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.

1 http://blogs.wsj.com/privateequity/2014/12/15/investors-to-allocate-mor…
2 https://www.preqin.com/docs/quarterly/pe/Preqin-Quarterly-Private-Equity-Update-Q1-2015.pdf

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Comments (13)

Jul 3, 2015 - 12:01pm

Interesting post. I think there will be a significant thinning of the herd given that there is too much capital chasing too few deals which will drive up purchase price and diminish fund returns. I've spent my career on the outside spectrums ($B+ acquisitions and now VC type deals) but I think your points apply across all stages. I don't think there is any question though that VC valuations are the frothiest. It's fascinating how private capital has replaced or at least delayed the traditional IPO process.

Jul 3, 2015 - 4:42pm

I appreciate the article. However, the most important or value-added contributions that you could have made are missing because too much detail was left out to analyze appropriately. What were the growth prospects of the company and the market it is was in? How defensible was its competitive advantage within a larger company? How did you arrive at a 30% liquidity discount? How closely did the target resemble the public comp you were pricing it against (and in what stage of growth was the public comp in)?

If the above questions were more thoroughly answered an analysis could be done to see whether or not the high multiple (which I admit is high for a middle market consumer deal w/ 10% EBITDA margins) paid for the target was a result of the underlying business or the "dry-powder" syndrome.

I hear people say all the time that a certain multiple is "frothy" but one can only say that if they can find examples of other investment opportunities with comparable risk and reward profiles that are much cheaper. I always challenge people to show me a better deal in the alternative for the money as opposed to just saying such a comment in theory. Ultimately, if I pay 10x with 5x equity/5x debt (mezz and senior) for a company that I can grow at 10-20% over 7 years and then sell at 6x-7x or take public at an even higher multiple I am making some good returns.

Not trying to be too negative, but it would have been an amazing post if more detail was provided.

Jul 3, 2015 - 5:49pm

1) Details are intentionally lacking because it was a recent deal process. If too much information is included, there's the potential for someone to recognize the deal which reflects poorly on us at the buy side, and could potentially piss off the sell side which restricts our ability to good future opportunities.

2) 30% liquidity discount is a pretty standard estimate for private companies. No sense wasting a ton of time estimating the "right" liquidity discount when it's only a rough guideline for our offer.

"The power of accurate observation is commonly called cynicism by those who have not got it." - George Bernard Shaw
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Jul 3, 2015 - 9:05pm

Totally get it. Just saying I love the topic...would be very interested to hear what you think the returns will be for the firm that paid 10x...I'm assuming you modeled your returns a certain way (i.e. structure and growth)...can they make money at 10x? Could they beat 25% IRR (gross before fees)?

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Jul 4, 2015 - 12:56pm

While a good thematic write up, based on what you outlined I'm not sure if your specific deal is so outlandish. You comped to a going private transaction yet still gave it a 30% liquidity discount - doesn't make sense. There are also so many possibilities that I can think of that would warrant a high multiple for this sector that have nothing to do with frothy markets. Could have been pricing on a forward multiple with new store normalization, maybe there was had a portfolio company that could create synergies, at 20mm in revenue and an assumption of 1mm per store so 20 stores, at a 250-500k in per store build out, internal cash flows could support 20-40% growth in footprint making it possible to double or triple the foot print in just a few years, ecommerce growth, etc.

While there is the winners curse to some degree, I don't think its purely frothy markets and over supply of capital that led to such a disconnect. My guess based on what you outlined would by they other firm(s) knows retail / is more comfortable with retail than your firm.

The interesting point that you bring up about all the dry powder will be what happens if/when credit markets start to tighten and these LBOs aren't so "cheap" anymore. If anything that would likely push valuations down unless firms start writing larger equity checks, which I don't see happening all that much.

Jul 4, 2015 - 1:31pm

The current market is definitely pushing people further out on the risk curve.

"I am that I am"
Jul 7, 2015 - 8:53pm

Thoughtful write up. As an analyst on the LP side, we are seeing a lot of managers come in and talk about the competitiveness of the market. Looking at S&P LCD data, the average multiple at entry for LBOs EBITDA is roughly at 2007 levels (~9-10x), although they are typically investing 40-50% equity, rather than the 30-40% in 2007. There is just so much dry powder and pressure to put money to work it seems like PE shops are willing to bid marginally higher than they would in the past. I am aware that multiples are impacted by various factors, industry, size of company, etc. but the story of an ultra competitive market has been told by the majority of managers we have talked with.

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