“David, it’s called LBO for a reason!” my unnamed private equity friend yelled, with particular stress on the “L” for “leveraged.” He went on to say what many of you have said yourself or heard your own friends say: “We can’t pay 10x for a business. These multiples are crazy!”
So in this environment, what is a private equity firm (or family office or a strategic) to do? As the lower to middle M&A market has become more efficient, the flow of capital to PE firms from LPs has increased dramatically, leverage remains relatively cheap and easy to access, and valuations have, not surprisingly, increased. Pitchbook and other services regularly address this trend in their reports – the consensus seems to be that multiples have increased roughly 2x in the past 5 years.
The “good old days” of finding undervalued, proprietary deals are gone, at least for the foreseeable future. And upward pricing pressure on hairier or more complex deals has increased. Another private equity friend who targets complex-situation investments noted that deals trading at 5-6x roughly five years ago are now routinely 8x deals. Same characteristics, higher price. Even larger private equity funds who developed sophisticated direct calling efforts have changed their focus. They have moved from trying to find proprietary, founder-owned deals to direct outreach to their smaller PE brethren in order to understand their portfolio and develop strategies to get ahead of the inevitable auction processes.
LBOs and Financial Engineering Are Dead…For the Lower to Middle Market
In the lower and middle market, “buy and hope” no longer works. Leveraging up, paying down debt, and cost cutting alone will not cover the ground to deliver the returns that LPs expect, especially when considering an 8x deal is now a 10x deal in today’s market. A true buy and build approach, in which there is meaningful industry consolidation and the ability to leverage synergies, remains an effective strategy.
Vertical Specialization Expands Rapidly
Many formerly generalist firms in the lower to middle market have recognized the need to focus on one or more verticals. By honing their industry knowledge and competency, they can source better deals, be more attractive buyers, and build stronger, more relevant businesses.
Value Creation Is the New Buy and Build
There is a movement among private equity firms to focus not on cost cutting, but instead on tangible value creation activities, particularly those that are growth-oriented. Operating partners, supply chain and IT consultants, and talent management strategists are all examples of value creation providers who are seeing significant growth in their work with private equity portfolio companies. Growing the top line, combined with prudent SG&A management and an effective add-on acquisition program, can be a wonderful cure for higher entry multiples.
At ACG New York, we are committed to helping our members grow their businesses and remain relevant in a fast-changing M&A world. Our network of deal makers, transaction advisory firms, and value creation consultants is an ecosystem that builds off of one another. While it is true that our ecosystem starts and ends with deal making, the other components of the ecosystem are critical contributors to the success of a deal. And the ACG New York network is an efficient, productive, and fun way to build and grow relationships that are vital to your business or firm’s success.
David Hellier is President of ACG New York and a Partner at Bertram Capital