4 Trends Impacting Dealflow Quality and Price

Recently, BDO released its fifth annual survey of private equity professionals. In addition to gauging overall perception of M&A and PE activity, the survey results identified the two major concerns for private equity professionals in 2014: pricing and deal flow quality.

The report explained, “When asked to rank the challenges private equity firms will face in the coming year, 39 percent of fund managers cite pricing as their most significant hurdle, a marked uptick from just 15 percent of respondents who said the same in last year’s study.”

The report continued, “The second largest percentage of fund managers (34 percent) say the identification of quality targets will be their number one challenge in 2014 (up from 28 percent in last year’s study), pointing to ongoing concerns about deal flow in the wake of a slow year for private equity deal sourcing.”

In the final analysis, these two concerns have been a long time in the making, being the culmination of several long-term trends that have been impacting the private equity world over the past 5-10 years. Below are four larger trends that feed into pricing and deal quality.

Poor Reinvestment Opportunities

One of the most problematic trends affecting quality dealflow is the lack of compelling incentive for business owners to currently exit their business. While valuations may be high, the reinvestment opportunities for their earnings are weak, at best. “Many sellers are faced with a serious problem,” explained Grant Kornman of NCK Capital. “If they have no way to invest the earnings from the sale of their business, thanks to low interest rates and volatile equities, why not keep running the business for just a few more years?”

The lack of motivation to sell this year is causing some of the best businesses to postpone conversations with potential investors. Until the overall economic conditions improve, or more business owners reach retirement age, many quality deals with stay out of reach.

Chasing Yield

The lower quality dealflow is coming at a particularly inopportune time, as many GPs look to make up for unrealized yield from the past several years. After not delivering desired a IRR to LPs, many fund managers are going after the attractive deals with a financial ferocity.

“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,” John Carvalho of Stone Oak Capital recently explained. “Since there is so much concern about yield, a business that can deliver solid returns is worth a high price.”

Rick Schmitt of AccuVal has witnessed similar competition around attractive companies. He explained, “businesses with a solid business plan that is scalable and/or produce a product with limited distribution…are more highly desired. Private equity funds can take these businesses, put in additional capital, and quickly grow sales and profits.”

If a firm is not able to compete financially, it has to offer some other advantage — like clear industry knowledge or expertise — if it wants to come close to any of these high quality assets.

Larger Firms Moving Downmarket

The pricing battles and dealflow quality have both worsened as many larger firms begin moving downmarket. “I have definitely seen the trend of bigger firms moving downmarket,” explained Michael Schwerdtfeger of Chapman Associates. “We’re seeing a lot of interest at the $3-$4 million EBITDA level from very large, established firms — both as investments and as add-ons. Firms that are significantly larger with very strong reputations are going down into that space.”

One reason for the inter-market shift is the rising number of PE groups in the marketplace. “Anecdotally, every time we go out with a transaction, we run into several new firms,” explained Schwerdtfeger. “A lot of these firms were founded in 2012 or 2013 or raised their first fund within the last 18 months. There is just a lot more competition in the space causing firms to look in all areas of the market.”

LPs are similarly encouraging movement downmarket. When commenting on Riverside’s latest fundraising effort, Michael Wursthom remarked, “For Riverside, however, an increasing number of limited partners continue to look to the midmarket, especially the lower end of the spectrum, for outsized returns.”

Growing Number of Small Boutique Shops

The sellside has become just as crowded as the buyside. “Over the past 5-10 years, there has been a proliferation of business brokers and boutique investment bankers,” explained Member Steve Connor of Hamilton Robinson Capital Partners. “Many bankers — after leaving Wall Street firms — have set up smaller shops throughout the country.” As these investment bankers develop a presence in new cities and new markets, “they [integrate] into the local community and get to know the business owners.”

With more limited bandwidths and networks, these boutique shops often opt for very small auctions. As Connor explained, “Very small auctions can be a great situation. Instead of going to hundreds of PE firms, the banker may go to just five or six. The more intimate auction allows you to get the…benefits of an intermediary without extra competition.”

However, becoming part of those auctions is increasingly difficult. As more and more small shops appear throughout the country, staying aware of all of them is proving to be a challenge. Consistently working to grow your connections through events or networks like Axial is critical to staying relevant as the middle market becomes increasingly dispersed.