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Published PEP Digest — After GF Data’s first quarter report was released last month, David Malizia, one of the founding partners of Westshore Capital, and I got into an interesting discussion about valuation trends on smaller deals during a panel discussion in New Orleans.

I noted that the “size premium” in private equity-sponsored middle market deals had never been wider than in the first quarter of 2011. Within the $10-250 million total enterprise value (TEV) range we cover, valuations averaged 5.4x at $10-50 million of TEV, 7.2x at $50-100 million and 8.5x at $100-250 million.

David observed that at the lower end, he thought our reported average was actually higher than much of what his firm has been seeing and hearing – that plenty of smaller deals were getting done at multiples in the 4-5x range. He asked whether I thought multiples in the lower deal size range might be disproportionately inflated by the inclusion of seller financing or projected earnout payments.

This led us to dive back into our data pool, which is now more than 1,400 private-equity backed transactions completed since 2003. We looked at a subset of 453 deals completed since 2006 for which the PE buyer had indicated the presence of an earnout or seller financing.
(We treat differently these two mechanisms used to bridge valuation gaps between seller and buyer. Seller financing is included in our calculations of TEV, discounted to present value as the PE firm thinks appropriate. Earnouts, because they require future performance not impounded in the buyer’s pricing at closing, are excluded.)

Here’s what we discovered:

  • Seller financing or earnouts (let’s call them SFEs) were reported in 70% of deals completed in Q1 in the $10-25 million value range, compared to 27% in the balance of the sample.
  • This is consistent with the longer-term trend. Since 2006, SFEs figured in 45% of deals completed in the $10-25 million TEV tier, compared to 35% of deals in the balance of the TEV range we cover (that is, $25 to 250 million).
  • Overall use of SFEs has been remarkably consistent over most years – ranging between 34% and 40%. The striking exception is 2009, which we all remember as annus horribilis for the M&A business. Fifty four percent of transactions completed in ’09 involved an SFE. (And this was on dramatically contracted deal volume. The 174 PE firms that have contributed to GF Data completed 79 deals in 2009, compared to 152 in 2010.)
  • 2009 also stands out with respect to the magnitude of SFEs. Deals completed without SFEs in ’09 traded at an 18 percent premium to those featuring an earnout or seller financing. The average premium for the sample period going back to 2006 is 12 percent.
  • Since seller paper is included in our definition of enterprise value, it is a fair assumption that the differential reflects the extent to which market conditions for any given period require earnouts, which are not included. In more quiescent times, you’d expect the differential to be less.
  • While SFEs are most common in the $10-25 million TEV bracket, the premium accorded to deals not requiring SFEs is greatest at $25-50 million. Deals of this size completed without seller financing or earnouts trade at an average premium of 15%. This compares to 5-7% on smaller deals or on larger ones.
  • One explanation for this may be that when there is a meaningful gap between bid and ask, these slightly larger businesses have more leverage to push for larger earnouts. Then, the differential falls off on $50-million-plus transactions because the buyers of these businesses tend to have access to more debt to accommodate seller expectations, if they want to.

As for the lower tier of the market, where this line of inquiry originated, it looks like SFEs are indeed more common. Also, there appears to be less scope for earnouts as a path to premium pricing, but perhaps more use of seller financing to bring pricing up to seller expectations.

When I shared our findings with Dave Malizia of Westshore, he noted: “The use of seller financing does affect the price. Seller financing is at lower rates and more flexible structures than institutional debt, thus allowing higher pricing. I would argue that if a seller will not hold seller paper, then the price for one of these businesses is a half a multiple lower than for an all-cash deal.”

Andy Greenberg is CEO of GF Data and a managing director at Fairmount Partners, an M&A firm in West Conshohocken, PA. GF Data’s quarterly reports and searchable data base are available to private equity data contributors and paid subscribers.

This article appeared Thursday June 30, 2011 in Morning Coffee the industry leading, daily and digital private equity news bulletin published by the Private Equity Professional Digest.