Bracing for inevitable economic headwinds, financial sponsors are proving a little less willing to stretch on valuations as their sell-side counterparts remain eager to exit under still-favorable conditions.
The tone of the market shifted at the beginning of the year as a result of two things: December volatility in the markets and an economic picture that looks more muddled than past years, said John Coyle, a partner and head of the New York office of private equity firm Permira.
“If I were a seller and I experienced December and I was on the edge — Do I sell? Do I not sell? — [that] may tip me into selling,” Coyle said. “The queue of companies lining up to sell is tipping on the side of: Let’s take some chips off the table. [Firms] have more aversion to risk.”
That said, some industry experts say the 2019 deal market got off to sluggish start as a result of Q4 conditions.
Some firms thinking about monetizing assets likely held off because “they weren’t sure which way the world was going,” said Chip Schorr, a senior managing director at New York’s One Equity Partners.
The first quarter produced 586 closed and announced deals totaling approximately $102 billion in disclosed value, down from 669 transactions totaling approximately $117 billion in disclosed value in the first quarter of last year, according to data provided by Thomson Reuters.
“There were a lot of hung bridges at the end of Q4,” Schorr said. “The debt market was a little jittery. That, coupled with the overall stock market downturn, caused folks to put on the brakes. That seems to be clearing itself out right now.”
Bill Kindorf, who heads the specialty industries group at Madison Capital, agreed: “The year got off to a particularly slow start — slower than I can remember in a number of years. … In the last few weeks or so we have seen an uptick in new opportunities coming to our desk. With all the PE capital on the sidelines, it seems likely that deal activity will bounce back.”
Still, “It could have been worse,” said Bob Rivollier, a partner in the private equity transactions group of law firm Ropes & Gray. “Deal [volume] in Q1 has benefited from the overhang from Q4.”
In other words, many deals that couldn’t get done in Q4 due to the volatile debt and public markets extended into January and February, Rivollier said.
The technology sector led from a deal-count perspective, producing 103 transactions in Q1, followed by industrials and consumer products, with 85 and 67 deals, respectively, Thomson Reuters reported.
Some of the quarter’s largest leveraged buyouts also occurred in technology. They included Hellman & Friedman’s approximately $11 billion deal for Ultimate Software, a human capital management company, and Thoma Bravo’s $3.7 billion purchase of mortgage software company Ellie Mae.
Signs of discipline
“The environment in the last half of the decade has been one of increasing competition and a public market that has driven valuation metrics to, in many situations, unreasonably high levels — levels we hadn’t seen since prior to the last recession,” said Scott Sperling, co-president of Thomas H. Lee Partners. “The industry has had to respond to that.”
Private equity’s response has included a migration to higher growth sectors, paying higher multiples with an impact on return expectations, and evolving core capabilities, the latter of which has been THL’s focus for over a decade, Sperling said.
Schorr of One Equity said he worries about some prices being paid in certain industry sub-verticals. “There have been some people who have been, in certain sectors, very, very aggressive,” he said.
If you pay three or four standard deviations from the long-term mean multiple, and the next sponsor reverts to the mean, no amount of growth makes up for that, Schorr said.
“If the music stops and [prices] revert to the mean, the investor community on the LP side looks at the entire asset class and takes more of a pause,” Schorr said. “That can impact everyone from a fundraising standpoint.”
While many GPs eager to deploy large sums of dry powder have accepted sellers’ lofty price expectations over the last several years, there are signs that the tide may finally be turning.
“For some time, a lot of sponsors were less sensitive to the rising valuations, and were willing to essentially disregard the fact that valuations might be too high,” said Rivollier of Ropes & Gray. “[Sponsors] decided, look, it’s an upmarket and that’s the only way we’re going to get deals [done].”
“Even up to a year ago, [I’d] see processes where diligence issues come up and sponsors just decide to assume the risks,” he added. “Now sponsors are much more willing to walk away from deals.”
Because investors increasingly expect a downturn to happen in the relatively near term, that’s enough caution to be a little less willing to overextend on valuations, Rivollier said.
From a lender perspective, there has been more discipline in terms of how much leverage sponsors want to put on cyclical companies, said Sunil Mehta, who heads up the general industries group for Madison Capital. “Two years ago we weren’t having those conversations,” he said.
That said, troubled situations thus far have tended to be more idiosyncratic in nature, Mehta noted.
Deals or companies that are being evaluated with a little more scrutiny are those with execution risk, whether that’s because sponsors are combining businesses or the target investment doesn’t have an existing management team, Kindorf said.
“Predicting and modeling those can be somewhat challenging over time,” Kindorf said.
Bracing for a downturn
As buyers seemingly grow more cautious in the late stages of the economic cycle, sellers are only becoming more eager.
The mindset if you’re a seller in today’s market is “Let’s go, let’s go, let’s go,” said Permira’s Coyle.
Sellers are doing a good job at being ready the minute they’re ready to go, preparing in advance and having things like their diligence and data room lined up, Coyle said.
“The risk in a trickier market [is] speed can kill,” Coyle said. “At the peak of the ‘07 crisis, people were doing deals over the course of a week. … I don’t think that’s going to happen, but if you start to get deals done from soup to nuts inside of 30 days, you are moving into the high-risk zone.”
For instance, buyers that believe that speed and willingness to pay up is worth it — because they’ll get a better deal — might discover an issue they missed six months later.
Like many other players, Sperling said THL has tripled down on finding opportunities outside of auctions. Simply put, he said: “It’s really difficult to win auctions without resetting return expectations.”
While THL hasn’t won an auction since 2013, the firm has managed to put about $6 billion to work for its funds and co-investors, Sperling said. “Our focus is buying at a growth-adjusted multiple that reflects the true value of companies,” he said.
“We model the 2008 recession into every base case we have,” Sperling continued. “That results in a portfolio that doesn’t have many things that are highly cyclically sensitive. … Where that takes you is recession-resistant areas like healthcare, technology and mission critical services.”
Being the No. 1, 2 or 3 market leader in a given sub-sector is a higher degree of importance in a recession, noted Coyle. “In a downturn, if you’re a market leader, you’re in a position to take share,” he said.
When sponsors think about how their portfolio companies can withstand a recession, one of the avenues is to invest in value-creation opportunities such as new hires, compliance tools, technology upgrades and R&D, Ropes & Gray’s Rivollier said.
“The problem is that when you go invest at extremely high valuations, your ability to fund [those] value-creation opportunities suffers,” he said. “The risk, then, is that there’s just not enough resources going toward value-creation.”