A high-price environment hasn’t stopped traditional private equity firms from finding new investments, with sponsor-led dealmaking in tech fueling a steady rise in both the number of closed transactions and disclosed dollar volume in the second quarter.
“Yes, multiples are high,” said Nehal Raj, who leads investments in the tech arena for both TPG Capital and TPG Growth. “Some of that is justified. Some of that will come and go. For us, when we have a theme we really like, the increasing turn or half-turn paid is not as important as making the right decision if we’re correct about [our thesis].”
TPG, among the 10 most active sponsors during Q2, was also behind the largest announced sponsor-backed TMT (technology, media and telecom) deal over the period. The firm in May disclosed plans to combine existing portfolio company RCN Telecom with Wave Broadband for $2.36 billion, creating the nation’s sixth largest cable operator.
TPG announced eight total investments or add-ons during the latest quarter. Four of those were in tech.
Retail stole the limelight in terms of the largest announced deal of the quarter. Krispy Kreme owner JAB Holdings reached a deal in April to take Panera Bread private for about $7.5 billion including debt. Other transactions of size included New Mountain Capital’s $6.4 billion deal for lab-supply distributor VWR Corp and Sycamore Partners’ $6.9 billion play for Staples.
But it was tech that produced the highest number of completed sponsor-driven deals in Q2, increasing by half to 93 from 61 in Q1. After tech came industrials, which saw one of the biggest jumps in PE deal volume quarter-over-quarter. Completed transactions in the sector more than doubled to 84 from 37 in the previous quarter.
From a valuation perspective, a software business with good growth will trade at a multiple within a broad range of 12x to 15x EBITDA, as opposed to about 10x to 12x a couple years back, Raj said.
The rationale behind rising valuations is twofold, he said. Besides a cyclical uptick associated with where we are in the economic cycle, a secular change in tech valuations warrants a permanent increase, Raj said.
On the software side — where most tech volume is — companies are increasingly oriented toward recurring revenue because their services are subscription-based, Raj explained. “Those businesses are more valuable; the less risk you have, the more you can pay as a multiple of cash flow.”
Other experts agreed.
According to David Solomon, CEO of Lazard Middle Market: “Technology deal volumes reflect broader participation in tech by traditional private equity over the past five years, reflecting an increase in technology businesses with strong cash flows such as subscription-based SaaS software companies.”
Solomon described Amazon.com’s recent $13.7 billion deal for Whole Foods Market as “symbolic” of how technology is penetrating further into traditional brick-and-mortar retail.
“Technology is permeating every sector, including business services, healthcare, retail and industrials, disrupting older models and providing scalable high-value solutions,” he added.
Undeterred in expensive market
High prices aren’t unique to the tech industry and they also haven’t deterred sponsors from executing on transactions throughout the first half. In fact, both the number of pending and closed sponsor transactions as well as the total disclosed deal volume reached their highest levels in Q2 since at least the same period in 2008.
Sponsor-backed announced deals in the latest quarter also spiked. Q2 saw 127 announced deals with about $72 billion in disclosed value, up from 75 deals valued at about $26 billion in Q1.
“When we look at the world of investable assets, we see elevated multiples across markets,” said Stephanie Cohen, global head of financial sponsors M&A at Goldman Sachs. “We’re not predicting capital is going to leave private equity. … Remember, you’re only seeing [price multiples] for announced deals. There’s always a group of deals that do not happen because buyer and seller do not meet on value.”
Lazard’s Solomon added that when looking at the past cycle peak ending in 2007, it is clear that volume and multiples tend to increase through the very end of the cycle: “We would expect continued increase in both volumes and multiples given the relative stability in capital markets, availability of large amounts of dry powder in PE funds, and relatively low interest rates.”
Indeed, PE firms are sitting with about $545 billion in available capital, according to PitchBook. U.S. M&A EBITDA multiples actually dropped to 10.5x in 2017, off from last year’s post-crisis high of 10.7x, the data provider said.
Leverage multiples have also continued to mirror the high valuations seen in M&A.
“The market is aggressive and approaching levels last seen in 2007,” David Brackett, co-CEO of Antares Capital said. “The difference? We’re slightly inside the 5 to 7 range, which was the norm last go around.”
Leverage multiples within the 4.5 to 6.5 range today are also more compelling partly because LIBOR rates are far lower than the 5 percent to 5.5 percent range seen last cycle, Brackett said. At the same time, the economy is on a slow-growth trajectory and the private debt asset class — and particularly middle-market lending — continues to present an attractive risk-reward profile, Brackett said: “What’s going on? There’s a lot of liquidity that’s come into the market.”
At Antares, newly originated volume is up 40 percent through the first half, compared with H1 2016. Q2 originated volume is up 33 percent over Q1.
“We’re increasingly turning down more and more deals where we feel competing lenders are being overly aggressive,” Brackett said. “We want to put in a capital structure that can continue to support companies if the market corrects.”
Traditional PE still dominates
As a broader pool of financial buyers compete for assets, traditional sponsors are increasingly behaving like strategic buyers, seeking to realize synergies through M&A, Cohen said.
The most active sponsor in Q2 in terms of closed transactions was KKR with 14 deals, followed by Blackstone Group and Genstar Capital with 11 each.
Cohen’s colleague, Allison Mass, global head of the firm’s financial and strategic investors group, added that while today’s sponsor market includes not only traditional sponsors but family offices, sovereign-wealth funds and pension funds, pure-play PE will continue to dominate.
“What we’re finding is that there might be 10 or 20 family offices that are very sophisticated and are doing direct investing, but they’re not going to do multiple deals,” Mass said. “Their velocity is slower.”
At the same time, Mass said, a lot of the emerging buyers doing direct investing today are beginning to realize how difficult diligence and execution can be. Canadian pensions over the past several years have evolved so that only a few continue to participate in direct investing, she noted.
“It’s a resilient market that is continuously evolving,” Cohen said. “Sponsor M&A is becoming an increasingly more important part of the overall M&A market, and over the last few years the breadth of transactions has increased and buyers have become more creative.”
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Photo of Nehal Raj of TPG by SRK Headshot Day.