Mid-Market PE Valuations: Where Up is Down
With U.S. stock markets near record highs, and M&A activity on-track for another big year, there has been much commentary about whether markets have once again detached from intrinsic value. By and large, the labour market has returned to normality, the housing market has recovered, and consumers are spending again. However, what's missing is any obvious catalyst for accelerating economic growth to drive corporate profits, and thus, boost markets any higher. This is all relatively common knowledge, but underneath this picture is the activity in the middle-market of private companies; an area that has some surprising facts of its own.
Traditionally, middle-market firms tend to be laggards of their public market brethren. This is often the result of their smaller size (which suggests greater risk), and liquidity discounts (because an owner cannot quickly dispose of their interest like an owner of a public company can). Recent experience by our team has turned this notion on its head.
Over the past few months, we were involved in a competitive sale process to acquire a niche-market retail company. This company had been able to carve out a segment of their industry that left them with few true competitors and subsequently had experienced consistent growth. Despite this growth, the company was still a regional player and thus had annual revenues of around $20MM, and EBITDA of approximately $2MM.
As part of our analysis of the company, we looked at some comparable transactions for public companies to get a feel for what sort of ballpark multiple we would be able to purchase the company for. Pure comparables were lacking, but thankfully, a large, public company in the same space had recently gone private through an LBO transaction at a multiple of 9.25x. Factoring in a liquidity discount of 30% put us at around 6.5x for our target.
After doing our homework and buying into the story of the company, we submitted an offer that was in the neighbourhood of what the public comparables were telling us. Unfortunately, our bid was not successful, but what we didn't expect was to find out how far off the mark we were. In fact, the winner had made an offer to acquire this small player for a whopping 10x EBITDA!
In our minds, there was no way to rationalize that sort of multiple. The company did have favourable growth prospects, but a lot of investment in infrastructure was required to take it to the next level, and further investment was needed to capitalize on geographic expansion. That's not to say we weren't willing to make those investments, but the prospect of additional cash outlays certainly affected the amount we would pay to acquire this business in the first place.
It wasn't until we revisited our original comparables analysis that we understood the magnitude of what this competing offer meant. A company that still had a considerable risk profile was being priced at a multiple that exceeded one for a public company that was orders of magnitude larger than it. But how could this be? Why would someone be willing to pay more for a business that by all measures didn't deserve it?
Which brings us back to the beginning of this article. With public market valuations feeling stretched, limited perception of further growth, and interest rates remaining stuck at historical lows, institutional investors are feeling the pinch to generate returns that can satisfy their funding requirements. In fact, in a poll conducted at the end of 2014, 40% of institutional investors surveyed by Coller Capital expected to increase their allocations to private equity in 2015.1 With more investors contributing capital to the private equity community, that means more capital chasing the same number of deals, which naturally boosts deal multiples.
The real question then becomes, can this trend continue? By our expectations (and with the help of some outside data), we're inclined to say it will. In particular, the current level of dry powder (private equity dollars waiting to be invested) recently reached a record high in the first quarter of 20152. According to a report by Preqin, a provider of private equity research, there is now $1.24 trillion dollars (US) of dry powder with private equity firms, of which 37%, or approximately $460 billion will be targeting buyouts. And if investors are planning to place more funds with private equity firms to invest, there's a good chance this figure will rise in the future.
Going forward, it is our expectation that there will be continued upward pressure on private market valuations; particularly in auction style sale processes. For this trend to reverse, there would need to a material reduction in the capital available for buyouts, or a change in investor perceptions regarding the relative appeal of private equity investments. For us, that means we will have to look that much further to uncover compelling investment opportunities with appropriate valuations in this current deal environment.