Lifting the Veil on Valuation Trends
One of the most interesting parts of our job is that we get to dialog with a cross section of companies that make up the local economy – big, small, growing, contracting, cyclical and non-cyclical. As part of these conversations we get a pulse on how the regional economy views the capital (equity and debt) and mergers and acquisitions (M&A) markets. This provides us an opportunity to educate where appropriate, as perception and reality often differ in this arena. The divide has probably never been wider than it is today.
M&A and capital market fundamentals have changed. Size premiums still exist, growing companies receive higher valuations, leverage is more widely available for larger credits, valuations differ substantially depending on industry, and M&A transaction multiples are generally better in consolidating industries. However, as a result of the recent economic downturn, transparency into the dynamics of the equity, debt and M&A markets has eroded. As an example, while our firm closed five M&A transactions in 2011, only one has disclosed any information with respect to the total deal value. This is consistent with the broader market as there remains limited relevant comparable data for most industries. Absent data, business owners are left to rely on their gut instincts and mass media, which too often miss the mark on what is really going on.
The net result of this information asymmetry is that people are left to hypothesize in isolation, and more often than not their assumptions contain a negative bias. Currently, we find that business owner’s perception of valuations and what we know from our experience differs markedly. In fact, valuations are quite good for the right companies even in today’s turbulent market, and in some cases can meet or exceed the peak valuations of 2007.
A couple of paradoxes are driving this misperception. First, a low growth economy puts pressure on strategic buyers to acquire growth. The second paradox is that the relative value of growth increases in flat or declining markets because it is a scare resource. Great companies distinguish themselves in challenging markets by growing faster than their industry and peers. Private equity firms and strategic buyers are paying substantial premiums for companies that with these characteristics.
Generally speaking strong valuation environments require three things--stock market expansion fueled by earnings growth, liquidity and leverage. Let’s look at these individually to assess the current state of affairs.
While investor sentiment swooned in the face of the European debt crisis, 2011 was in fact a strong year for the equity markets. The stock market, as represented by the Dow Jones Industrial Average, generated a total return of 8.3% (price appreciation plus dividends) in 2011. Notably, earnings grew 15.6%. Strong earnings drove equity prices higher, increasing the likelihood that acquisitions would be accretive, but also improving the balance sheets of corporations and pensions/endowments/charitable trusts, the primary contributors to private equity funds.
From a liquidity standpoint, the market remains flushed with cash. As of the third quarter of calendar 2011, the S&P 500, excluding financial institutions, had $1.15 trillion in cash on their balance sheets. Private equity funds raised approximately $100 billion in 2011 bringing total “dry powder” for financial sponsors to $425 billion. This hefty cash position resulted in strong M&A market dynamics in 2011 where total deal volume in the U.S. approached $986 billion, the best year since 2007. There is simply too much money chasing too few good opportunities. When strategics and private equity firms compete, valuations spike.
Leverage is the piece of the puzzle that remains the most fickle. While more loans were issued in the U.S. than at any time since 1991, $1.86 trillion, the vast majority went to large corporations. Despite this, loans to fund transactions by financial sponsors nearly doubled in 2011. Larger deals attracted much greater leverage, however, as evidenced by the fact that leverage buyouts valued at over $1 billion utilized 61 percent leverage in 2011 versus 46 percent in deals below this benchmark. That said, overall buyout deal leverage increased nearly 35 percent to pushing average valuations up 25 percent in 2011. In fact, 2011 ranked as the second best valuation year for leveraged buyouts in the last 10 years. When private equity can provide an attractive valuation alternative, it ups the ante for strategic buyers as well.
While there are no universal truths in the capital markets, the confluence of a strong public equity market, a cash rich buyer population, and available leverage means that attractive valuation outcomes do exist. In 2011, our practical experience bore this out and we are expecting more of the same in 2012.
Bryan Jaffe and Christian Schiller are managing directors at Cascadia Capital, a Seattle-based boutique investment bank serving companies in diverse industries, including information technology, sustainability and middle market.
