Bridging the Valuation Gap

Valuations in private equity buyouts have been growing at a steady clip for years, but a variety of market headwinds could now make them come down to earth. Rising interest rates, limited access to debt capital and a volatile market have all made high sale multiples less likely in the coming months. Panelists at the “Valuation Trends & Strategies” panel at ACG’s DealMAX conference last month discussed ways buyers and sellers can agree on terms despite these challenges and some unique deal structures they’re employing.

Speakers also weighed the merits of different investment strategies while deal flow is light and shared their expectations for the future.

For one thing, falling valuations might not actually be a bad thing, some of the panelists noted. Valuations and deal flow are coming down from unnatural highs in 2021, after pent-up supply was unleashed post-COVID. “There has definitely been a noticeable gap between seller and buyer expectations over the last year or so,” said Brian Crosby, managing partner at Traub Capital. “And part of that stems back to coming out of COVID, when there was record deal activity.”

According to research from data provider Preqin—who sponsored the Valuation panel—enterprise value has been growing exponentially while earnings have remained relatively flat. Between 2016 and 2022, enterprise value increased by 6.5% while EBITDA of the companies being sold only grew by 1.5%. Valuation multiples, meanwhile, grew from 8x to 12x since the Global Financial Crisis in 2008.

For buyers, the lower valuations could be a welcome change, though it’s hard for sellers to process, panelists said. “Sellers are slower to recalibrate their expectations. For years, sellers heard whispers what their companies were worth,” said Crosby. “They hear about peers selling for double digit multiples. That’s stuck in their head and it’s tough for sellers to even entertain selling the business for a lower valuation.”

Between 2016 and 2022, enterprise value increased by 6.5% while EBITDA of the companies being sold only grew by 1.5%.

Preqin data

Structuring Elements

But Crosby said there are ways to bridge the gap between buyer and seller expectations in the meantime by using creative deal structures, such as structured equity, seller notes or earnouts. “These are ways to move up the capital structure and be a little bit more protected, especially going into economic uncertainty and a looming recession,” Crosby said.

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He pointed to Traub Capital’s recent investment in a family-owned food ingredients business. Based on sales of comparable businesses, the company was expecting a multiple in the teens in a deal. “They had that number in their head when they entered into the sale process, but from our perspective, that was a high multiple especially going into market uncertainty, so we employed a couple of structuring tools to bridge the gap,” Crosby said.

One was a sizeable earnout agreement. Crosby said that the founder strongly believed in his growth projections but Traub Capital was a bit more cautious. “So we said, ‘If you hit your projections over the next two years, we will pay you that earnout,’” Crosby explained. Traub Capital also required the owner to roll over a sizeable stake, so the founder still holds one-third of the business.

Embracing Add-Ons

For the past year or so, private equity investors have also been more focused on add-ons because they’re easier to close than platform investments.

“We all know the market is slow and most funds are hesitant to make big bets right now. They are in an uncertain economy with lots of volatility, so the shift of looking inward to the portfolio happens naturally,” said Ryan Anthony, partner at Longshore Capital Partners.

For founders of smaller companies who have been through the global financial crisis and COVID, going through another adverse event might be tough. “They might say, ‘I see storm clouds in the distance. I don’t really want to go through something choppy again by myself. I’m better off just selling to a larger business,’” according to Anthony.

For buyers, especially those that might have paid high multiples for platforms in recent years, add-ons are a way to juice growth while planning for an eventual exit in a lower valuation environment. “Unless the platform has had some great organic growth, they’re probably feeling a little bit over their skis. And buying add-ons at a much lower multiples is a way for them to get more comfortable with their all-in multiple as it blends down,” said Anthony.

The current credit climate has also been more forgiving to add-ons. Sourcing additional debt capacity within an existing credit facility has made add-ons easier than securing a new facility for a new platform investment, the panelists said. Plus, noted Anthony, lenders have felt more comfortable supporting add-on transactions. “When you’re doing these add-ons, you’re supporting the company with some equity as well. Lenders love that. They love cash coming into the company,” he said.

Recaps, Refinancings and Restructurings

Dividend recaps, meanwhile, have gone out of style for the time being. While there is limited debt capacity available, lenders are unlikely to agree to raise new debt facilities for the purpose of sponsors paying themselves a dividend, panelists said.

To do a dividend recap now, the cost of capital has gone way up. It’s pretty difficult from a lender perspective.

Ryan Anthony

Longshore Capital Partners

“To do a dividend recap now with the cost of capital way up is pretty difficult from a lender perspective as interest coverage ratios are being watched closely,” said Anthony. Bobby Sheth, managing director at Salt Creek Capital, agreed: “We’ve definitely seen a real push back around doing dividend recaps for sponsors to take money out.”

Crosby noted that 14 months ago, his firm started out on a path for a dividend recap that later got scrapped. “Between interest rate hikes and the Silicon Valley Bank collapse, it ended up transitioning from a recap to a refinancing for all those reasons. There was just very little lender appetite for any kind of a recap situation,” he said.

Dan Lee, partner at Comvest Partners, said he’s seeing more interest in refinancings on the horizon while restructurings could be further down the line later this year.

“With interest rates being much higher, we’re seeing capital structures that were built for a very low-rate world are challenged and not because companies aren’t performing well but because their debt service levels are so much higher than they were before interest rate Increases,” Lee said. “So we’re starting to see the uptick in refis and then restructuring activity we think is going to pick up later this year,” he added.

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Lee said that on the bright side, despite market calamity, portfolio companies are continuing to perform well. “The good news is, these body blows keep coming and the market keeps chugging along, although it certainly slows things down,” he said.

“We are hearing that there is still strong interest and activity around getting deals done. There are certainly a lot of seller pipelines,” Lee added. “We think this banking crisis has pushed things out a quarter or two. But we’re hopeful that in the second half of the year, we’re going to see some meaningful M&A generation.”

Anastasia Donde is Middle Market Growth’s senior editor.