Private equity: Déjà vu all over again?

At Crosbie & Co, we pay close attention to private-equity-deal activity in the mid-market, as it is an important barometer for broader M&A market conditions.

In a report we released this month, we reviewed the recent activity levels of private-equity firms across North America compared with prior periods, and analyzed the valuation and capital-structure data for mid-market deals in the periods before and after the 2008 financial crisis.  The report provides some important perspectives that we believe would be relevant for business owners (particularly those contemplating a sale), for potential acquirers, and for their respective transaction advisors.

The following has been adapted from our report for PE Hub Canada readers. We hope you find it interesting.

North American private-equity data cited here were provided by GF Data and Pitchbook.

Private equity in the mid-market

“Those who cannot remember the past are condemned to repeat it.”

– George Santayana, Spanish philosopher and poet

Valuation and leverage multiples in the mid-market segment of the North American private-equity market have recently exceeded the highs of the pre-financial-crisis era, making us wonder whether both sponsors and lenders are suffering from a severe case of selective amnesia, forgetting (or perhaps repressing) the painful years from 2008 through 2010.

However, this frothiness appears to be much more pronounced in larger deals, as well as premium-quality businesses, and has failed to result in a flood of transactions in the lower mid-market.

Are we heading for another crash comparable to what occurred in 2008? It is possible; but despite the recent market dislocation, we consider it unlikely. There is, however, the distinct possibility that many of the high-value high-leverage purchases being made in the current environment represent excessive risk at a very uncertain point in the economic cycle.

Richard Betsalel
Richard Betsalel, Managing Director, Crosbie & Co

Given the cross-border nature of North American private-equity deal-making, as well as its importance to Canadian M&A trends in general, we believe these trends are instructive for the domestic market.

In our report, we attempted to provide some insight into the underlying factors driving the current market conditions, and reiterate our view that it remains a sellers’ market and a great time for business owners to consider a sale or other liquidity event.

Valuation: Is the sky the limit?

Private-equity firms have recently pushed purchase-price multiples above levels last observed during the debt-fuelled run prior to the 2008 financial crisis, particularly at the upper end of the mid-market (US$100 million to US$250 million) where the average multiple has moved to 9.0x EBITDA, well above the long-term average of 7.6x EBITDA. In addition, businesses with above-average EBITDA margins and sales growth traded at 7.4x EBITDA in 2015, a 23 percent premium to other buyout targets.  This “quality premium” was higher than the historical spread of 6 percent.

Similar overheated multiples, however, are less prevalent in the lower midmarket, where multiples are trending only slightly above their long-term averages.  What is be­hind this discrepancy in valuation multiples between smaller and larger companies?

  • Availability of leverage: Larger com­panies are generally capable of sup­porting greater levels of leverage, allowing buyers to use more aggressive bid­ding strategies.
  • Competition: Both private-equity and corporate buyers have mountains of cash to deploy. The focus has been on larger companies that are more likely to ‘move the needle’ in respect of future portfolio returns or corporate earnings.
  • Risk profile: Larger companies tend to be more diversified (geographic, cus­tomer base, product lines), have more established professional management teams, and are generally more capable of withstanding market downturns.

Deal volume

Despite an increase in valuations and plenty of capital available to support deals, the number and aggregate value of private-equity transactions remained relatively flat in 2015 compared with the prior year.

Why have we not seen a meaningful uptick in private-equity deals?  Given the positive conditions for M&A, we can only point to a short supply of quality targets. For the past 10 years, market pundits have been forecasting a veritable tsunami of succession-driven M&A activity as the baby-boom generation began to retire. However, the leading edge of boomers (born in 1947) appears to be holding onto businesses well past the expected retirement age and, as a result, the wave of succession deals has yet to materialize.

Although we do not have any data explaining this trend, we have some thoughts based on our extensive experience working with mid-market business owners.

  • No succession plan in place: Not having a qualified management team in place to run the business in the absence of the owner can make the business significantly less attractive to potential buyers and private-equity firms in particular.
  • Loss of income: In the current interest-rate and investment climate, business owners cannot reasonably expect to replace the income from their businesses by investing the proceeds from a sale. This is often a significant barrier to selling the company.
  • Investment alternatives: Given the current low-interest-rate environment and volatile capital markets, many business owners are often not comfortable with the alternatives for investing the sales proceeds and elect to remain invested in their businesses.
  • Taxes: The prospect of paying taxes on the sale of a business is often a deterrent for owners.
  • Performance: With the U.S. economic recovery continuing to trend up, many company owners are expecting the recovery to drive improved performance in their operations and further boost the value of their businesses.

Transaction leverage: hitting new highs

Similar to last year’s market environment, debt financing remains cheap. In fact, many banks and other lending institutions have become even more aggressive as they compete to deploy capital. This has resulted in leverage multiples for mid-market deals exceeding pre-financial-crisis levels. This has been true for both smaller and larger transactions.

For deals completed in 2015, senior and total debt multiples averaged 3.0x and 4.0x EBITDA, respectively, increasing over a quarter of a turn compared with 2014.  Larger transactions (US$100 million to US$250 million) had on average over a full turn of leverage more than smaller transactions (US$10 million to US$25 million). In fact, senior lenders have been particularly aggressive in 2015 in response to competition from other products, resulting in senior-only deals averaging 3.8x EBITDA.

Interestingly, sponsors used existing platform companies to support much higher levels of debt compared to last year to complete add-on acquisitions. In 2015, senior and total debt multiples averaged 4.4x and 5.2x, respectively, for add-ons, compared with 2.9x and 4.0x debt multiples of last year.

As a result, capital structures have become more aggressive, with equity-contribution levels falling to 43.5 percent, just a notch above the pre-financial-crisis level of 42 percent. This has allowed private-equity firms in many cases to outbid strategic buyers.

It will be interesting to see how capital structures are affected going forward by the U.S. Fed’s recent rate hike, the potential for future rate tightening, and the recent spike in yields for high-yield debt.

PE portfolio inventory: a growing overhang

About 6,000 PE-backed mid-market companies are out there, up 131 percent since 2005. However, a significant portion of this inventory is aging, with 44 percent having been acquired in 2010 or earlier. In some cases, private-equity firms have struggled to exit these investments, resulting in median hold periods increasing from just over 3 years in 2008 to 5.5 years in 2015.

This situation has led to a significant overhang and created a large number of zombie funds (pools consisting mostly of unrealized aging investments). The number of zombie funds could grow if private-equity owners are unable to find buyers.

However, S&P 500 companies have more than US$2 trillion of cash on their balance sheets, and mid-market private-equity funds have a record US$360 billion of dry powder that is itching to find a home. This leads us to believe that there is significant opportunity for M&A deal-making to pick up as the overhang is cleared and older portfolio investments are finally sold.

You can view the entire Crosbie report (including charts) by downloading it here.

Richard Betsalel is a managing director at Crosbie & Co and has over 15 years of corporate finance and M&A advisory experience. Based in Toronto, Crosbie is a provider of independent advice and investment banking services to private and public companies, business owners, families and shareholder groups.

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