Insights & News

Valuation Pulse: Q2 2016

After a mild first quarter, deal volume picked up in Q2.  GF Data® reported that 205 contributors completed 58 deals compared to 46 in Q1 and a slight increase from 54 in Q2 15.  Average valuations came in slightly higher than the previous two quarters at 6.8x.

According to GF Data®, the increase in deal volume is likely the result of more firms (both small and large) taking advantage of accommodating market conditions.

Here is the summary transaction data for the previous six quarters:

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Highlights  

  • According to GF Data®, although the private equity market has been relatively stable in terms of valuation, debt levels have increased.  Total debt to EBITDA has averaged in the mid-threes in years past and is now consistently closer to 4.0x.
  • As debt levels rises, equity contributions as a percentage of total capital has declined to about 44% from 50% and above in years past.  The abundance of relatively cheap debt capital has helped stabilize valuations and reduce interest expense for private equity buyers.  It will be interesting to see how long bankers will fund a disproportionate amount of total deal price as the prospects of rising interest rates loom.
  • In an interesting turn, year to date, only a few industry sectors had valuations in excess of historical averages.  Manufacturing, business services and distribution sectors (normally associated with slower growth) were slightly ahead while health care services, media and telecom and technology valuation came in slightly lower.  It may be that we are finally seeing peak valuations in certain sectors in this cycle.

Pitchbook® Reports Increased Uncertainty in M&A and Private Equity Activity 

During Q2, Pitchbook® reported a decline in total M&A deal value and deal volume of 14% and 25%, respectively (as opposed to the increase in the private equity submarket).  Overall, the supply of quality targets has thinned, resulting in less capital being put to work.  Although strategic buyers continue to push valuations higher for certain deals, it appears the overall appetite for and supply of such deals may be slowing.  As dealmakers approach new transactions, growth implications are being more carefully vetted as overall economic conditions remain sluggish.  With respect to capital structure, Pitchbook® reports the median debt percentage used in 2Q deals shrunk to 48.6%, the lowest number recorded since the first quarter of 2010.  After reaching a maximum debt to EBITDA level of 5.5x during 4Q 2015, debt to EBITDA has dropped to 4.3x in 2Q, again reflecting a more conservative approach. The following graph presents the annual breakout of EV/EBITDA and total debt/EBITDA multiples since 2014:

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Summary 

As economic growth continues along at a sluggish pace, PE buyers are becoming more selective and cautious.  For example, the volume of smaller deals (under $100 million EV) is slowing while the volume of larger deals ($100 million to $500 million) has increased. Smaller deals are generally perceived as more risky, and buyers appear less willing to pay premium valuations.  Additionally, based on 2Q data, certain sectors (healthcare, media, telecom) may be reaching their cyclical peak valuation relative to historical averages.  This trend is usually more pronounced in the public markets as investors tend to make more sudden swings into and out of sectors.  Despite all this caution however, average valuations have remained relatively stable over the last two years.

PVG Corner 

What’s My Multiple?
As a business valuation professional, clients frequently ask me “What’s My Multiple?”  In other words, if private equity EBITDA valuation multiples are X on average, what could I expect someone to pay for my business?  It’s a perfectly reasonable question for an entrepreneur to ask.   After all, the vast majority of a business owner’s wealth is usually tied up in their business.  Before we answer this question, let’s consider some facts we know about the businesses that private equity (PE) buyers are attracted to.  Number one, PE buyers want to see historical and prospective growth.  Whether you are buying shares of IBM or a small business, all other things equal, investors will pay more for a company that demonstrates growth than a company in decline or fighting to maintain market share.  Declining businesses are generally relegated to the ‘bargain basement’ bin.  Second, PE investors want cash flow.  Cash flow capacity is a key driver of value because it is the thing that pays salaries, provides for a company’s capital purchases, pays off debt and allows for payment of dividends.  In general, companies that attract PE buyers have adjusted EBITDA profit margins averaging 20%.  Lastly, PE buyers want competent management that is incentivized to stay and grow the business.  Competent managers typically know how to identify talent and develop and motivate their peers to perform well.  Developing a well-rounded, motivated management team will go a long way to enhancing the attractiveness of a business.

Back to the question of, “What’s My Multiple?”  Sorry, the truth is all companies have a completely different set of facts and circumstances to consider to even begin assessing a reasonable valuation.  Some companies are what I refer to as ‘lifestyle’ businesses that have limited cash flow capacity, and therefore, limited value.  The business provides the owner a desired ‘lifestyle’ but not much else.  Other businesses are what I call ‘cash flow machines’ operating within growth industry sectors.  These businesses attract both strategic and PE buyers.  Most businesses fall between these extremes.  So rather than spend time worrying about “What’s My Multiple?” – I would advise business owners to get busy growing, producing cash flow and developing a talented management team.  The valuation multiple will take care of itself.

For additional information, please contact Patrick Lowry at plowry@pvgroupllc.com or 410-418-9290.

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