A new report from Firmex in partnership with Mergermarket, Mid-Market Mergers & Acquisitions: The Valuation Gap, reveals that amidst a valuation gap between buyers and sellers, corporate cash holdings and private equity dry powder remain at high levels and appetite for mid-market deals should remain robust.
According to interviews with six M&A professionals and data provided by Mergermarket, a downturn in the US economy could potentially help close the valuation gap between buyers and sellers.
Warren Buffett: If You Own A Good Business, Keep It
Not surprisingly, the majority of experts interviewed pegged the technology sector to see the most pronounced valuation gap, followed by life sciences.
The Valuation Gap In Mid-Market Mergers & Acquisitions
How big a part has a valuation gap played in stalling North American mid-market mergers & acquisitions? We ask six leading experts for their take.
Over the last year, a paradox has persisted in the North American mid-market: buyside interest in deals has been at an all-time high, and yet the number of deals has fallen. In fact, it was the worst January in 25 years for mid-market mergers & acquisitions deals in 2016. What’s going on?
Part of the explanation is a valuation gap between buyers and sellers. High-quality targets in the mid-market have become few and far between, and sellers are trying to leverage that scarcity to peg their valuations a notch higher. Buyers do not always get on board, particularly in frothy sectors such as technology and life sciences, creating a divide. However, the picture could change in the coming year. According to our expert panelists, a macroeconomic downturn may temper expectations on the part of sellers, allowing the two sides to find consensus on valuations. Technical solutions such as earnouts can also be part of the solution.
With corporate cash holdings and private equity dry powder still at high levels, the appetite for mid-market mergers & acquisitions deals will remain robust. The question is: How can buyers and sellers close the valuation gap?
Mergermarket (MM): According to Mergermarket data, the number of mid-market mergers & acquisitions deals (US $10m-$250m in value) fell considerably in North America in 2015. Observers point to a growing valuation gap between sellers and buyers as part of the reason for the fall in deal volume. In your opinion, what factors have been widening the valuation gap in mid-market deal negotiations?
Joseph Feldman (JF): From my perspective, the responsibility for the valuation gap is probably more on the sellers’ side than on the buyers’ side. In my discussions with business owners over the last year, fairly often I’ve encountered what I would say are unrealistic expectations about valuation multiples. Owners sometimes see reports in the press or hear stories from their peers about deals getting done at multiples that they consider to be representative of the entire market, when that just may not be appropriate. On the buyside, I think there’s a tremendous amount of pressure and competition among private equity firms looking for attractive deals. That competition puts pressure on them to pay more over time.
Many of the middle-market companies I consult for are regularly looking for add-on opportunities, and they’ve been relatively steady in looking at core business valuation and synergy opportunities. But they’re not fundamentally changing the multiples that they’re prepared to pay.
Andrew Lucano (AL): I definitely agree that there is a valuation gap going on. The biggest factor is that sellers’ expectations have been raised very high, as Joe mentioned, because they’re looking at the multiples in these mega-merger deals and then trying to apply those same multiples to their middle-market companies. But it doesn’t really always translate. The other thing in the middle market is that there is a dearth of solid businesses with strong earnings that are being sold. So there is extreme competition to get those businesses, which raises the prices for them, even if their financials don’t support such high valuations.
Andrew Hulsh (AH): The current valuation gap that we’re seeing lately has resulted primary from the substantial competition among private equity sponsors and strategic buyers for high-quality investments and companies and the availability of relatively inexpensive financing, which has resulted in extraordinarily high valuations for companies and assets that are for sale on the market. The valuations for many companies relative to their earnings, or EBITDA, are at unprecedented levels. I’m also seeing a decrease in deal volume from private equity sponsors which I believe is the direct result of this “frothy” deal market. Private equity buyers, as distinguished from strategic acquirers, are simply unwilling to pay these extraordinarily high valuations in many cases, unless the companies they’re considering are virtually unblemished. PE firms, unlike strategic buyers, have specific targeted rates of return from their investments, and often these high valuations that we’re seeing have caused these PE sponsors to be more hesitant to proceed. Simply put, where the valuations for particular investments and assets are priced at the top of the market, it becomes more challenging for PE sponsors to obtain their required returns for their investors.
On the other hand, operating companies have strategic needs and growth objectives that, in certain cases, can be more easily met by acquiring companies rather than through organic growth. And these strategic corporate buyers, unlike private equity sponsors, may not need to be quite as concerned about the short-term impact of paying a higher price for these companies and assets, and can sometimes offset the premiums paid for these companies in part through business synergies and related cost savings. So we are seeing an even greater proportion of companies that would normally be acquired by private equity firms being acquired by strategic corporate buyers.
David Althoff (DA): As described above, there were a lot of deals in late 2014 and early 2015 that were completed at really strong multiples, and potential sellers increased their expectations based on these valuations. These marquee deals drove the tone in many industries – building products, industrial distribution, consumer products, and restaurants. It is important to keep in mind, these deals were often aggressively leveraged and the multiples paid were arguably too high. So part of the gap is simply prevailing expectations.
Part of the gap is also caused by unrealistic comparisons that companies make. We were involved in a deal for a building products distribution company at 10x EBITDA – but the management team was fantastic, their systems were unbelievable, and you could really leverage its infrastructure and put tuck-in companies on top. If you compared it with other firms in the same sector, there was a reason they got a premium multiple – one could argue too high, but there was a compelling reason.
The last reason I would give is that, for most of 2015, if you wanted it, you could get a very aggressive debt package on just about any deal.
Richard Herbst (RH): I would say it comes down to expectations vs. reality. There has been a bit of a phenomenon, especially over the last 18 months or so, where the deals that get publicized are the very attractive deals. People tend to shout those from the rooftops. So some companies that are thinking about coming to market are encouraged by these stories, but they don’t really have an appreciation for what the specific auction dynamics were or what the real dynamics were of the company that was able to achieve that multiple. Maybe that company had some outstanding characteristic that was particularly germane to whatever the buyer was interested in, or the buyer had come into a situation where the company wasn’t for sale and the buyer had to offer a real premium because it had tremendous value for them. I also just honestly believe that there is an underreporting of the average and poor deals.
Oscar David (OD): First, I think the growing attention on the mid-market segment has prompted increased competition. Mainly, corporate buyers are paying more attention to this space, and that leads to a rising buyer base. So we see valuations rise for the stronger sellers – those that have strong earnings and strong management teams. We’ve also seen significant improvement of performance among mid-market companies, which have had access to capital and have used that capital to drive their operations – they focus on growth. With greater performance comes higher valuations.
One other factor that may come into play is that the public market has been adjusting its valuations downward of seemingly high-growth companies — meaning those with earnings that aren’t as strong or prospects that aren’t as identifiable. The private market is beginning to catch up in that regard. o you may see the valuation gap start to shrink a bit for the companies that don’t have as strong earnings or prospects.
AL: I think the biggest gap is in the technology sector. In the tech world, you frequently see companies being sold on unrealized potential – certain buyers are willing to gamble that what they are purchasing is going to be the next Google or the next Uber, which can result in very high sell-side valuations. Certain buyers are willing to take a flyer on tech companies sometimes without having the financials to back it up. Some mid-market tech companies look at the big tech companies that have gone public, or have gotten swallowed up by a company such as Facebook at some extremely high valuation, and think that’s going to work for every technology company out there.
One other thing is that strategic technology buyers are sometimes willing to overpay for a tech company target that just happens to be a perfect fit for their operation. That also raises valuations. PE companies don’t really have that same luxury, but you might see a company such as Cisco, for example, go out and buy some startup at a very high valuation because they feel like that technology will fit perfectly with what they’re trying to do in the future, or will help it to knock out a competitor.
JF: Rather than sectors, I would identify three types of sellers where a valuation gap might be evident. The first is baby-boomer owners. You’ve likely seen reports in recent years that some 10,000 baby boomers are retiring each day, and that trend is going to continue. There is a small percentage of those that represent owners of businesses who are looking to exit, and in my experience this will include individuals who are not experienced with buying and selling companies, and some of them are prone to have valuation expectations that are not going to be realized.
The second type is companies that are going to market because they think the valuations they read about in the papers or hear about from intermediaries might apply to them, and if they’re able to realize that sort of valuation, then they’re prepared to sell the business. So, they go to market, and they have a high sell-price in mind, and those are transactions that are just not closing.
The third type of business that might contribute to this sense of a valuation gap is venture-backed firms in areas where you have a limited number of buyers and the valuations are not based on cash flow. So you might have biotech companies that are developing drugs and tech companies that have unproven business models, maybe even no revenue. But those are companies that at some point are going to sell, and the ambitions they have in the market may be out of whack with what buyers are prepared to pay.
See full the report here.