Private Equity firms fashion themselves as pretty good students of relative value. While managers may have different investment styles from deep value and relative value, to growth at a reasonable price and straight growth, they all understand the nuances of valuation. For example, as a value investor we have set our benchmarks to tell us when we should be aggressive buyers, when we should be aggressive sellers and when we should sit on the sidelines until a trend emerges. One of those benchmarks is the historic relationship between public company and private company valuations.
Valuation theory has almost always suggested that private businesses should trade at a discount to publicly traded peers because the latter are predictable earners with access to cheap capital. In addition, there is often a liquid trading market for their shares and, in the large cap universe, institutions with huge dollar positions can move in or out of a position without affecting value. Valuation convention would suggest that the private company discount should be 20-30%.
Sanity Check For PE Professionals
Whenever we are wondering if the valuation we are willing to pay for a private company is sound, we look at the choice we have of buying the leading public company in the same industry. This is a sanity check and an IQ test for our analysts and associates who are crunching the numbers and providing opinions on bid strategy and capital structures.
Occasionally the old guys in the firm, like me, look at this equation just to get a perspective on valuations trends. Yesterday, our friends at Key Banc Capital Markets sent around their 2014 Merger and Acquisition Review. We are particularly interested in their data because they have a strong industrial focus and are one of the leaders in the country relating to middle market industrial M&A. It came as a surprise to me that Key Banc showed the median Enterprise Value/EBITDA multiple for 2014 reported middle market industrial transactions being 9.8x. That is up from 6.8x in 2009 and 7.7x in 2013. Key Banc also reported that the number of transaction with PE firms had increased 27% from 2013 with almost 1000 deals in 2014. Even more surprising was the leverage multiples. Bank debt represented 5.1x of transaction value, almost reaching the record of 5.2x recorded in 2007.
ALL EBITDA Is Becoming Equal
These statistics were so provocative that I talked my friend and former colleague, Raj Trikha, Head of Industrial and Energy Groups at Key Banc Capital Markets for a little perspective. Raj said: “We are seeing a compression of multiples. Whereas traditionally there were distinct bands based on size, we are seeing a convergence of purchase price multiples into a single band.” According to Raj, the largest EBITDA companies(above $40 million) historically commanded the top multiple. The middle band from $20-40 million were a step down and industrial companies under $20 million were another step down. There also was a quality of earnings scrutiny within each band with industrial companies that had exceptional EBITDA margins commanding premiums. Today Raj is finding “ that differential significantly compressed.”
10X Gets Your Attention
The 2014 EV/EBITDA valuation multiple of 9.8x suggested to me that industrial public peers should be trading 20% – 30% higher, but what I found was not what I expected:
None of the best and largest capitalization industrial companies was trading at a 20% premium to the MIDDLE MARKET M&A Exit Values. In fact, you could buy both Emerson Electric and Parker Hannifin at a discount to the valuations in the middle market!!!!
And….Industrials Are The Relative Value Play
Even more interesting was Key Banc’s data that showed private industrials as the cheapest middle market sector with Consumer at 11.1x , Healthcare at 13.7x and Technology at 10.7x . By comparison public leaders in those three sectors, Apple, Merck and Google, trade at 9.99x, 12.7x and 14.76x EV/EBITDA respectively.
What makes me think of the Bubble, Bubble idea is that the private markets derive their liquidity in large measure from one source-U.S. BANKS. Unlike the millions of independent actors in the stock market, the liquidity that is putting middle market private companies at valuation parity with the best public companies is a highly regulated, government controlled marketplace comprised of domestic banks which are all influenced by the same master, the Federal Reserve. That master can end the valuation game by raising interest rates, discounting collateral or raising tier 1 and tier 2 capital requirements like it did in 2008 and 2009 when the bank portion of M&A capital structures fell to less than half what it is today. It can remove M&A liquidity with the vote of seven men and women.
Valuations Will Follow The Fed
For the moment, an accommodative Fed is fueling historic valuations in the M&A markets. This is not a time to be on the sidelines. These windows close abruptly and the catalyst is often unforeseen. When that happens you can expect that trading ranges for private companies will revert to a 20-30% discount to public peers.
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