the real-world issues that make smaller companies’ earnings streams more volatile. These kinds of issues include but are not limited to reliance on one or more key employees, customer concentration, having a single site facility subject or susceptible to outages or natural disasters, limited compliance documentation, and deficient internal financial controls. We know that buyers use projections and discounted cash flows to price deals, and we know that their projections assume substantial uncertainty when they are acquiring smaller companies. And we have seen buyers demanding much higher returns to assume these greater risks.

Many buyers simply won’t bid for very small companies in the aerospace and defense industry. That is the first market action that drives down prices: a lack of buyers. Second, to attract buyers, the expected returns must be greater than the returns offered by owning larger companies that do not have those same risks, by the nature of their size. Together, these two factors explain the real-world behavior that we have seen for 23 years. And while buyers don’t use blackboards and mathematical proofs to price deals, their real-world behavior is 100% consistent with the lessons taught in textbooks and classrooms.

Have a great day everyone,

Bill Alderman
Founding Partner