LONDON, Sept 12 (Askume Breakingviews) – Private equity dealmakers love to preach ways to improve companies, such as boosting growth or cutting costs. However, there is evidence that buyout tycoons owe their success to soaring valuation multiples. With that boost likely to fade, Stephen Schwarzman’s Blackstone (KKR.N) and Henry Kravis’ KKR (BX.N) are set to take a position on private equity.
Following the 2008 financial crisis and the 2020 pandemic, years of extremely low interest rates and ubiquitous money printing by central banks caused stock market valuations to soar. According to a McKinsey & Company report, MSCI World Index(.MIWO00000PUS) the average enterprise value to EBITDA multiple reached nearly 15x in 2021, compared to less than 10x in 2012. This phenomenon boosts returns for buyout tycoons, who often find themselves able to sell companies for far more than they paid for them.
Carlyle (CG.O) and Hellman & Friedman own drug development businesses and conduct clinical trials. In 2021, both have an enterprise value of US$21 billion.(about 23 times EBITDA) Thermo Fisher Scientific (TMO.N) . That ‘s about 13 times more than it was worth a decade ago, according to Breakingviews calculations. During that time, the pair managed to quadruple the company’s revenue to $5.9 billion, but they were also helped by a significantly growing market.
This is not a one-time thing. Bain & Company advisors analyzed transactions made between 2013 and 2023 to find out why a company’s enterprise value increased during private equity ownership. Rising valuation multiples contributed an average of 47%, while revenue growth contributed an average of 53%, and improving profitability contributed almost nothing. In other words, about half of the valuation boost that buyout tycoons get for their portfolio companies comes from higher price-to-earnings ratios. The stock is worth even more if the dealmaker buys a division of a larger company or takes a listing target private, at 64% and 71%, respectively.
That should worry buyout veterans like Rob Lucas of CVC Capital Partners (CVC.AS) and David Mussafer of Advent International , because the surge in valuations since 2008 is unlikely to be repeated. Central banks are cutting interest rates, but probably not to near zero, and they are generally still tapering their bond-buying programs, providing fuel for price-to-earnings ratios to rise. The S&P 500 (.SPX) currently trades at 27 times earnings, while the 20-year average is 19 times, according to LSEG Datastream, meaning there is little room for valuations to rise. That means dealmakers will have to make up the difference elsewhere or accept lower returns.
The private equity industry still has a few tricks up its sleeve, though both are becoming harder to come by. That’s changing as buyout giants pursue a strategy called “buy and build,” which involves taking control of a mid-sized company and taking over smaller rivals, taking advantage of the relatively low valuations of smaller private companies. Since 2019, these add-on deals have accounted for about 60% of total U.S. private equity deals, according to PitchBook data.
This strategy allows buyout giants to increase valuations regardless of the direction of the stock market, as large bundled acquisitions command higher price-to-earnings ratios than bolt-on acquisitions. An example of this is Vista Equity Partners’ 2015 acquisition of British software group Advanced , which absorbed smaller peers and attracted a 50% co-investment from BC Partners in 2019. LSEG’s M&A database lists 13 deals since 2016 in which Advanced has been the acquirer.
The problem is that this strategy often relies on debt, because the acquiring company needs cheap and flexible financing for future deals. Now it’s in short supply and it’s very expensive. For example, last November, S&P Global downgraded Advanced’s credit rating to CCC. The average leverage multiplier on U.S. acquisition debt fell below 6 last year, from 7 last year, according to LSEG LPC data replicated by Bain & Company. The consulting firm estimates that financing costs on a hypothetical buy-and-build strategy financed with debt equal to 7 times EBITDA will roughly double from 2020 to early 2024.
Another possible solution for buyout tycoons is to boost valuations by changing the characteristics of the businesses they own, for example by generating more stable revenue streams. EQT’s (EQTAB.ST) investment in wastewater filtration business Desotec in 2017 is an example. According to a person familiar with the matter, the Nordic acquirer’s move to shift the company toward a subscription-based business will allow it to sell to Blackstone in 2021 at 18 times EBITDA , compared with the original acquisition multiple of 12.5 times.
However, such opportunities for a turnaround are rare. And there is little evidence that buyout tycoons generally have a track record of driving up valuations by adding to their investments – often generating windfall profits. McKinsey & Co. recently released an analysis based on Stepstone data covering 2,512 deals from 2010 to 2021, which showed that private equity firms trade at higher valuation multiples and grow at a slower pace than comparable public index benchmarks. This means that, on average, private owners are not adding any additional impetus to market-wide revaluations.
The result is that buyout giants can no longer rely on rising markets. In fact, according to bankers, they are now considering significantly lower exit multiples when considering potential targets. To compensate for the potential loss in valuation, private equity firms will have to focus on increasing company profits.
Relying on cost cutting may seem difficult. Public companies are more focused on cutting expenses, and many businesses have already experienced the private equity crisis, so there’s nothing left to cut. The other remaining lever is increasing revenue. Companies in rapidly expanding industries such as software and healthcare provide an additional layer of protection because they have a better chance of growing sales and eventually offsetting falling valuation multiples.
According to Bain & Company, buyout tycoons have a proven track record of increasing revenues in portfolio companies over the past decade. But they will have to try harder than ever to compensate for adverse market effects. Also, the extensive search for fast-changing targets increases the risk of competitive bidding and thus higher purchase prices. If that happens, buyout tycoons could be trading one valuation headache for another.
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