The following is ValueWalk’s Q&A Session with Lincoln International discussing the performance of the private companies vs. public markets in first quarter and the rise of alternative investment funds.
1. Can you give us a little background on yourself?
I am a Managing Director in the Valuations & Opinions (or “VOG”) group at Lincoln International. Lincoln is an investment bank that specializes in merger and acquisition advisory services, debt advisory services, private capital raising, restructuring advice, and valuation opinions. We have 20 offices located in North America, Asia, and Europe; I’m based in Chicago and have been with the bank for almost 5 years now.
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My background is in valuing financial instruments. The VOG group is a market leader in valuing illiquid and difficult-to-value financial instruments as well as public and private companies for fairness opinions, tax, and other purposes. We perform 1,200+ valuations for the portfolio companies of leading PE firms each quarter. We have taken these valuations, anonymized and aggregated the data to create the Lincoln Middle Market Index, which is an index of the performance of private (mostly PE-owned) companies in comparison to public companies (via the S&P 500).
2. Does your company study public market valuations? Can you give us some color?
Empirical data consistently demonstrates that the values of private companies correlate but lag relative to public companies. In other words, private company debt and equity values correlate to the public company marketplace but are less volatile (i.e., lower standard deviation of returns). They also experience valuation increases or decreases later than those observed in the public markets.
For example, if there is a stock market correction or decline of, say, 10%, private company values will most likely see a decline of <10% 1-3 months later.
3. How do you compile data as it’s private after all?
We are retained by more than 100 investment managers every quarter, and they provide us with a significant amount of company information to allow us to complete these valuations. This information includes historical and projected financial information, stakeholder presentations, as well as any other information relevant for valuation purposes.
We take these specific company valuations and anonymize and aggregate the data to create the Lincoln Middle Market Index each quarter. We are able to create descriptive statistics based on this aggregated information.
4. To what degree can you be sure the data is accurate?
The information provided to us is vetted by a number of parties. The companies provide their information to the investment manager to form the basis of the investment manager’s balance sheet, which is then audited by their third-party auditing firm. The investment manager’s auditing firm also performs audit procedures on the company’s financial information (i.e., income statement, balance sheet, and cash flow statements). Our analyses are based on these audited results.
5. What are the latest private market trends for 2019 and how does it compare to prior years?
Based on our valuations and analyses, we have observed:
- in 2019 Q1 almost two thirds of companies valued by Lincoln increased revenue; but,
- only about half of the companies were able to grow EBITDA versus the prior quarter; and,
- only 36% of companies valued by Lincoln outperformed calendar year 2018 budgets on an EBITDA basis.
In other words, revenue increases do not always lead to earnings increases.
6. What is currently the median EBITDA being paid and how does it differ from historic multiples?
We have seen that enterprise value multiples continue to increase. For the quarter ending March 31, 2019, they ranged between 9-10X EBITDA. That is an increase of approximately 0.25-0.50X EBITDA from a year ago. Relative to the year ending December 31, 2013 enterprise value multiples ranged between 6.6-8.5X EBITDA.
Consistent with historical trends, larger companies tend to attract higher enterprise value multiples.
Technology companies, on average, are generating the highest multiples at 10.5X. In contrast, energy companies experience the lowest multiples at 7.8X.
7. Are most of the gains coming from unicorns or also smaller less glamorous companies?
The valuation gains that Lincoln observes are being generated by traditional middle market companies rather than unicorns. In the middle market, earnings increases, rather than multiple increases, account for the majority of gains in valuations. Valuation multiple increases tend to have a greater valuation impact for public companies versus private companies.
8. Private market valuation has become a very hot topic, what are you seeing in terms of VC or even hedge fund or endowment interest?
We continue to observe strong demand for investing in both private credit and equity in the United States and Europe. Particularly in the US, we have seen an increase in both foreign capital and new entrants into the market.
9. Companies are going private much later than pre-SARB Oxley what are you seeing?
We continue to see a strong market for merger and acquisition deals and private credit investments. As the private market becomes increasingly liquid, the private markets become a more bona fide and reliable source of capital.
10. Do you think the SEC, FINRA or others should better regulate the sector?
The SEC and PCAOB have continued to step up their oversight of illiquid securities (i.e., debt and equity) and the determination of fair value by public and private funds. The reason is that the SEC realizes that if losses occur in private debt and equity funds, investors in retail and institutional funds (including pension funds) will be adversely impacted. In other words, retail investors are impacted adversely by losses that arise in the private markets.
11. What are your predictions about the next 5 years for private markets?
From a corporate credit point of view, in the decade following the credit crisis (2010-20190, the growth of non-bank lenders has offset the decline in leveraged lending by banks. For example, non-bank lenders have grown market share dramatically. As a result, the availability of credit particularly in leveraged lending has increased.
- The percentage of non-bank loans relative to the percentage of all bank loans in the United States has nearly doubled from about 25% in 2009 to about 45% today.
- Today there is an estimated $700 billion of private debt outstanding. In aggregate, $700 billion equates to a bank nearly the size of Morgan Stanley.
During this decade, as a result of the growth of non-bank lenders, they have had a substantial impact on debt financing, specifically: (1) the range of debt products continues to expand; and, (2) the debt market has become more specialized with the market comprised of many sub-markets and specialties, each of which has unique characteristics, pricing and terms.
In addition, as the economy has improved throughout this decade and the demand for credit has increased, relatively low interest rates has created a global search for maximizing yield.
Predictions for the Next 5 Years for the Private Markets:
There is nothing to suggest that traditional commercial banks will re-enter the leveraged lending industry. Therefore:
- Non-bank lenders will continue to be a significant source of commercial credit in the United States and outside of the United States.
- Given the rise of alternative investment funds, risk has shifted from commercial bank shareholders to limited partners of alternative investment funds (i.e., retirement funds, endowment funds, etc.).
- The SEC is well aware of the increase of the alternative investment fund industry and will increase its supervision of alternative investment funds and their corporate governance.
- Successful funds will need to continue to Identify strategies to create alpha (i.e., risk adjusted returns) given the competitive nature of the financing industry.
- Globally, credit will follow opportunities for risk-adjusted returns.
- Alternative investment funds will need to increasingly focus on environmental, social and governance (ESG) issues. More and more investors are interested in the ESG activities of alternative investment funds. This was not a significant issue for alternative investment funds this decade.
- The alternative investment industry has matured; there is a trend toward larger funds, with multi-asset and multi-national strategies.