Over the past several years, there has been a lot of discussion around America’s transformation to a service economy. Abandoning the basic, labor-intensive goods of the past, many companies have opted for service-based products. As Natalie McGullogh explained in a Forbes article, “This new service economy is brought to life by a combination of people, data and technology.”
The growing demand for and scalability of service-based companies has made the Business Services sector a popular target among mid-market financial sponsors. “Many buyers are recognizing the movement to a service-based economy and, as such, the competition has risen,” explained Axial Member Grant Kornman of NCK Capital. He continued, “Business Services is an industry that has historically been many mom and pop shops. But it is now ripe for professionalization.”
Activity on the Axial network supports Kornman’s theory. The average pursuits per deal in Q3’13 was 10.4, a 41% increase over the same quarter last year.
Given the mom and pop nature of American service-based companies, the aging of the baby boomer has been particularly impactful for the entire Business Services sector. “There is an aging baby boomer generation that is looking for liquidity,” explained Kornman. “As they approach retirement, they are looking for an exit strategy and their kids are either unwilling or unable to inherit the business.”
As these business owners look for non-familial exit opportunities, their options are much more limited. While many are choosing ESOPs or management buyouts, private equity firms, family offices, and other financial sponsors are becoming increasingly attractive partners.
While this trend benefits mid-market investors, it also benefits the baby boomers. As Benjamin Gerut of Kuzari Group, LLC previously explained earlier this year, “The trend is a very promising one for many private equity groups, and even more, for the baby boomers. As the baby boomers look to retire, many private equity firms will be vying for those assets.” The competition is driving valuations and demand.
Poor Re-investment Opportunities
But just because these owners are aware of the rising valuations and are of retirement age does not mean they are being thoughtless about their exit strategies. “Many sellers are faced with a serious problem,” mentioned Kornman. “If they have no way to invest the earnings from the sale of their business, thanks to low interest rates and volatile equities, why not keep running the business for just a few more years?”
One strategy for overcoming the ‘just-a-few-more-years’ challenge is to create the urgency for the business owner. Kornman explained, “We try to show business owners that now is a great time to exit. Even though reinvestment options are limited, valuations are at an all time high because of the enormous amount of capital looking for a home.”
He continued, “More importantly, sellers are at a place in life where they can stick around for a couple of years post sale, which the data shows will get them up to an entire turn more in valuation of their company. As a result, selling today — despite the reinvestment environment — will ultimately yield more money in their pocket.”
The valuation discussion is especially important for the Business Services sector. “Valuation is particularly challenging in Business Services because financing can be difficult since many of the businesses are asset light,” explained Kornman. He added, “The most difficult lending is in service-based businesses below $5 million in EBITDA. Financing for asset light businesses drops off enormously after $5 million.”
Kornman continued, “In a service-based economy, the traditional hard assets are pretty limited relative to dollars people are trying to borrow. There are a number of specialty lenders that are filling the void — and traditional banks will eventually follow.”
Given the rising competition and price tags, it is becoming increasingly important to have a point of differentiation from other firms. One clear advantage is an awareness and expertise in the Business Services sector. Kornman explained, “I think the biggest challenge as an investor comes from demonstrating an understanding of the business and the industry. If a seller is going to leave a material portion of equity, they want to know that their partner is well versed the challenges of today’s market.”
Continuing the idea, Gerut added, “I really believe that most of these retiring entrepreneurs want more than a simple check; they want a real transition with real mentorship…they want succession. Operating partners at large caps are often seen as less significant to overall investment performance, but in the middle and certainly the lower-market, they are truly the head of the spear.”