Is 2018 the new 2007?
Across the industry, private equity investors are reporting strong M&A activity in the middle market. According to Pitchbook, middle market PE deal volume was up 14% year-over-year in 2017 compared to 2016. Fundraising in the middle market was also strong ($121.9 billion across 174 funds).
But even as they celebrate successes, some middle market dealmakers are beginning to voice concerns. The bull market has gone on for so long that some say a contraction is inevitable.
For sellers who have grown used to high valuations, there’s a very real risk of over-indexing expectations.
“There’s an old saying in our business: Bulls and Bears make money; Pigs get slaughtered,” writes Ken Marlin, Managing Partner of boutique investment bank Marlin & Associates in the firm’s February update. “M&A values are strong. We’re busy. But we are beginning to see signs of greed. And that is worrying.”
He says the current climate is more than a little reminiscent of the months before the 2000 and 2007 market crashes. He recalls one CEO in 2000 who turned down an offer at 100% above market price because he wanted to see an offer at 200%. Buyers weren’t having it. “Shortly afterwards, the market crashed and his stock price plunged 90%.”
Back then, “we got a lot of good deals done. But sellers saw a strong market — and insisted on unreasonable values. Buyers balked — then they got slaughtered. Now its déjà vu all over again.”
We reached out to Marlin to learn more about what he’s seeing in today’s market and how sellers can avoid repeating the mistakes of the past.
Axial: Tell us more about the greed you’re seeing from sellers.
“Greed” may not exactly be the right word (some have chastised me for using it). So let’s call it irrational exuberance — it’s a form of risk taking when the risk taker doesn’t really understand the downside risk. They don’t understand that their company (or home or car) isn’t worth what they think it is. In some cases, they don’t understand that there is a very real possibility — even a probability — that their company could grow and yet be worth LESS money.
Axial: Are there any industries in particular you’re seeing the exuberance manifest? Is it particularly concentrated in tech?
I believe this sort of irrational exuberance is not industry specific. I once offered to buy a home from an irrational seller at a rational price. They declined. My sense of rationality was based on the current market — which I understood quite well.
The seller based his desired sale price on a combination of:
- The price they had paid 7 years ago (at the peak of a market that had since declined.)
- The fact that the seller had a mortgage that was higher than the price I offered (current market value)
- The fact that the house next door sold at about the same price he was asking (but that house was 30% larger).
The seller declined my offer. A year later, they came around and sold it to me at a market correct price.
I’ve seen irrational exuberance among players in low growth industries as well as high growth ones. But it seems to be more prevalent when people see other firms (or other houses) that they naively (incorrectly) believe to be similarly situated command high multiples.
Axial: Do you have any specific tips for sellers in the current market to benchmark “reasonable” values?
Hire a pro you trust, and then listen. They should understand how investors and buyers look at value — scarcity and strategic value and how that interplays with things like revenue growth rates and synergy potential. They should understand that near-term profitability may or may not matter depending in part on those revenue growth rates and on perceived risk.
Pros should understand the wide range of risks that buyers consider — management risk, competitive risk, technological risk, competitive risk, customer concentration risk, and a dozen others — and how the perception of those risks can impact value.
Axial: What did you say to those sellers who walked away from good offers to try to get them to change their minds?
It’s tough. We’re talking generally about type A personalities — CEOs and Board members who are usually smart and successful and think they know more than we do or believe that they understand the risk they are taking. (Usually they don’t, but they think they do.) Too often they think we’re just in it for the deal, that our position is driven by our own short term greed. It’s not; we really do try to put our client’s interest first. There have been many times when we have advised clients to walk away from deals. But with these people they can perceive that we are biased in favor of a deal.
Axial: Any other signs you’ll be looking out for in the next few months to see if this “déjà vu” continues (or gets worse)?
All we can do is be vigilant — and show clients the data — and hope they listen.