LUTZ BUSINESS INSIGHTS
factors driving elevated deal valuation environment in the private equity world
mark otte, m&a manager
As we begin 2022 with expectations of strong continued M&A activity, we wanted to recap the main 2021 deal valuation drivers. The historic economic recovery was a key theme in 2021, along with high deal volume, leading to robust valuation multiples in the low-to-middle market.
According to GF Data, the average valuations in the third quarter of 2021 was 7.6x (Total Enterprise Value/EBITDA). This is the highest quarterly mark in the last decade. During the first and second quarters of 2021, valuation multiples averaged 7.1x. GF Data provides data on private equity-sponsored M&A transactions with enterprise values of $10 to $250 million.
Below we highlight the main factors that helped drive record-high valuations in 2021.
1. Record private equity dry powder
The amount of capital chasing deals has caused valuations to spike. Private equity dry powder was at a record level of nearly $920 billion as of fall 2021. This increase in dry powder is partially generated by the growing number of institutional investors turning towards private equity investments.
2. Solid demand for quality assets/businesses
Deal volume in the lower middle market continued its rebound in 2021, with deal count for the second half of the year higher by 48% from the same period in 2020.1 In just one year since COVID began, US deal volume reached its pre-COVID peak levels. Private equity buyers have continued to show strong interest in quality investment opportunities, particularly for platform acquisitions, which have tended to be valued slightly higher than add-ons.2
3. Economic stimulus has led to favorable conditions
Increases in the money supply and boosts from fiscal stimulus programs have improved the overall economic stability. Legislative relief packages such as the CARES Act and Consolidated Appropriations Act have supported the overall economic recovery. This, in part, has led to high expectations from investors for future business growth and their willingness to acquire high-performing businesses at a premium.
4. “Value bridge” concept is at the deal forefront
Acquisitions vetted through this concept include numerous value levers/dynamics. Through detailed due diligence and data analytics, buyers uncover value creation opportunities which allow higher buy-out multiples. There are three main areas where experienced buyers can create value post-acquisition:
- Strategic positioning – (i.e., business model and market focus)
- Performance improvement – (i.e., growth opportunities, profit margins, risks and headwinds)
- Asset optimization – (i.e., tax efficiency, net working capital and capital expenditure requirements, etc.)
If a buyer can get comfortable with the seller’s baseline enterprise value and understand the value creation opportunities of the target, the buyer may be more inclined to offer a strong bid price to remain competitive with other potential acquirers.
5. Ongoing digital revolution
Companies adopting digital technologies will continue to be in high demand. As the digital revolution was magnified by COVID-19, it became clear that technology fundamentally changed many business models. Buy-out targets who have created competitive advantages through technology improvements have been rewarded with high valuations.
6. Increase in the amount of debt financing
As more and cheaper debt is available to fund acquisitions, a company’s return on equity increases (although so does the risk). According to GF Data, the 2021 third quarter transactional total debt/EBITDA multiple reached 4.1x. In 2020, a typical debt/EBITDA multiple ranged from 3.3x – 3.8x. The current low interest rate environment has led to a greater ability to leverage financially sound businesses, leading to higher valuation multiples.
7. Deal price structure includes an earnout
An earnout is an agreement between the buyer and seller in which a portion of the purchase price is paid contingent on the business achieving certain defined financial metrics – such as revenue growth or EBITDA targets. The benefit of an earnout is to help bridge valuation gaps seen between the buyer and seller. A target’s enterprise value may include a lofty earnout, leading to a perceived higher valuation multiple, although there is no guarantee of the earnout being achieved.
For businesses that have performed better than most in their industry, the extraordinary valuation gap has been shown in the successful deals completed in 2021. GF Data reported the “quality premium” – the reward in valuation for above-average financial performance, led to a 28% increase of the seller’s EBITDA multiple. GF Data defines above-average performers as businesses with trailing 12-month EBITDA margins and revenue growth rates both above 10%, or one above 12%, and the other metric at least 8%.
It is important to keep in mind that not all businesses are generating higher than average valuation multiples when selling. During periods of economic and financial uncertainty, it is typical to see a “flight to quality” by investors. This has been a common theme among private equity managers who have chosen to invest in higher-quality, resilient businesses that have been able to withstand COVID-19 disruptions.
Are you considering M&A options for your business? Lutz M&A can help! Our team has the expertise to assist both sellers and buyers in navigating the deal market. Please contact us if you are interested in learning more.
1. PwC Deals 2022 Outlook
2. GF Data®
ABOUT THE AUTHOR
MARK OTTE + M&A MANAGER
Mark Otte is an M&A Manager at Lutz with over five years of consulting and valuation experience. His primary responsibilities include assisting with merger and acquisition projects and providing valuation services for estate and gift taxes, litigation support, marital dissolution matters, purchase price allocations and financial/tax reporting. He focuses on analyzing and interpreting company historical and projected financial data and financial modeling.
AREAS OF FOCUS
AFFILIATIONS AND CREDENTIALS
- Iowa Society of Certified Public Accountants, Member
- Nebraska Society of Certified Public Accountants, Member
- American Institute of Certified Public Accountants, Member
- Certified Public Accountant
- Accredited in Business Valuation
- Bachelor's of Accounting, University of Northern Iowa, Cedar Falls, IA
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