An article by Simon Martin
To understand the rise in multiples for lower middle market companies, let’s look at this from the buyer’s side of the table. Specifically, let’s look at buyers known as Private Equity Firms. Private Equity Firms, by definition, invest in companies that are private and not publicly traded. They raise capital from large investors and pool it together in funds. They then use these dollars to purchase good companies, ultimately hoping to grow the company over the next five to seven years and then sell it again for a profit. Those profits are then distributed back to the fund’s investors to provide a return on their investment. No different than a mutual fund, Private Equity Funds live and die on their track record of delivering returns to their investors. Therefore, they are constantly on the hunt for good companies to buy.
This inherent need to buy companies, coupled with the massive levels of capital investors have injected into Private Equity has created competition for good deals. In turn, Private Equity Firms are looking more and more to the lower middle market for these opportunities and are paying a heightened multiple for the privilege.
While there are many factors that contribute to a good purchase price, the demand of buyers is the most important. During the run-up to 2008, investors in Private Equity Funds committed a record amount of capital – about $1.9 trillion. Private Equity Firms have since depleted their war chests and raised new funds; right now the collective dollars available to purchase companies — or “dry powder” — is estimated to be between $300 billion and $500 billion. When you consider that most transactions are structured as 40% equity and 60% debt (borrowed from banks), total transaction dollars available are between $750 billion and $1.25 trillion!
The Transition Wave
With that kind of capital to spend, Private Equity Firms have had to leave traditional strategies in search of better opportunities found in the lower middle market. Why you ask? Because of supply.
The Pew Research Center estimates that from 2011, and for the next 19 years, 10,000 baby boomers per day will reach the age of 65. More than 9 million companies still remain in the hands of the baby boomer owners who founded them. Of those 9 million companies, 83% will be forced to make key strategic planning choices around the retirement of the baby boomer owner. IBBA’s Market Pulse reports that baby boomer retirement is the number one reason driving the sale of companies in the lower middle market. Some estimates predict that approximately $5 trillion in assets will change hands is the US by 2025.
Time Maybe Running Out
2015 saw an overall softening of M&A activity in the U.S. Total deal value came in at just under $606 billion across 3,602 completed deals, representing a year-over-year decline of 4.77% in value and 8.2% in the number of transactions. Overall median multiples slid to their 2012 levels for US buyouts.
Having said that, in deals valued between $0 and $25 million, the median multiples shot up to 7x, the highest it has been since 2012. Funds sitting on massive dry powder are migrating into the lower middle market and paying up for those companies.
As we enter 2016, we believe Private Equity will continue to seek quality deals to put capital to work and replace investments in their portfolio. While deal volume and transaction value were down in 2015, Private Equity exits ended the year at new record highs. Private Equity exited approximately 1,132 companies for more than $321 billion. This money will need to be reinvested in quality companies, and the lower middle market is an attractive area to Private Equity. Most analysts agree multiples in the lower middle market will stabilize and then begin to decline throughout 2016 as more quality companies are brought to market.
This bull market for lower middle market private companies will have many of those baby boomers looking to exit and harvest their years of blood, sweat and tears through a full or partial sale. For most boomer entrepreneurs, exiting their businesses will be the most important and most impactful move in their lives. In many cases, the business they have built is by far their single largest asset. They have to get this right.
As Merrill Lynch puts it, “A good investment banker can help screen out unqualified buyers and identify sources of demand that might not occur to owners. The right banker can also help even the playing field, defending value of a business and driving a premium….nine times out of ten unrepresented sellers give up a full 1x EBITDA multiple…”
The M&A team at White Rock Advisors would love to walk alongside you as you make these decisions. White Rock Advisors is a wholly owned affiliate of Chapman Hext & Co., P.C., a 25 year old financial services firm. White Rock Advisors provides merger and acquisition advisory services, institutional private placements of equity and debt, restructuring and turnaround services to companies with revenues ranging from $25 million to $250 million. Chapman Hext & Co, P.C. and its affiliates provide complete audit, tax, and wealth management.