Valuations are at levels we haven’t seen since 2007 and concerns are rising about the sustainability of the market and the amount of leverage the middle market is taking on. We asked six senior bankers how this was changing the advice they gave potential sell-side clients as they think about an exit.
Paul Sperry, Sperry Mitchell
“There is no question that deal pricing is at, if not above, 2007 levels. And, there is also no question that lenders are really stretching on the larger deals, with leverage multiples growing every quarter.
Yet, though middle-market leveraged lending has certainly roared back since 2009, with lots of lenders and plenty of money, we have not witnessed the same magnitude of stretching on cash flow multiples as in the large deal sector of the market. Indeed, The middle-market lending multiples seem to have remained somewhat constant at an average of 4-6X cash flow.
Basically, the bulk of the increase in middle-market deal pricing is coming from more equity as a percentage of the capital structure, as opposed to more debt.
Of course, even at 4-6X total debt, a company can quickly get into trouble with a sudden downdraft in earnings. Any amount of leverage adds risk to a deal, and we always make certain that our sell-side clients are well aware of the potential impact of capital structure on the future of their companies. However, to the question at hand, we do not see today’s PE-sponsored leveraged deals as particularly more risky than they were 3-5 years ago, despite the significant increase in pricing.”
Russ Warren, EdgePoint
“Prices being paid for good middle market businesses are as rich as I have seen in my 40 years of advising sellers. Overall, now a great time to be a seller; a challenging time to be a buyer. Of course, each situation is somewhat different, so an owner should ask, ‘do I have a credible plan to compete, thrive and grow in my changing marketplace? Is time my friend or foe? Can I pick the time to transition the business on my terms?’
In my experience, the most frequent regret of owners who fail to achieve the transition they want is “I waited too long.” Once the window closes, it usually takes about five years before macro conditions come back to favorable.”
Ivan Ruzic, Corum Group
“I think there have been several impacts on the mid-market as a result of higher valuations and higher leverage.
The first is that higher valuations tend to drive greater selectivity on the part of buyers. And this applies to both Strategic and Financial buyers. As a result, buyers are increasingly demanding both top line growth and some level of profitability as evidence of business model viability. This doesn’t mean unprofitable businesses aren’t being bought – merely that it is becoming easier to attract buyer attention if the seller has critical mass.
From what I can see, higher leverage seems to be largely confined to Financial buyers – naturally leading to a greater emphasis on EBITDA. Interestingly, some buyers are choosing to “de-leverage” by partnering on deals while others are moving down market – considering acquisition opportunities that are smaller and therefore less expensive.
Regardless, my advice to potential and actual clients remains the same – “Continue to drive your business as if there is no acquisition process underway, while seriously exploring the potential opportunities created by the current high-valuation environment.”
Corey Luskin, England & Company
“It’s an interesting question, because it forces us to be forward looking. We’re reading about this, but not seeing it directly in our deal flow.
Thus far in 2018, our sell-side engagements have not been particularly credit-sensitive. Because we are highly focused on certain vertical industries, most of our buyers have been strategics who, for the most part, do not rely on leverage. The credit environment is impacting some of our smaller clients that are on the cusp of a sell/don’t sell decision. Anecdotally, our smaller clients seem to be spending more time talking to their banks about month-by-month results, pipeline status, and other immediate cash flow items. The implication is that their banks are following things more carefully. This signals to us that, in a transaction scenario, new lenders are likely to be more cautious than they would have been 18 months ago. It’s a small factor in an otherwise strong deal environment.”
We don’t see the overall activity level under pressure. If the client has strong prospects for a strategic scale, we advise them to go. If it is a financially driven situation, we evaluate the timing carefully, on a case-by-case basis.”
Steve Rathbone, Stout Advisory
“Valuations are higher than they were in 2007, as equity is more abundant, competition for quality assets more fierce, and interest rates lower in the current environment (albeit rising). There is a view in the market (right or wrong, time will tell) that middle market company cashflows are of a higher quality now than they were during 2007, thus supporting a higher quality and more stable credit, even at elevated levels of leverage. Supporting this view is the fact that due diligence in 2018 vs. 2007 is a more extensive, thorough process on the buy-side, and sellers are now frequently conducting sell-side diligence and quality of earnings prior to going to market. We are often advising our clients to engage a sell-side diligence firm as a preparation component for a sale process.”
Sheon Karol, The DAK Group
“We have refined our advice. Business owners tend to sell in accordance with a timeline that fits their personal life rather than only market conditions. Their timing is often driven by family and exit considerations as well as by valuations. However, as valuations have risen, we advise our clients to take into account, or at least be aware of, the opportunities presented by private equity and strategic buyers’ “war chests” and the growing role of family offices.
King Solomon in Proverbs said that ‘wisdom dwells with prudence.’ Nothing lasts forever – not even high valuations. Therefore, we also explore with them the optionality that is available in the current business climate. For example, there are opportunities to ‘take money off the table’ but still retain some ownership. Our foreign buyers, in particular, provide business owners with greater flexibility in this regard as they often want a continuing role for current management.”