The Widening Valuation Gap

“In March 2013, I wrote that we should see record valuations in 2013 — and, in fact, we did,” said John Slater of FOCUS Bankers.

Indeed, the high valuations of late have been noteworthy. However, while valuations have been on the rise, certain companies — especially the high-quality ones — have benefited from bubble-like valuations. As Slater explained, “The very good companies are routinely seeing north of 10x EBITDA.”

The reason for the exponential rise is the overarching focus on returns. While better companies have always been able to fetch better multiples, the desire to make up lost yield has driven investors to offer higher and higher valuations.

“The market bifurcated itself in 2008 and 2009,” Rick Schmitt of AccuVal explained. “On the one hand, businesses which have a solid business plan that is scalable model and/or produce a product with limited distribution, and less competition are more highly desired. In this type of company private equity funds can take these business, put in additional capital, and quickly grows sales and profits.”

This ability to quickly scale the business with little additional work is appealing to any GP concerned about his IRR. As John Carvalho of Stone Oak Capital explained, “PE firms are willing to really overpay for a business that fits their model because they know they can make the returns on the back end. Since there is so much concern about yield, a business that can deliver solid returns is worth a high price.”

Schmitt continued, “On the other hand, there is still a broad base of companies that are over-leveraged and struggling with significant competition. Those companies have not seen the same increases in valuation multiples because there is some basic deficiency with the company.” Since these companies require significant overhaul, and are less certain to deliver solid IRR, financial sponsors are not willing to pay as much. Schmitt believes these companies can still be bought for 5-7x EBITDA.

As long as investors are seeking high IRR, they will be willing to pay high valuations. Although these premium valuations are already at near-record levels, they could continue rising in 2014 if…

…capital remains cheap and interest rates stay low

One of the most critical factors buoying high valuations has been cheap cash. “There is a twofold factor driving valuations,” explained Schmitt. “One is the low cost of debt which has been stable and broadly available and the banks’ aggressive desire to grow their commercial loan portfolios has been beneficial to the M&A market.” He continued, “The second is the high supply of money available to buyers. The money for leveraging good companies is coming cheap and there is a lot of competition in order to fund deals. When you see WACC being influenced by the lower cost of debt, it helps to justify high multiples.” Given that PE firms now have $1 trillion in dry powder, paying high price tags is easier.

However, any changes to interest rates could rapidly deflate valuations. As Slater remarked, “once interest rates go up, valuations will fall.” But, that won’t likely happen this year. “Right now,” explained Slater, “the predominance of analysis says that we are in a deflationary period and interest rates will probably stay somewhere near where they are.”

Schmitt agreed, “Many of the banks we work with are projecting that interest rates will remain stagnant for 2014.”

…stocks continue to rise

Although the stock market has dipped in the past several days, the general growth over the past year has helped encourage higher valuations. As Schmitt explained, “The investment world looks to the publicly traded marketplace to guide them for what is anticipated for growth in industries and the relative market returns. With the increased indices in the S&P and NASDAQ, the buyers have a guideline supporting higher multiples for the M&A market.” As the stock market continues to rise, comparables will also rise as well, helping to naturally raise valuations.

 …strategics come out to play

Despite their cash-laden balance sheets, strategics have been relatively inactive recently. “The part that we don’t yet understand is why there isn’t greater demand from strategics,” explained Slater. “In a slow growth economy, these strategic acquirers need acquisitions to grow, and it doesn’t make sense that they are not more active.”

Corporate development offices may look to capitalize on the extra cash by acquisitions that immediately add to the bottom line. While the results of our Corporate Development Survey revealed that 43% of corporate acquisitions are driven by accretion or synergies, the recent rise in stock prices may also spur many companies to make acquisitions simply on the basis of multiple arbitrage.

As Carl Shapiro mentioned in his New York Times article, “…deals occur when corporate profits are high and the stock market is feeling bullish: corporate executives seem unable to resist going on a shopping spree when their stock is soaring and they have lots of cash on hand.”