Soaring valuations in today’s frothy M&A environment have made it difficult for the average private equity firm to win deals. Even when a private equity firm is able to buy a company, the margin to create value is thin, due to the high price paid to acquire the company in the first place. According to S&P Capital IQ’s LCD unit, U.S. buyout firms paid an average of 10.3 times Ebitda for their purchases in 2015. That’s surpasses the 9.7 times Ebtida seen in 2007.
While the lower middle market is considered a bright spot in the overall M&A market, purchase price multiples also soared at the low end, making it difficult for private equity firms to compete. According to GF Data Resources LLC, which provides a database covering the lower middle market, valuations for deals for 2015 through the third quarter with a total enterprise value of $100 million to $250 million hit 9.1 times Ebitda, up from 7.8 times Ebitda from 2014 and 7.5 times Ebitda from 2013.
“Valuations are frothy, and the higher-quality companies are demanding higher valuations,” says Graeme Frazier, founder of Private Capital Research and co-manager of GF Data. “The leverage markets are certainly driving prices up.”
As interest rates climb and leverage becomes less available, valuations should come down. That said, the drop in valuations may not be significant enough for private equity firms that have been out-bid by strategic acquirers that have lots of cash on the balance sheet. “We really don’t think there will be a drastic change, but more of a flattening out in 2016. It’s going to be really hard for multiples to expand anymore, and there is a reasonable likelihood they will contract, on average,” says Frazier.
A drop in valuations is expected to spur dealmaking for PE firms in 2016. There is still plenty of equity capital out there that needs to be put to work. Going forward, buyers need to see more high-quality targets so they can put their money to work wisely. “The highest-quality companies maintained their valuations through the great recession, and they will always been demand. The problem is they have been scarce,” says Frazier.