MURRAY DEVINE Q3 PE BREADKOWN
Q&A: Lender Liquidity Keeps Valuations Steady
The third quarter saw a slight pullback in purchase prices that is probably more reflective of how rich valuations were in the first half than a sign of any emerging buyer doubts
By Kamil Dmowski, Director, Murray Devine Valuation Advisors
- As you look back on the third quarter, how would you characterize the activity? Was there anything that stood out from your perspective that really drove deal flow?
Deal flow, although down this quarter, remains healthy and strong.. While deal flow, often seems to trough in the third quarter, with July and August traditionally slower months, when activity picks up again in September it can take some time before it translates into actual closed deals. In fact, since 2010, Q3 has represented either the weakest quarter for deal flow or the second weakest quarter every year but once. So there’s definitely a seasonal effect at play.
That being said, as we near the end of year eight of an extended upcycle for private equity, I do sense that buyers are perhaps more cautious today than they might have been five years ago. If you flashback to 2011 and 2012 when you first saw investment activity begin to approach pre-crisis levels, sponsors were paying far less from a valuation perspective. Also, at the time, there probably seemed to be a longer runway to grow the acquired businesses, with the benefit of being at the front end of an economic recovery and against the backdrop of an accommodative Fed.
Today, investors still seem to be quite confident in the economy. With valuations as high as they are and in a rising-rate environment, sponsors may be less inclined to invest in lower quality assets that tend to come with more risk.
- In Murray Devine’s First Half Private Equity Valuations Report, the median valuation for domestic private equity transactions had reached a more-than ten year high and you just mentioned that valuations remained elevated in Q3. Do you have a view of where purchase-price multiples may be headed in the fourth quarter?
That’s a good question. If you were to look at the data, you’d see that prices have moderated slightly, but still remain near historic peaks. Of course, valuations seem to be elevated everywhere. In the public market, for instance, the S&P 500 is trading at a forward P/E ratio of 19x, which is also well above historic norms.
In the private markets, beyond company performance, the biggest catalyst driving growth in purchase prices tends to be the liquidity of the debt markets. We work with many of the leading business development companies and private debt funds, and we can see first-hand that debt portfolios remain healthy and strong. This is a telling proxy for the wider universe of middle market lenders. The low default rates — below 2% for both US leveraged loans and high-yield bonds – also speaks to the underlying strength of the debt markets. Throughout this year and in the third quarter, there has been an influx of new capital, particularly as several private equity firms have launched new private debt funds over the past 18 months. Many of the usual lender names have also raised new capital, but we are also seeing more new and traditional PE firms branch out with either new mezzanine funds or new private debt vehicles.
This is a long way of saying that the market has plenty of liquidity to support purchase prices. The challenge for investors is that with valuations so high, sponsors don’t necessarily want to invest in any assets that come with major question marks.
That may also underscore why the deal count is down this quarter and off by nearly 25% compared to last year. We are finding that, for the most part, only high-quality assets are going to auction and the competition for these deals is quite intense.
I’d also add a caveatthat it can be very hard to generalize when it comes to valuations. In the retail sector, for instance, the bankruptcy of Toys R’ Us was something everybody in the industry took note. This was a buyout from before the financial crisis and seemed to serve as a cautionary reminder. Shortly afterwards, reports emerged that the taking-private deal for Nordstrom was in danger of falling apart after the banks became suddenly skittish.
- That seems to highlight some of the concerns in retail, particularly those companies that may be exposed to the Amazon effect. Conversely, are there any sectors that stand out as it relates to new deal activity?
The same way uncertainty tends to scare away investors, sponsors will gravitate toward areas positioned to benefit from long-term secular trends. With that in mind, we are hearing more and more buzz around the aerospace and defense sector. United Technologies’ massive $23 billion acquisition of Rockwell Collins, for instance, was the kind of bellwether deal that signals investors are likely to become more active in this area. PE, generally, can often find a way to capitalize on broader industry consolidation, either through pursuing their own rollups or being opportunistic as companies rationalize their evolving portfolios. There is also some activist interest in the space, which can create openings for sponsors. For long-term investors, though, it’s the $700 billion military budget, which passed the Senate in September, that will likely draw ongoing interest in the defense space for the foreseeable future. As part of that, there’s also more money and more attention going into cybersecurity, which is another area that has drawn PE interest.
Interestingly, we also saw a lot of activity in the healthcare sector over the summer. Bain Capital backed outpatient care provider Surgery Partners’ acquisition of National Surgical Healthcare.; Clayton Dubilier & Rice acquired the dental imaging equipment business of Carestream Health; and HGGC closed its taking-private deal for supplements maker Nutraceutical International. The activity reflects that the compelling demographic trends still overshadow the uncertainty caused by Washington’s on-again/off-again attempts to replace the Affordable Care Act.
- To that end, when the year began there was a lot of excitement about the possibility of tax reform, the potential for increased infrastructure spending, and of course, healthcare reform. Nine months later, however, there hasn’t been much in the way of progress in these areas. How has that influenced the deal market?
It’s possible there has been a limited impact in select areas. There was certainly a lot of build up around the potential that these policies would have on the market if implemented. Sponsors, though, aren’t generally going to make wild bets on something that may or may not happen.
Moreover, you really need clarity around the policies and how they ultimately take shape. Take tax reform: if it passes, would certainly benefit public companies, particularly multi-nationals, but the impact on private equity is far less clear. The repatriation of overseas capital would probably support the exit market, but it could also push purchase prices even higher, creating even more competition for new deals. The bigger questions, though, relate to corporate interest deductibility and potential changes to carried interest. Also, if tax reform goes through, what would the impact be on the federal deficit and how would that effect spending elsewhere?
There are just a lot of questions to all of the prospective policies, and many sponsors would prefer to take a wait-and-see approach if they’re going to be investing in areas that will be affected.
- So given the activity that we’ve seen over the past three quarters, do you have any predictions for Q4?
Unless there is some dramatic geopolitical event, I would expect deal flow to remain on a steady course. I think Warren Buffett’s minority stake deal for Pilot Travel Centers is a good example of the mindset many dealmakers have today. An investment in truck stops seems to fly in the face of all the talk around self-driving cars and even electric vehicles, but at the end of the day, he describes it as a bet on U.S. economy. I think financial sponsors are indeed confident in the country’s long-term prospects, so I would anticipate that deal flow will remain healthy going into next year.
Kamil Dmowski joined Murray Devine Valuation Advisors in 2006. His responsibilities include financial analysis and advisory services relating to financial opinions, portfolio valuations, collateralized debt obligation funds, and the valuation of business enterprises. Prior to arriving at Murray Devine, Kamil held several positions with Lockheed Martin Corporation where his responsibilities included international project management, planning, analyzing and presenting budgets, performance and cost information for the manufacture of radar systems. Kamil received a Bachelor of Arts degree in History from Grinnell College, and a Masters in Business Administration from the University of Iowa.