Private Eye: Many deal pros see mid-market prices heading lower

Private equity is its own universe in many ways. But don’t expect that universe to be shielded from the same forces rumbling through the public equity markets in the first few weeks of January.

A survey of some 60 deal professionals and investors conducted by Buyouts Insider in December and early January found 30 percent of respondents predicting that prices would fall in the North American middle market over the next 18 months. Last spring, a similar survey found just 13 percent of respondents predicting a decline. Another 50 percent of respondents to the latest survey see level prices ahead. Just one in five (20 percent) sees prices heading higher.

And just where are prices? A separate, informal survey of six investment banks conducted in the same time period found a median enterprise value-to-EBITDA multiple of 9.8x for companies generating more than $25 million in EBITDA, and 8.5x for companies generating less than that. Reasonably strong credit markets have helped sustain those prices. The same survey found median total leverage multiples of 5.5x for the larger companies and 4.5x for the smaller ones. Survey participants included Carl Marks Advisors, Duff & Phelps, Harris Williams, Lincoln International, Raymond James and Stifel Investment Banking. Talks with investment bankers at these firms suggest prices have held roughly steady over the last year.

Asked about factors sustaining mid-market prices, Rob Brown, managing director and co-president of North America at Lincoln International, said: “There is a lot of money on the private equity side that still is under pressure to be put to work.”

At the same time, strategic buyers continue to see M&A activity as a way to meet shareholder demands for earnings growth. It has added up to demand that is simply “outstripping” the supply of “high-quality companies” available for sale, Brown said.

That said, Brown sees some signs of cooling off. Compared with several months ago, fewer bidders remain standing toward the end of auctions of high-valuation companies — possibly due to “fatigue” among buyers that have lost previous auctions and have become more selective, he said. In addition, Brown said he is more frequently hearing private equity bidders talk about modeling a downturn into their holding periods.

In the meantime, credit markets have wavered — spreads have risen, particularly on big deals, and terms have become more creditor-friendly — but not to the point of impacting deal prices, said Ron Kahn, a Lincoln International managing director.

In fact, the broader survey suggests we’re witnessing an inflection point in the credit markets. More than three-quarters (76 percent) of respondents described the credit markets over the past 12 months as “borrower-friendly,” just 5 percent described them as “creditor-friendly,” while the rest (19 percent) described them as “balanced.” But their answers change markedly when asked to anticipate credit market conditions over the next 12 months. In that case, more than four in 10 (44 percent) predicted credit markets would be creditor-friendly, just one in four (24 percent) predicted they would be borrower-friendly and one in three (32 percent) predicted they would be balanced.

Here are other highlights from the broader survey:

• More than three-quarters (77 percent) of respondents describe deal pricing in the North American middle market has “high.” Another 10 percent describe it as in “bubble territory.”
• Respondents pointed to “sponsors with dry powder to deploy” as the biggest factor sustaining prices right now (36 percent), followed by “borrower-friendly credit markets” (26 percent), “public equity valuations (12 percent), and “competition from strategic buyers” (10 percent).
• Asked to name the top ways sponsors are dealing with high prices, more than half of respondents (52 percent) selected “stepping up efforts to find proprietary/limited auction deals.” (Respondents could pick more than one answer.) Other popular strategies included “finding ways to add value, such as through add-ons, to justify prices” (49 percent); “targeting under-performing companies” (36 percent); and “looking for more complicated deals at lower prices” (33 percent).

Needless to say, deal pricing is a complicated topic and doesn’t yield easily to straightforward statistics. Bob Bartell, global head of corporate finance at Duff & Phelps, emailed a thoughtful series of caveats with his firm’s latest deal pricing numbers. As a general rule the firm is seeing, across industries, North American companies generating less than $25 million in EBITDA trade in the 6x to 8x range, and those generating more than that trade in the 7x to 9x range. But when it comes to the price of any one company “growth prospects and profitability margins (market position) are equal if not more important considerations,” Bartell wrote.

“For firms that generate EBITDA margins north of 20 percent and organic growth of approximately 10 percent,” he wrote, “it is likely that they will command multiples closer to 10x or higher (even 10-12x). For firms that generate EBITDA margins less than 15 percent and their organic growth is less than 6 percent per annum, they will likely trade closer to 6-7x EBITDA.”

In other words, buyers are rewarding growth prospects with higher multiples. No doubt those predicting lower prices believe that finding fast-growing companies to buy is going to get even harder in the months ahead.

Action Item: Read additional analysis of deal pricing in the coming edition of Connections in the Middle Market, published in partnership with Duane Morris.

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