The availability of leverage in the middle market is contributing to high purchase-price multiples, pushing the firms that do not use leverage in transactions out of the running, and giving the firms that do a way to keep paying more. The high prices are driven by a few variables, including the leverage markets and the emergence of non-bank lenders.
Cash reserves of strategic buyers and dry powder held by private equity firms are also contributing to large multiples.
“Multiples have moved into double-digit territory because of the emergence of the non-bank lending ecosystem,” says Rich Lawson, CEO of HGGC, Palo Alto, California the 2014 M&A Mid-Market Private Equity Firm of the Year.
Alternative lenders, including business development companies, continue to expand to deals previously financed by banks. Because they do not have the same regulatory oversight as banks, some of these lenders can provide more leverage for transactions, enabling buyers to pay more for businesses.
For example, if a firm is willing to pay 10 times Ebitda for a business, and can get up to 6-times leverage from a traditional bank, but had an alternative lender that would provide 7- or 7.5-times leverage, that firm could increase the Ebitda multiple it is paying to maybe 10.5- or 11-times leverage, potentially winning the deal.
“The frothiness of the leverage markets is contributing to higher purchase-price multiples,” says Lawson. “People keep one-upping each other.”
Lower middle-market private equity firm Striker Partners rarely uses leverage in deals, according to Derek Spence. In today’s M&A climate, that puts the firm at a disadvantage. For example, a firm that would put two turns of leverage on a deal, and then still pay a 6-times Ebitda multiple, could win a transaction with an 8-times multiple, while Striker would be coming in with an offer of 6-times leverage.
“We’ll get blown out of a few of them but our goal is to find the opportunity where a partnership is more important than the almighty dollar,” Spence says. For more, watch our video interview with Spence, below.