As equity multiples continue to levitate to unprecedented highs, recently rising above 20x on a trailing basis, now in the 99th historical percentile according to Goldman Sachs, the lack of bargains is reflected in the acquisition prices paid by PE firms. According to a new report by PitchBook, after reaching new highs in 2016, acquisition multiples inched even higher in the first quarter of this year, and as a result the median EV/EBITDA multiple hit 10.8x in 1Q 2017, up from 10.7x last year. That was the highest median multiple paid since the financial crisis.
As the report notes, "PE firms are victims of their own success when it comes to pricing. The industry’s strong returns have led to significant stores of dry powder available to tap which, in turn, has created more competition for suitable buyout targets. Meanwhile, strategic acquirers provide plenty of additional competition and have no shortage of available capital. If anything, corporate ability to pay top dollar has only intensified in the last few months. Additionally, rising public market valuations will drive mark-to-market PE prices higher."
Is there any hope that multiples will pull back from what are the current bubble levels? Not much: PitchBook cautions that "barring economic disaster, multiples shouldn’t recede for at least the next few quarters."
The lack of any notable bargains has also resulted in a general slowdown in average LBO activity: "after three consecutive years of strong PE activity, US deal flow started off slow in 2017. 745 transactions were closed totaling $118.7 billion in value, compared to $138.7 billion across 867 deals in the final quarter of last year."
That, however, has not dented the capital allocation mood and fundraising has continued at a rampant pace and dry powder sits at a record $552.6 billion as of 3Q 2016 according to PitchBook. "Due to higher multiples and strong competition, capital deployment will be a challenge" the report notes.
Though we’ve been expecting a slowdown in PE fundraising this year, the first quarter could not have told a more different story. Capital commitments totaled $55.8 billion across 57 vehicles in 1Q 2017. Extrapolated across the entire year, that puts PE funds on track for a 15.8% year-over-year increase in commitments across 14.6% fewer funds. In a world where yield is hard to find and there are more available dollars than feasible investment opportunities, LPs are increasingly leaning on PE to meet their growing obligations.
Fund sizes grow KKR led the way this quarter with its $13.9 billion upper-middle-market buyout fund, exemplifying the shift toward larger and larger funds. LPs, often anxious to not get cut out of top-tier funds, have been increasing the size of their commitments and reducing the number of managers they employ. This also gives them more leverage when it comes to negotiating fee structures and co-investment.
Yet while overall deal activity has slowed down despite strong flow of capital in PE firms, one sector stands out: one-fifth (20.4%) of all PE deals completed in the first quarter involved companies in the IT sector, above the 10%-15% range seen for most of the last decade. The most popular targets have been software companies, which have made up 54.2% of all PE investments in the space since 2006 and 63.1% of IT transactions in 2016.
Some prominent Q1 examples of this included KKR's $2 billion acquisition of Optiv Security, and Thoma Bravo's $800 million purchase of PlanView.
In an amusing tangent, the report notes that "in the tech industry, there are returns to be made by avoiding quarterly earnings expectations and focusing instead on longer-term growth initiatives." The reason is clear: if one were to focus on the deteriorating cash flows among some of the most overvalued tech giants, the PE community would have nightmares every day. Best to just leave it to "growth" and avoid some of the scarier cash burn stories out there.
The report also highlights the disappearance of mega-deals. It highlights one of the major themes in PE last year, namely the rate at which firms were investing in “mega-deals.” Though generally not of the magnitudes seen prior to 2008, 20 transactions were completed at enterprise values $2.5 billion or greater last year. 2017, however, is off to a slow start. Just two deals of this size were completed in the first quarter: Blackstone’s $6.1 billion take-private of healthcare administrator Team Health Holdings, and Koch Equity Development’s $2.5 billion growth investment in enterprise software developer Infor. The latter represents a new type of “corporate private equity,” similar to what we see in the venture capital realm, and could mirror the permanent capital strategy used by firms such as Berkshire Hathaway. Having made similar investments since 2013, Koch also participated in the aforementioned buyout of insurance software provider Solera.
Perhaps the most interest point of the report is how PE firms are exiting existing investments: not through such conventional methods as corporate acuqisitions or IPO, but increasingly more frequently by flipping to other PE firms, or secondary buyouts: "it’s no longer in vogue for tech founders to exit via IPO. Just 5.0% of US venture-backed exits in 2016 happened via IPO, down from a post-financial-crisis high of 11.6% in 2014. Conversely, 13.3% of venture-backed exits last year were via PE firms, the highest of any year since at least 2006."
Some more observations on exits:
PE-backed exits of all types fell to their lowest level in almost four years last quarter. Just 207 PE backed exits were completed, totaling $31.2 billion in deal value, representing quarter-over-quarter decreases of 28.9% and 58.0%. Firms have already divested of most of their portfolio companies bought before the financial crisis, and median hold periods for PE portfolio companies have hovered between five and six years for the last half decade. That leaves the vintages of 2011 and 2012 now ready for harvest. It will still be some time until the bulk of PE investments made in the boom years of 2014-2016 are realized.
Finally, for those curious, here is the latest PE leage table according to PitchBook: