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Ever increasing deal valuations

Ever increasing deal valuations

Welcome to the 'boom', an extended economic era of growth, extremely cheap capital in the form of low interest rates, and private equity (PE) funds with record-high levels of funds to invest. These ingredients have given rise to an incredibly buoyant mergers and acquisitions (M&A) market which, while competitive, can be seized by smart and creative buyers.

Valuations on the rise

No doubt, the competition is mounting. Whereas deals of the past typically entailed one buyer per asset, it is now common to have multiple PE and strategic buyers all vying for the same stock. In fact, a recent study of private equity deals found there has been a 45 percent increase in deal valuations in North America when compared to the start of the global recession in 2009. That means that 10 years ago a company would be valued, on average, 7.7 times its earnings before interest, tax, depreciation and amortization (EBITDA) multiple. Today that figure is already over 11 times the EBITDA multiple with no signs of it slowing down. Combined with what we have seen in the market, we can infer that buyers are picking up bigger companies or paying more for the same businesses. Either way, valuations are rising and it's time for buyers to think outside the box.

Creative ways to compete

How do you compete for these assets in such a competitive market and avoid overpaying? One tactic is to identify assets that are not yet on the market and pursue an exclusive deal process. More often than not, however, the owners and boards of these assets will react by triggering the buying process in their bid to earn a better sale and any perceived exclusivity is lost. Another option is to look beyond highly-competitive geographies for assets in developing countries such as South America, Asia, or Africa. Still, while the deal process may be less competitive, buyers face the risks of operating in unfamiliar markets and economies.

A third strategy is to seek divisions and carve-outs from organizations – especially non-core assets that would flourish under new ownership. This often means re-building the back-office from scratch (e.g. hiring corporate leaders, implementing enterprise resource planning (ERP), undergoing change management, etc.), and is better suited to investors who are skilled at such transformation and possess a healthy appetite for risk.

A fourth (and arguably more viable) deal strategy is to include post deal operational value in the purchase price. For example, a buyer might consider acquiring a business with a discounted cash flow of $100M a year, yet see potential to increase that to $110M a year by way of extracting $10M of costs out of the business, thereby enabling them to pay a higher purchase price. This is becoming an incredibly common technique, smart sellers are doing it proactively and smart buyers are looking for those cost reductions to give them an edge on the valuation of the organization. Still, the success of this strategy on the buyer's side hinges on their ability to 'make good' on those cash extractions post deal.

The 'cost' of inaction

These are all viable strategies, albeit with several associated risks. Getting the financials wrong could eliminate any perceived upsides, while economic shifts, market changes, or future interest rate hikes could erode projected savings.

Nevertheless, there is a cost to standing on the sidelines. Not making a deal may mean getting locked out of that opportunity for the next five to six years due to the cyclical nature of assets coming on the market. So while the competition may be stiff and the prices may be high, smart buyers will always find ways to overcome a challenging market and grow their portfolio profitably. It does however imply better preparation, greater risk appetite and reacting quickly when opportunities arise.

And when you are ready,

Let's do this.