The M&A world isn’t quite sure what to expect in the next recession. Private equity players weren’t nearly as dominant during prior recessions but we anticipate a course correction through this down cycle. Today private equity firms have $1.81 trillion in uncommitted capital they need to put to work. Businesses are earning the highest multiples we’ve seen in decades. If we can see this kind of activity during the current economic headwinds, dealmakers are optimistic we won’t see a painful drop in the years ahead.
What it means for middle-market companies (10-250MM TEV)
The shift toward private capital has several implications for middle-market companies. First, the trend has created an appealing environment for potential sellers. Valuations for private equity transactions are at record highs.
For example, if we pooled a subset of companies in 2021 with total enterprise values (TEV) of $10-25 million were earning 6.1 multiples, on average according to GF Data. In 2022 year to date, those companies are getting 6.6 multiples (or a 8.2% TEV YoY increase). The spread is even great in the $25-50 and $50-250 TEV ranges (for a drilldown specific to your company and industry, email me to see how this analysis applies to you). These premiums – and improving valuation trends – are unexpected in times of risk and uncertainty, as we have with the war in Ukraine, supply chain constraints, fuel prices, inflation, and the (potential) looming recession.
While there is no crystal ball to predict where valuations go next, there is good reason to expect high valuations to continue. Private equity fund managers are forced to put funds to work in investments or risk the viability of the firm itself, since insufficiently invested funds are not able to generate positive returns in future periods. The race to commit ballooning capital reserves becomes ever more competitive as the industry for private funds expands. Private-fund demand for companies has grown exponentially and continues to increase. The supply of companies, on the other hand, has essentially remained constant even in the face of the silver tsunami (retiring owners from baby boomer population).
Private equity ownership of U.S. companies continues to rise as the private equity sector flourishes and initial public offerings (IPOs) decline, a trend that has helped to boost company valuations to record highs.
The move away from publicly held stock toward private equity ownership has been underway for decades. According to a 2019 report from Ernst & Young, the number of U.S. companies that are publicly held has declined by 50% since the late 1990s. Meanwhile, private equity funds proliferated during that period, soaring from fewer than 1,000 PE funds to nearly 4,000. As a result, PE-owned companies have outnumbered publicly held companies since around 2012, and the trend continues as the private equity industry expands.
The appeal of high returns
Investment returns are a powerful engine driving the shift toward private capital. According to the McKinsey Global Private Market Review 2021, a pool of private equity funds from 2007 to 2017 had median annual returns of 13.3% through September 30, 2020, based on the internal rate of return (IRR) calculation that is standard for the industry. In comparison, the S&P 500 Index returned an annualized average of 8.6% in that same time frame, while the Russell 2000 Index returned 3.6%.
Flight to quality
An investment redistribution, “flight to quality” occurs when investors start hedging out of risky assets during financial downturns. While M&A itself is not in a downturn, we will likely see private equity be more selective – focusing on the consistent performers to the exclusion of “big opportunity” entities with unproven potential.
With a maybe-recession ahead, buyers are looking for companies with predictable performance, solid margins, and low customer concentrations. Unicorns are out. Work horses are in.
Previously, private equity was targeting minimum returns of 18%-20% for their investors. Today, many PE groups have adjusted projections down to 15%. Expectations for returns have come down in anticipation of a softening market.
Resiliency
Things will slow down. Good companies sell in any market. Private equity has money they need to deploy and they have to continue buying. Meanwhile, strategic buyers will need alternative avenues for growth as long as the tight talent market constrains organic expansion.We could see a recession in the next couple of years, but it likely won’t have as big an impact on M&A as in the past.
To learn how your company can benefit and best position itself within the M&A landscape, call or email me now to receive 3 hours of free consultative analysis. Our analysis offers clarity, based on your objectives, if a full or partial exit, recapitalization, divestiture, acquisition or pre-sale exit strategy provides the greatest benefit to you and your company.
Vercor has been delivering M&A expertise for over 25 years. We serve as a trusted partner to help build long term, iterative strategies that ensure you are positioned to meet your unique personal and financial goals whether it is selling, recapitalizing, acquiring or divesting of a division. Now is the time to evaluate, strengthen, prepare and increase the market value of your company regardless of your timeframe.
Todd Cummiskey
Vercor
704-926-6564
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