In an M&A market where deal multiples are contracting, private equity managers are heralding to return to more authentic methods of value creation.
This article first appeared in the February 2023 Valuations Insights Report
In an M&A market where deal multiples are contracting, private equity managers are heralding to return to more authentic methods of value creation.
Multiple arbitrage is dead, long live ‘operational value-add’. Private equity’s manifesto is being re-written for the tight money era and managers are going back to basics – or at least most of them are.
“In the last 10 years, the infusion of low interest rates, cheap money and broad multiple expansion has been a strong tailwind for most portfolios,” says Johan Van de Steen, a managing partner at IK Partners. “In the current headwinds and multiple contraction, the approach of the last 10 years is no longer effective and needs to be more active”.
The float up
Since the Global Financial Crisis, average entry multiples for leveraged buyouts in the US and Europe have floated up from below 10x to 12x or more, as private equity was ploughed into companies showing growth and new technology. Swimming in a rising tide of easy money, most investors could generally assume a higher multiple on exit. In 2023, the outlook is not so clear: buyouts have slowed, and multiples are uncertain. The total value of buyout-backed exits now looks to have peaked in 2021, when it hit US$957bn globally – almost twice as high as any other year since 2005.
A prolonged war in Ukraine, persistent inflation and a turn in the credit cycle have forced a reset in deal valuations – seen in the public markets in early 2022 but still to be fully realised in private M&A.
New normal
“Valuation memories are sticky. Boards and management teams will become more balanced and realistic in their views on valuation, but it will take time,” said Avinash Mehrotra, co-head of M&A Americas at Goldman Sachs in a report by Mergermarket in December. “The question really is whether the current valuation reset is the aberration or if it’s now the new normal.”
The current impasse puts pressure on private equity funds with excess dry powder, placing them in a waiting game for buying opportunities as potential fees on new assets under management slip away.
“We anticipate a rebound in deal activity, albeit under a different valuation framework,” said Alexis Maskell, partner at BC Partners at the end of last year. “As a GP, we view this as time to be an investor, not a deployer. This new cycle will provide an attractive opportunity for investments, but the focus should be on asset quality, and prices need to reflect the new valuation environment.”
So, what does the valuation reset look like for private equity?
There are some early indications. The first can be seen in a swing to smaller acquisitions.
Last year, UK companies experienced a wave of interest from foreign investors, particularly US sponsors looking at potential take-private opportunities, but larger buyouts are typically more vulnerable to volatility and tighter borrowing conditions.
“Given the level of valuation uncertainty in the markets, large buyouts face a huge amount of scrutiny at board level, so it makes them more complicated, along with the increased level of regulatory scrutiny and the higher cost of debt,” says Andrea Guerzoni, EY’s Global Vice Chair, Strategy and Transactions.
With fewer mega deals taking place, smaller acquisitions (US$100m-US$500m) have surged – increasing by 27% globally in number last year compared to pre-pandemic levels, according to EY.
Smaller acquisition targets can be harder to find but often quicker to price and complete, especially by sector specialists with strong conviction. Bolting on smaller assets to an existing private equity-owned portfolio company or platform – for example in software or medical diagnostics – can also grow a valuation at exit when multiples are contracting elsewhere.
Research by StepStone published in January found that when buyout managers invest in smaller, less established companies, there is more room to create value by installing skilled management teams, upgrading technology, and developing the sales team.
Around the same proportion of value creation was generated by “multiple expansion” as it was by revenue growth in an analysis of pre-pandemic buyout funds by Preqin, but this balance will have to shift in the years to come as market dynamics change. An increased focus on operational value is the second feature of private equity’s valuation reset.
“There’s an inherent conviction that you can create synergies [with bolt-on acquisitions] so you can mitigate the risk of pricing uncertainty and ensure that these platforms can continue to grow, even in this environment,” says Guerzoni. “It can also be more appealing to go for something that can be better analysed by the management team you have in your portfolio company – they know the environment and understand the risks.”
Buy-and-build is the base case for almost every IK deal, says Van de Steen, and he believes the current environment is likely to lead to more M&A opportunities of this type.
Borrowing lens
A third way to see the shift in private deal valuations is through the lens of debt financing.
Guerzoni believes the valuation reset will be most evident in sectors where multiples have been driven up by a lower cost of funding. If cheap debt and highly leveraged buyouts have driven up entry multiples through the previous cycle, then the opposite will be true in the years to come. According to Schroders Capital at the end of last year, if only 50% leverage is available pre-acquisition, entry prices would have to fall by 12% for investors to still earn an 18.5% return. With 40% debt in the transaction, the purchase price would have to drop by 18.6% to earn the same return.
Of course, once acquisition prices fall, a new multiple expansion cycle can start all over again. This is difficult to predict. M&A activity is expected to remain flat for the first six months of 2023 with an acceleration in completed transactions before the summer, says DC Advisory in an M&A Report at the end of last year. Dealmaking confidence will return in H2 2023 when “the impact of inflation is better understood, and the new valuation reality is established”, it says.
For younger private equity managers that have only known a market of easy money and multiple expansion, adjusting to this new reality could be painful. For many outside the industry, the return to more genuine value creation should be a welcome change.
