The strength of the auto retail market and the improving economy will drive dealership acquisition activity and blue sky values throughout 2015 and into 2016. From my vantage point as a buy/sell advisor, I see three important market trends impacting the 2015 buy/sell market: (1) increasing reliance on acquisition financing; (2) declining generational transfers of dealership ownership; and (3) increasing investment activity by outside investors.
Increasing Reliance on Acquisition Financing
The lending market is once again enamored with auto retail. Auto dealers have gone from being the pariahs to the darlings of the financial community. This is of no surprise given the strength of auto retail. Dealers earned a record level of profits in 2014 (estimated at $1.1M for the average dealer according to NADA). Their balance sheets are as strong as they have ever been and their return on equity is at an all-time high of 31.9%. The public dealership groups, amongst the largest companies in the industry, also experienced record profits in 2014 and have been rewarded by Wall Street with an aggregate market capitalization growth rate four times faster than the S&P 500.
The dealership lender landscape is highly competitive. New banks have entered the market, while other banks have re-entered after exiting during the recession (sometimes a tough sell to some dealers!). These lending institutions are anxious to increase their auto retail market share and are increasingly willing to finance dealership acquisitions on aggressive terms in order to win business. For instance, several institutions who have offered dealers 100% financing on both blue sky and real estate (effectively a zero money down acquisition) if the dealer brings their whole loan portfolio to that particular bank. In addition to increasing the amount that can be financed, the spreads on these acquisition loans have declined to razor thin levels. The banks find it particularly difficult to compete with the captive finance companies who have been growing their lending portfolio and are often very aggressive with acquisition financing, particularly when they are fond of the buyer.
The effect of more aggressive acquisition financing is higher prices. The more buyers can finance at very low rates, the less sensitive they will be on price. The one caution is that the more leveraged the acquisition market becomes the more sensitive it will be to interest rates, which are expected to rise this year, albeit slowly.
Declining Generational Transfers of Dealership Ownership
Dealerships and dealership groups have grown tremendously in value over the last decade. The average dealership (including real estate) appreciated 92% in the last 10 years and the average dealership group, which consists of ~3 dealerships is worth an estimated $35.7 million ($11.9 average dealership value, including real estate, times three). At those valuations, fewer dealers are choosing to pass down their valuable assets to the next generation. Rather, many are choosing to sell their dealerships and dealership groups and capitalize on today’s high values. This is particularly true for those who are keenly aware of the changing auto retail landscape. The effects of this generational shift combined with the ageing of the dealer population will result in a growing number of dealerships and dealership groups coming to market while the buy/sell market is strong and valuations remain high.
Increasing Investment Activity by Outside Investors
Our industry is enthralled by the billions of dollars of private equity and family office money seeking to invest in auto dealerships today. Many assume these groups are less sensitive to acquisition pricing. This could not be further from the truth. The reality is that these investors are experts at valuing private businesses to achieve a strong return on investment. Most are interested in auto retail because they believe they can achieve attractive investment returns relative to the alternatives in today’s low-yield market. This does not mean they are willing to overpay. These investors are disciplined about their investment strategy. Their financial models, not their ego, drive their pricing decisions.
This investment discipline has resulted in more talk than action. Many private equity firms and family offices have come very close to making big acquisitions, only to back out of the deal after extensive due diligence proved their financial models and investment returns incorrect. With these investors, the purpose of due diligence is to validate investment assumptions and financials models. If either comes up short, they will not do the deal, regardless of how much time and money they have spent.
Not all private investors are seeking the same returns. Family offices, which are firms created by high-net worth families to invest their own capital are often more focused on wealth preservation. These group are sometimes willing to accept lower yields for capital security. They are less likely to deploy leverage and are not looking for turnaround opportunities. Generally, family offices are focused on top luxury and non-luxury import franchises, such as Mercedes, BMW, Lexus, Toyota and Honda. Assuming a pre-tax return in the range of 10% to 20%, the blue sky multiples what a group would pay for an average performing dealership, which would be in the range of four to six times, with the rare case of a nine times for a top luxury franchise.
Private equity firms are very different from family offices. These firms are investing other people’s money and are paid to achieve very high returns (i.e. 25% plus). In order to do so, private equity firms are willing to take risks. They will deploy leverage to achieve their returns and are willing to invest in turnarounds. Given their return requirements, it is difficult for these groups to invest in luxury franchises and top non-luxury import franchises (they also have a hard time getting approved by these OEMs). As such, I see these groups investing primarily in non-luxury franchises and their valuations are expected to range between a three and five multiple, with the rarer case of a seven multiple for a very attractive underperforming dealership with the opportunity to double earnings.
Note: As interest rates rise, so too will the return requirements of these groups. When returns increase, multiples decline.
In closing, blue sky values will likely remain high into 2016. I also expect that rising interest rates will eventually impact dealership earnings and put pressure on multiples and blue sky values, though I cannot predict how much or when (my crystal ball is not that good!). Until then, sellers can still enjoy very high values and buyers can still enjoy very attractive financing. As a dealer recently told me, everything is awesome in the 2015 buy/sell market!