The No. 1 issue facing private equity firms and strategic buyers today is: Where are the deals? There are very few deals out there, and those that are in the market are overpriced or mediocre and may still be overpriced. Hosted by SourceMedia and sponsored by Benesch Friedlander Coplan & Aronoff, this roundtable explored where financial and strategic buyers are finding deals, why it is so hard to find high quality deals at a good price today and where deal origination is headed. To discuss this issue, SourceMedia convened a special roundtable consisting of a transactional attorney, a private equity professional, a strategic acquirer, a deal origination consultant and two advisers-one who focuses on smaller investment banks and one who focuses on proprietary deal flow.
The following is an excerpted transcript of the discussion.
Danielle Fugazy, Moderator, Mergers & Acquisitions
How would you characterize the dealmaking environment today?
Jim Hill, Benesch Friedlander Coplan & Aronoff:
I would characterize it as choppy. Good companies that are for sale are getting incredibly high valuations. You have a lot of private equity capital that has not been utilized and $2.3 trillion in excess cash from the Fortune 500 companies. If you have a great company with a pretty good compounded annual growth rate and compounded annual Ebitda rate, it will get a much higher valuation than it would have in 2007. So that’s the good part if you’re a seller.
The bad part is if you are a conservative buyer, it is very dlifftcult because there is so much leverage being applied to these companies. If you want to do a 50/50 equity to debt split or 40/60 split you really can’t compete on pricing because you are not leveraging up the company enough.
Additionally, there is a scarcity of inventory because there are a lot of baby boomers that everybody expected would sell their companies and haven’t.
These people are 65 years old plus, but have a profitable company and decided it wasn’t time to sell because they are still healthy and people are living longer. These people were also smart enough to create mnanagement teams beside themselves, so it is not a one-man band and they say to themselves, “Why do I want to sell the company? What am I going to put the money in, bonds or something like that? Given the interest rates, I’m just going to continue to run the company.” At some point things will change, but right now there is not this deluge of non-sponsored private company owners selling.
Jim Hill, Benesch Friedlander Coplan & Aronoff
Ina word: Frothy. Multiples are sky high, far higher than we could have imagined 16 years ago when I got into the business. The debt multiples now are higher than the multiples we were paying for the entire company back then. We all run very similar models on a deal. When the debt multiples go from three times to more than six times, it really boosts the total enterprise value. It is a very expensive time to buy. Fortunately, we can play both sides of that. We’ve already announced eight exits this year and there will be more to come.
Graeme Frazier, Private Capital Research LLC:
At both Private Capital Research LLC and GF Data, we focus on the lower middle market, buying companies with $10 million to $250 million of enterprise value. And from the sourcing standpoint, we find there to be a real bifurcation in the market. Based on our proprietary data set drawn from domestic private equity sponsors, we draw a line at $50 million of enterprise value; above which you are getting a lot more leverage and the valuations have exploded to 8.9 times Ebitda on average, and below which the same is not happening, meaning that leverage is not here and the valuations are still somewhat reasonable, averaging 5.1 times Trailing Twelve Months Ebitda.
Holland:
If we buy something with $3 million of Ebitda and build it to $10 million of Ebitda with more customer diversification we are now looking at a very different set of market multiples. There will be much more leverage available for the next buyer. We aim to build not just quantitatively bigger, but qualitatively better businesses. When that happens, we effectively create product for bigger private equity firms and strategic buyers because they don’t want to waste time-in their words, not mine-with very small assets that don’t move the needle for them.
Hill:
But we all see the larger middle market funds going down to the lower middle market because there is not enough inventory at the larger Ebitda level. We just sold an aerospace company of $8 million of Ebitda. The buyer was a $5 billion fund and they viewed this as a platform company, not an add-on, but they have expertise in aerospace.
Holland:
The key was that it was in line with their expertise. Riverside has developed eight specializations to complement its generalist approach. This allows us to dive much deeper, move quickly and with enough knowledge to filter out which opportunities to spend time on. Specialization is the biggest trend in the market.
Fugazy:
So the A and A-plus assets are trading at high valuations, but what about the B or B-plus assets?
Holland:
Those deals are getting done as well if the lenders like them and will provide attractive terms. Beauty is in the eye of the beholder. Something that one firm may view as a B quality product for an acquisition could be an A product for an add-on acquisition because it may fit the strategic goals for a platform company. So it comes back to specialization. You need to have a smart and sophisticated approach or deep domain expertise. You need a view on how you’re going to improve that asset to be able to pay a high multiple today and still generate a strong return for your investors in the future.
Nadim Malik, Sutton Place Strategies:
It is definitely a seller’s market and it’s very frothy. Having said that, if you looked at our data for 2013, we identified over 730 different sell-side intermediaries that closed at least one deal in the U.S. or Canada. So if you look at a complete table of active advisers on the sell side there is concentration on top, but about 75 percent of the more than 730 different advisers completed three deals or less in the year. These are often quieter, more limited processes run by boutique firms that private equity firms would find very attractive. It’s no surprise given the fragmentation in the investment banking market that our work with over 120 clients has shown that private equity firms on average only see 14 percent of their target market deal flow when the seller is represented by a boutique adviser, so 86 percent of their potential deal flow from this channel is still falling through the cracks.
Yes, the market is frothy, and yes, valuations are high, but one of the key factors for success for a private equity firm is deal origination. Our data proves that relying on a handful of relationships with larger investment banks, especially in a frothy market, could hurt buyers because they are not seeing the whole picture.
Jeremy Holland, The Riverside Company
We are closing today on a company that has a $320 million enterprise value. It was sold by a small Midwestern investment bank and had three institutions looking at it. In this case, it was a family-owned business and they didn’t want to have a big auction. They wanted to be very comfortable with three or four potential buyers. They didn’t want to disrupt their entire business. There are a lot of boutique investment bankers out there that frankly, unless you spend your time developing the relationships, you’re missing out on, which is to Nadim’s point.
Michael Dinan, Dinan & Company:
Generally though there is often a direct relationship between the size, enterprise value of the deal and quality of the investment bank. As you go downstream, you will find there are smaller investment banks and there are more inefficiencies in the market. That’s where the opportunities are. Clearly, there are three investment banks that handle most of the sizable PE divestitures and I don’t see that changing.
Holland:
It really is a relationship. If the bankers know you and they know that you’re a specialist in that particular industry, you may get on that list. We’re consistently out there staying in front of as many different intermediaries and alternative sources of deal flow as possible.
Fugazy:
Riverside has a unique situation where you have many people on the ground doing the origination for smaller deals. But where are most small market private equity firms finding the deals and how are they building those relationships?
Holland:
Things are changing rapidly. Historically, many firms didn’t have a deal origination function at all and had to rely on the outsourced specialists and services to figure out how to manage deal flow. Over the last several years, many of the larger private equity firms that have raised substantially more capital have decided to hire a dedicated origination specialist. These firms are now looking for experienced people that can run that process efficiently for them. Historically, when a firm got busy on a deal, they stopped looking for new opportunities. Firms need somebody to stay focused on origination so when they complete the transaction they have a pipeline to turn back to, thereby avoiding deal flow peaks and troughs.
Malik:
Before starting Sutton Place Strategies in 2009, I was a business development professional. This is somebody that is spending the majority, if not all, of their time sourcing deals. If you asked me back in 2005, there were probably about 40 PE funds in the U.S. or Canada that had a dedicated person on their team doing this. Today, now about a third of the market- over 300, perhaps 400 funds-have a dedicated origination team and that number is only increasing.
Wolfgang Berger, Mondi:
As a corporate player, I think you know a lot of your competitors. You encounter a lot of companies you compete with and you see who are the most capable competitors. Obviously, that helps us a lot in assessing the fit for an acquisition. Not to say any good competitor is a good acquisition target, but you are normally looking for a good acquisition target with a very good business model. And normally if they have a very good business model, they are also good competitors. This is how we come across a lot of our targets. The market is filled with investment banks and advisers, even some online platforms and databases are available, but I think our unique advantage is really to look at our competitors to see how they deal with customers and suppliers and if we have interest in acquiring them.
Dinan:
We have observed private equity over the last two decades to determine if there is gold standard for deal sourcing and these are our observations. Broadly speaking there are only three means of sourcing deals: through intermediaries, networking and direct solicitation. And we believe that the best private equity groups use all of these methods concurrently to source deals.
Holland:
Sourcing requires a multifaceted approach. One of our current portfolio companies, Emergency Communications Network was a result of what I believe to be a very broad auction. We had to pay a market-clearing price for that company. But we had conviction and we believed in the company’s organic and inorganic growth opportunities and that we could build a better company over time. Since acquiring the company in 2011, our origination team has developed relationships with ECN’s competitors and we’ve completed five proprietary add-on acquisitions.
Frazier:
The reality is that you have to apply resources to affect and grow your deal flow pipeline, and outsourcing at least part of that function is an increasingly effective approach. There are so many buyers out there that believe that just because they have a fund they’re going to see all of the deals they should see. But over time, reality sets in and they see too many tombstones come and go, and they say, “Geez, we never even got a look at that; why?” What they need to do is apply more resources to affect that, both internally, and with outsourced help.
Fugazy:
To be a part of a process that isn’t an auction seems impossible today. Is exclusivity today possible?
Hill:
It’s tougher. We’re working on a deal right now and we are one of three potential buyers. The seller’s banker basically tells you that you’ve got to run down the runway, do all the due diligence, examine the industry, negotiate with the sellers, who are negotiating three purchase agreements, and it’s a lot of expense. It could cost a million dollars plus, between all of your diligence costs, and you may not win. There are a lot of strategic buyers that we represent that do not want to go through that process. As an investment banker, that banker may think they are getting the optimal results and candidates because that banker sees people running down the runway with financing commitments, but it causes a lot of people to drop out.
Nadim Malik, Sutton Place Strategies
It absolutely turns buyers off. It is an increasing and common phenomenon that investment banks are not granting exclusivity.
Hill:
Three or four years ago, middle market investment banks would let you run down the runway with only one competitor, and if you lost, they would give you some kind of reimbursement from the seller. Now, in many instances there is no reimbursement, it is just a loss.
Berger:
Reimbursement is something that we rarely see in non-exclusive situations. Exclusivity is also a kind of power game between the buyer and the seller. As a buyer, you might ask for exclusivity just to hear the answer, which is usually “no.” ‘Then you might say, “I will still continue even when there is no exclusivity.”
Dinan:
The real answer to the exclusivity dilemma is to focus on proprietary deals. You can find proprietary deals in all three sourcing methodologies, including intermediaries, but direct solicitation provides the highest level of proprietary deals. Again, you can’t rely on any one particular deal source. The holy grail of this business is the proprietary deal, but you can’t live and die by it.
Holland:
That is correct. Riverside manages $4.6 billion and yet we focus on the smaller end of the market. So we need to pursue a large number of deals regardless of how they were originated.
Hill:
Working with an adviser on proprietary deal flow can make sense. If you hire someone like Dinan and Company, they know how to approach the owners and they actually have people involved within the industry, which I think is very, very important . And they also do enough diligence on the financials so you’re getting something presentable; it nay not be the glossy book that we’ve seen for many tears from the large-bracket investment banks, but you’re getting something professionally presented. There’s a risk if you don’t use someone professional. It takes a lot more time and due diligence to get your brain around the company and figure things out, which costs a lot of money, and there might be seller remorse before closing.
Berger:
I agree. A good adviser understands the company and the deal. It is very important to have in adviser, maybe not the classic sell side adviser, gut maybe a transactional lawyer or someone with experience who can help the seller throughout the process.
Holland:
Private equity professionals love proprietary deals… until they actually get one! fellers typically don’t closely follow market conditions and understand all clauses used in legal agreements. We all greatly enjoy proprietary deals find the attractive returns that can benefit from them, but great intermediaries or counsel can act is a buffer or even a psychologist to the seller. It is grueling process at times. A major benefit of an experienced intermediary or adviser is to explain to a seller the normal processes and the depth of data :hat buyers need and the reps and warranties that are required to get a deal done.
Dinan:
Proprietary deals are more difficult; there is no question. But more often than not, they’re worth it. The positive benefits, besides pricing, is that you usually have greater access to management than you otherwise would in a process. You will also typically ave a much longer due diligence period. Long courtships make good marriages in this business. And oftentimes we are able to work through the business plan with the management team during the due diligence process. So it’s not, as in a highly competitive process, where you’re kept at arm’s length and you’re tossed the keys at closing and told Congratulations, now you go figure it out.”
From a merchant banking perspective, we have been in and out of transactions where Ebitda was flat as a pancake and debt stayed at the same levels. The only return that we were able to generate was from Ebitda mnultiple arbitrage. So there is no panacea. There is rood and bad. But I would argue that proprietary teals and the typically lower entry level multiples, which in our experience is one-and-a-half to three turns of Ebitda, is worth the effort.
Fugazy:
How is the lending market and the proliferation of business development companies impacting deal making?
Hill:
Last year, 73 percent of the leveraged loans were completed by lenders who were not regulated banks. They were done by BDCs, collateralized loan obligations and hedge funds. So the lending market has changed dramatically because of the capital requirements and the banks not being allowed to lend as they were. BDCs are a much larger part of the industry and they are driving a lot of leverage.
Michael Dinan, Dinan & Company
We’ve definitely seen the BDCs come back. We’re tracking approximately 80 BDCs and their investments. By and large BDCs are here to stay and I think people can feel safe using them.
Holland:
To be a prudent investor in these market conditions, one cannot expect the same lending dynamics to exist when they go to sell a company years in the future. For the first time in our careers, we’re seeing people model Ebitda multiple contraction on future exits. You can’t, with a straight face, tell your investors that you are highly confident that debt will be as inexpensive and readily available seven years from now as it is today. This is an interesting phenomenon.
Fugazy:
Are we headed toward a bubble?
Berger:
As a buyer, you have to be patient. And I think you have to know what you can afford in terms of paying for a business. If now is not the right time, then you wait. It is maybe not that easy for a private equity fund as it is for a strategic acquirer because it has the alternative option of investing into capital projects. Instead of a frenzied process, as a strategic buyer you have more options on the table, you stay patient, don’t overpay and eventually the right opportunity will come along.
Frazier:
I don’t think that we’re at the top of a peak or a bubble right now. I think this recovery has been very slow. I think corporate earnings have been slow to recover, valuations have been slow to recover and they are continuing to recover. And there are a lot of businesses that still have not yet recovered that will recover. I think this market has more room to run. The one wild card is interest rates. If rates go up, it will change the game a lot. If the rates stay low, we can have another couple of good years.
Fugazy:
Are a lot of strategic buyers waiting on the sidelines for things to settle down before they make acquisitions?
Frazier:
When you’re a private equity sponsor or a portfolio company of a private equity sponsor, you are executing acquisitions on a regular basis, so if one fails, it will likely not destroy your career. However, if you are a strategic buyer, maybe you are not a serial acquirer. You need to be more careful about which deals you execute, so I believe strategics are naturally more selective and risk averse, particularly in the current M&A environment.
Berger:
Certainly, we look at it differently, but I think one limiting factor is to not distract our people from their core business unnecessarily. So we tend to try to focus our business management in the acquisition process on due diligence and post-closing integration. We try to use their time as wisely as possible.
Divan:
I think that a private equity group with a portfolio company that has a strategic fit is the absolute best acquirer. Corporate strategics oftentimes tend to maybe overanalyze acquisitions a little bit because of the fear of failure. And the private equity guys tend to be a little more aggressive and obviously have a little more pressure to employ capital. So I think that there is no question, the number one preferred buyer from an investment banker’s standpoint, as well as from a seller, would be the private equity group that has a portfolio company which presents a strategic fit.
Fugazy:
How do the limited partners feel about the environment today?
Holland:
We don’t have a mandate to sit on the sidelines. Our investors have given us this investment period to deploy their capital. We need to pick our spots. Our specializations enable us to quickly and efficiently complete transactions in a hyper-competitive deal environment. It’s just as important to know which ones to walk away from. Our specializations and origination team helps us analyze the add-on acquisition landscape before we acquire a business. Oftentimes we can complete add-on acquisitions at lower multiples, which reduce our blended purchase multiple.
Graeme Frazier, Private Capital Research LLC
It is important to narrow down the funnel of origination early in the process. If you spend a lot of time analyzing things that you finally don’t go for, you’re just losing time plus money. So I think it is important to screen early and then continue on those interesting projects.
Malik:
It goes back to how important deal origination is. A limited partner is not going to know how their investment in a private equity fund turned out for at least, two, five, seven years down the road. What they can know today, however, is whether or not the private equity firms they are investing in have an effective deal-sourcing strategy, what their approach is and how they are able to see deals that perhaps others are missing, which should translate into better returns down the road. LPs are asking for more information and conducting greater diligence on a PE firm’s business development. They also have an increased appetite for direct investing and co-investing alongside their general partners. So a GP that can demonstrate a strong market share of deal flow can really differentiate themselves in the eyes of investors.
Hill:
LPs want to see their PE funds being creative in deal origination beyond heated auctions.
Fugazy:
Are there any challenges on the horizon?
Divan:
I don’t see any significant events that are going to change the deal world in the next six to 12 months. The thing that we’re probably the most concerned about is the interest rate environment. To the extent that the Federal Reserve really starts to pull back on bond buying and we see a jump in interest rates, I think that can have kind of a shock to the deal environment in the next six to 12 months. Otherwise, we don’t see anything significantly changing.
Hill:
Privately held, non-sponsored companies are probably going to remain relatively dormant because they are making plenty of money and don’t need to sell the company. What you’re starting to see now is the limited partners getting much more aggressive with private equity fund principals and looking at the fund’s entire portfolio, including companies that have been flat the last four or five years, and telling the funds they need to sell those companies. The LP may only get 80 cents on the dollar, but the limited partner says, “We don’t care; sell the company. You are taking portfolio management fees and dragging on these investments. Just sell them.” I think you will see a lot more activity in the next six to 12 months of companies that aren’t bad companies, but aren’t great companies, and the PE sponsor can no longer grow them as they are dated and have no future ability to invest equity in them. This will create another wave of sellers. There should be great opportunities for alert buyers.
Roundtable Participants:
— Wolfgang Berger, Mondi
— Michael Dinan, Divan & Company
— Graeme Frazier, Private Capital Research LLC
— Danielle Fugazy, Mergers & Acquisitions
— Jim Hill, Benesch Friedlander Coplan & Aronoff
— Jeremy Holland, The Riverside Company
— Nadim Malik, Sutton Place Strategies