Webinar Recap: Multiple Perspectives on High Multiples
Our 2019 Valuation Outlook underscored the rich pricing environment that has confronted private equity investors the past six years. A webinar discussing the report’s findings offered a first-person account of how equity sponsors and lenders are approaching deal sourcing and value creation in light of the market.
Entering 2018, few if any investors expected any respite from high purchase prices. Generous tax breaks were expected to fuel earnings growth and, at least domestically, companies of all sizes were enjoying the tailwind of a robust and growing economy. Twelve months later, based on the level of activity and the prices sponsors were willing to pay, it’s clear that the optimism going into the year persevered — even in the face of renewed stock market volatility and growing anxiety about the escalating trade war.
Against this backdrop, PE sponsors forged ahead to complete more deals—by number of investments—than any other time in history. In total, U.S. sponsors completed 4,578 deals worth a combined $665.1 billion in 2018. And while the median purchase-price multiple paid by sponsors fell slightly, dipping to 11.6x Ebitda, 2018 still represented the sixth year in a row in which PE buyers faced double-digit multiples. To put this into context, the median entry multiple for sponsors was two full turns more than what strategic buyers were willing to pay last year.
In many ways, the activity represents the focus of the asset class on portfolio-company growth and value creation. It also speaks to the liquidity of the debt markets, particularly as the lender universe continues to grow, thanks to the emergence of new private-debt providers. And not to be overlooked is the expansion of the private capital market, a point we discussed in the white paper, reflecting family offices and LPs increasingly eager to participate in direct private equity investments. The overriding questions that the webinar sought to answer, however, revolved around where we are in the current cycle and how are sponsors and lenders managing to cope?
In addition to Murray Devine Senior Managing Director Dan DiDomenico, participating in the webinar were Apollo Global Management Partner Matt Michelini, PennantPark Investment Advisers Founder and Managing Partner Art Penn, and LinkedIn Senior Editor Devin Banerjee, who moderated the discussion for the second consecutive year.
As most might expect, the consensus around where we are in the current cycle was that both the economy and capital markets remain in the later innings. And if that sounds familiar, Penn noted that the baseball analogy has become particularly apt, “because, without a clock, the eighth inning can go on and on.”
In the past, however, macroeconomic and geopolitical uncertainty tended to slow deal activity. Flashback to 2012, the last time the pace of dealflow decelerated, and investors then were confronting a presidential election, the Eurozone debt crisis, and a Supreme Court decision on the Affordable Care Act. Since then, however, investors have found new ways to keep the deal engine running even when multiples make value at entry a harder proposition.
Michelini, overseeing Apollo’s new equity and debt vehicle Apollo Hybrid Value Fund, noted that the investment mandate reflects one of the ways the firm has adapted its product set to the environment. The new fund invests across the capital structure to target structured equity, capital solutions and investments in stressed and distressed assets.
But speaking to Apollo’s more traditional private equity strategy, Michelini also noted that even in the rich pricing environment, Apollo very much remains a value investor. The firm’s most recent annual report, for instance, confirms its average entry multiples for Funds VI, VII, and VIII stand at 7.7x, 6.1x, and 5.7x adjusted Ebitda, respectively.
On the webinar, he noted Apollo’s long track record and past work with over 160 portfolio companies has created an expansive network of executives who help uncover opportunities otherwise not available. Moreover, over the past 12 months, Michelini cited that market volatility has created value opportunities in select sectors, such as financial services, commodities, and retail. He also noted the firm won’t pursue deals, unless Apollo has “some edge, reason or angle” to be involved.
He pointed to Apollo’s investment in OneMain Holdings last year. “This was a company formed through a merger that hadn’t been fully integrated,” Michelini noted, adding the firm’s strategy in this environment is to lean heavily on a compelling thesis, be cautious in how they structure the deal and be willing to trade potential upside for more protection in a downside scenario.
To be sure, the robust level of activity reflects the very liquid debt markets. But again, while lenders are less interested in “value,” per se, the growth of the space – with approximately $239 billion raised across 530 private debt funds over the past two years – has made the longer-tenured lenders sharpen their pencils when underwriting.
Given that the market is thought to be in the later innings of the cycle, Penn noted that his firm, over the past three years, has been underwriting deals based on downside scenarios. “With debt,” he describes, “It’s about avoiding mistakes and knowing where you can get hurt.”
But he adds that amid the aggressive and competitive landscape, he stays active through leveraging domain expertise and industry knowledge, underscoring the specialization trend that has become evident in the debt markets.
“An informational edge can guide investments,” Penn noted. He added that public market volatility also creates opportunities, when outflows affect bank-loan mutual funds or syndicated arrangements dry up. “When the tide goes out, we lean in hard to drive risk-adjusted returns,” he cited. “These periods, when they occur, are also when a long-term view can provide certainty, particularly in a market that’s influenced by emotional, or noneconomic, decisions.”
Another trend that could effect both equity sponsors and lenders is the growth of senior-stretch financing and unitranche structures in which first-lien debt descends deeper and deeper into the capital structure. Beyond just the propensity of new lenders in the market – who perhaps have yet to live through a downturn – observers will be watching closely to see how senior lenders behave at the first sign of trouble.
The good news, though, is that even as the consensus is well aware of the threats that loom, nobody foresees a return to 2008. “I expect to be in the exact place a year from now,” Penn described.
Michelini, meanwhile, believes that by the end of the year, the focus will turn to the 2020 election, and it’s likely that Europe will start to experience weakness. The issue, whether or not deal prices climb or fall, is that the landscape is just becoming more difficult for true, Benjamin Graham disciples. “I believe value investing in the next decade will just become harder than ever,” Michelini noted, pointing to growing concerns about the credit rating of U.S. debt, underfunded pensions, and questions about how technology will ultimately regulated. Given these issues and others, he added, “Determining the terminal value [of an investment] will be harder than ever.”
Those who can discern value, however, will enjoy a competitive advantage over those can’t, which is why we believe the multiple still matters even amid rich pricing environments.