When private equity folks get together, they’re likely discussing valuations for the middle-market businesses they are buying or selling. And, when those people are the business development professionals within their firms responsible for finding companies to buy, these conversations can be depressing, and have been for quite a while.
Since 2009, valuations for middle-market, change-of-control transactions have slowly and steadily increased. Expressed as a ratio of enterprise value to trailing 12 month-EBITDA, middle-market deal multiples rose from 7.6x to 9x between 2009 and 2018, and up to 9.9x for the first nine months of 2019, according to Robert W. Baird & Co.
There are a number of reasons that conventional wisdom offers as explanations for why valuations have marched up the staircase over the last decade.
Supply and demand/dollars available for investment. Institutional investors doubled down on private equity during the 2010s and poured money into the asset class. Committed capital available for use by U.S. sponsors increased steadily, from $424 billion to $695 billion between 2010 and 2018. Abundance induces value.
Supply and demand/Companies available for investment. Eight years ago, we licked our wounds after the troubles brought by the recession. We soothed ourselves with the belief that with baby boomers starting to age out, they’d be selling their businesses to us and we’d be awash in opportunities. For a brief moment, we were right. The number of middle-market M&A transactions jumped from a cyclical low of 3,313 in 2009 to 5,398 in 2010. For the rest of the decade, however, we have been wrong. In 2018, transactions totaled 3,101, the lowest value of the decade. Scarcity induces value.
Lender aggression. Sponsors buy businesses with a mixture of borrowed money and committed equity capital from the funds they administer. How much to borrow? It depends upon how much lenders are willing to lend. Measured by average total debt/EBITDA multiples over the last 10 years, lenders today are more willing to lend additional dollars against a dollar of EBITDA than ever before. These values rose from 4x to 5.8x between 2009 and 2018. More access to borrowed money translates into a higher price a sponsor can pay.
Historically low cost of capital. Not surprising to anyone who has borrowed money since the Great Recession, cost of capital available to borrowers generally, and those borrowing to finance a leveraged buyout in particular, remains well below long-term historical norms. In finance class, they taught us that the long-term risk-free rate in the U.S. economy (think prices for 30-year Treasury bonds) averages 6 percent. That value at this moment is 2.4 percent, and yields have fallen pretty much in a straight line from 14 percent in 1981.
It might cause the casual observer to wonder how sponsors can continue to pay more and more for the businesses they buy and still generate returns satisfactory to their investors. I propose another factor driving increased valuations: Sponsors have figured out how to build value in the businesses they buy.
Thirty years ago, in the nascent years of our asset class, the formula for success was simple: Buy at four times EBITDA from an uninformed seller, with 10 percent down and 90 percent borrowed from a bank, whack some costs, massage working capital, sell off unneeded assets, automate the office, figure out who really needs to own the company next and sell that company at seven times EBITDA.
This “multiple expansion,” overlaid on high financial leverage, enabled outsized returns. In the 1980s, and well into the ’90s, sponsors targeted (and often enjoyed) annualized IRRs in the mid-30 percent range. Not surprisingly, this attracted attention. Committed capital trickled into the market, then flooded it, and competition amongst buyers increased.
Sell-side intermediaries emerged and held auctions on behalf of sellers, and prices started to bump higher. Debt providers began to insist upon higher equity contributions, and leverage dropped as a result. Soon, it wasn’t enough to simply find a decent company to buy. In an increasingly competitive market, sponsors who wished to survive needed to figure out how to build value in the businesses they bought.
Today, successful sponsors have developed tools and techniques that build value in their portfolio companies. They engage their management teams in strategic planning, they specialize in specific industry verticals and become experts in their field, they implement buy-and-build programs, and they engage operating partners to actively assist and augment management teams.
They have gotten better, perhaps even good, at owning businesses, and this trend should continue into the next decade. The world of middle-market M&A transactions is more efficient than it was 30 years ago, but private equity has managed to stay afloat and satisfy its aggregate investor base so far. To the extent that sponsors continue to deliver operationally oriented value creation to their portfolio companies, this party has a chance to carry on well into the next decade.
Jim Marra is Director of Business Development at Blue Point Capital Partners. Before joining the group, Jim held various positions with Citicorp in the leveraged capital, investment banking and venture capital groups.
