Deal Multiples Continue Ascent

One thing is certain: private equity firms are not afraid to pay a premium. Awash with both capital and confidence, general partners today are acquiring companies at purchase price multiples that are, on average, the highest they’ve paid in the last decade.

What’s more, this phenomenon is taking place market-wide, regardless of deal size. Transaction multiples in the large and middle markets have been increasing ever since the end of 2001, and if they continue on their current trajectory, 2006 will shape up to be the most expensive year in the history of the asset class.

“It’s the continuation of a trend; lenders are lending at attractive terms, financial buyers are flush with cash and strategics are back on the prowl.” says Harris Williams & Co. Managing Director Glenn Gurtcheff. “I expect the rest of the year is going to be pretty busy, too. You don’t have to keep your ear to the ground too long to hear about a lot of product coming to the market in the fall season.”

For the first half of 2006, the average deal multiple paid for companies at the lower end of the market (defined for these purposes as companies with $50 million or less in EBITDA) was about 8.6x earnings, a full turn higher than the 7.6x average of 1997, which was the peak year of the last market cycle, according to Standard & Poor’s Leveraged Commentary and Data. Last year, mid- and small-market deals carried an average purchase price multiple of 8.5x EBITDA.

At the larger end of the market, which includes deals for companies with EBITDA of more than $50 million, the average deal multiple paid was around 8.6x, according to S&P. If those multiples remain at their current state, then 2006 is on par to out-do the average 8.2x multiple that adorned PE transactions in 2005, the current record-holding year.

It’s not hard to find instances of the market’s current zeal. The $13.7 billion take-private of Univision Communications Inc. values the company at a lofty 16x its estimated 2006 EBITDA, while the recently agreed-to $22 billion sale of oil-and-gas pipeline giant Kinder Morgan Inc. works out to more than 13x its LTM EBITDA for June 2006. Meanwhile, crafts supply retailer Michaels Stores Inc. is set to be taken private from the New York Stock Exchange in a deal that values it at about 12x EBITDA, or $6 billion.

To be sure, the generous debt markets are contributing to the market’s overall vim, and debt multiples are, according to S&P LCD, equally impressive. Debt-to-EBITDA multiples for the first half of this year weighed in at about 5.3x for the large market and about 4.75x for the middle market—nearly matching 1997’s figures of 5.7x and 4.77x, respectively.

“The number of people willing to lend at attractive multiples has expanded immensely over the last five years, and borrowers are like investment bankers: they will always use competition to get more attractive terms,” Gurtcheff says.

David Brackett, a senior managing director at GE Antares Capital, holds that today’s high multiples are justified because firms today are investing in “real companies” with proven earnings, established market positions and strong management teams, as opposed to the irrational exuberance of the previous cycle, when buyout firms got caught up in the venture style of investing and started chasing growth stories as opposed the stable, cash flow generators that have historically been their bread and butter.

Moreover, interest rates are still about 150 to 200 basis points less than they were in the 1997-98 period, so companies are in a better position to support more debt, Brackett says.

Recalling Returns

A loose credit environment is not the only driver behind the market’s froth, says Justin Abelow, a managing director at Houlihan Lokey Howard & Zukin. “There has been a secular decline in the cost of capital and the equity guys are willing to accept lower returns because they have so much money to put to work.”

Indeed, buyout firms so far this year have already raised more than $100 billion in dry powder, on top of the record-breaking $173.5 billion that was raised last year, according to information compiled by Buyouts.

“Based on how firms are bidding for deals, I think they are definitely lowering expectations…Today, I’d say that they’re down to the 16% to 22% range,” one GP says.

But that’s not necessarily a bad thing, according to some market participants. Rather, the phenomenon can be likened to a buffer that allows firms to better hedge against an unforeseen occurrence while still being able to markedly outperform the public markets.

“For many deals completed in the late 1990’s sponsors expected returns in the low to high 30% range,” Brackett says. “In hindsight, [those] return expectations were unrealistic, as many of the value creation strategies were flawed. Many were dependent upon growth tied to the Internet, failed roll-ups or industry consolidation plays that lacked. In these cases, sponsors swung for the fences and in many cases whiffed and were left with nothing.”

“In today’s environment,” he adds, “we see sponsors bidding up purchase prices aggressively, resulting in IRR targets in the high teens and low twenties. The difference is that they are acquiring real businesses with proven track records as demonstrated by their performance in the last cycle. As a result, the beta, or volatility of returns, is drastically reduced.”

Evolving Debt

As private equity firms opt to take on more and more debt, they are pushing for better borrowing conditions from their lenders as a way to save money and protect their investments.

“There have been big changes in the way GPs finance their deals since the last cycle because now they are competing on terms as well as purchase price multiples,” Abelow says, “The same now holds true in the credit market. Terms, in a way, have become the new price.”

On top of that, some private equity firms are looking for more creative ways to secure financing for their deals. Take for instance the acquisition of Dunkin’ Donuts by Bain Capital, The Carlyle Group and Thomas H. Lee Partners, which lined up about $1.7 billion in asset-backed financing linked to a securitization of nothing more than the company’s intellectual property.

The acquisition of Hertz Corp. is another example of success through non-traditional financial engineering. To finance that deal, the buying group (Clayton Dubilier & Rice, The Carlyle Group and Merrill Lynch Global Private Equity) put together more than $12 billion in debt in a multi-layered structure. It included two separate multibillion-dollar asset-backed loans to cover Hertz’s U.S. rental car and equipment rental businesses; a more customary (albeit large) bond deal—both senior and subordinated notes—as well as traditional bank debt. On top of that, the consortium put in place a bank-led ADS-like structure in Europe to finance Hertz’s European car fleet.

“The level of sophistication is spreading industry-wide,” Abelow says. “Even in the lower and middle markets we’ve seen, for example, financings done using intellectual property and brand names as collateral, covenant-light structures, highly customized amortization packages and other bells and whistles.”

Preparing For The Pinch

Over the last two years, an untold number of market participants have been quoted saying something to the effect of, “The market will take a turn sometime in the next 12 to 18 months.” Despite the dour prognostications, here we are 18 months later, and the market continues its meteoric rise.

But that’s not to say that buyers today aren’t taking precautions anyway. GE Antares’s Brackett says he’s seen a number of sponsors making sure they have a lot of liquidity in transactions, utilizing vehicles such as outsized revolvers that are able to be tweaked to meet changes in the economy.

“We have also been getting more requests from sponsors to use an institutional amortization schedule to pay down the debt, so instead of requiring them to make large principal payments, we do sweeps of the company’s cash flow at the end of the year. This provides them with more flexibility if the borrower experiences a bump in the road,” he notes.

Additionally, Brackett says that some sponsors are electing not to take the most aggressive debt deal available, as they are concerned about the potential of an economic cycle and don’t want to overburden a business.

“We’ve offered sponsors the choice of syndicating a deal to friends and family versus a broad retail distribution,” Brackett says. “The friends and family deal may not be structured and/or priced as aggressively, but the sponsor knows their partners will presumably be more amenable to working with them through tough times.”