By Andrew Greenberg, CEO GF Data –
The “Calling the Crest” article published a few weeks ago generated a wide response. Most of GF Data’s correspondents seemed to agree with the thesis that it may be early to say this “seller’s market” has crested, but that a tightening in the debt markets will be the most likely cause of a correction when it comes.
Most of the questions we received centered on two points:
- How will a tightening affect deals of different sizes in the middle market, given that leveraged finance is more available to – and utilized more heavily by – the buyers of larger companies?
- What is the basis for our view that, in the absence of some cataclysmic macro event, this retrenchment is likely to have “an unmistakable but moderate” impact on valuations, rather than causing a more severe decline?
Let’s tackle the size question first. Our subscribers are familiar with the “size premium” we track regularly – the spread between valuations on platform buyouts in the $10 million to $50 million and $50 million to $250 million value ranges. (The GF Data universe comprises transactions completed by private equity firms and other sponsors, including more than 200 current active contributors.)
This “size premium” spread has been unusually high in the past 18 months. The chart below focuses on the lowest and highest valuation tiers in our universe and disaggregates the size premium. The differential in total debt is defined as the spread due to “leverage.” The balance of the spread is given the catch-all label of “scale.”
What can we draw out of this decomposition of the size premium?
- The total premium has been consistently higher in the years since 2011 than the years prior, perhaps reflecting the profusion in number of capital providers and in amount of capital available to support sponsored transactions.
- The portion of the premium accounted for by greater leverage has been remarkably consistent over the past four and a half years – between 1.2x and 1.4x in each period.
- The portion of the premium that we are attributing to “scale” – all of the other reasons why larger firms are valued more highly than similar smaller ones – has also been consistent, in the range of 1.0x to 1.1x for every period except 2012.
In the first six months of this year, platform acquisitions in the $100 million to $250 million Total Enterprise Value (TEV) range traded at an average of 8.3x TTM Adjusted EBITDA, compared to 6.0x in the $10 million to $25 million bracket, with the leverage premium accounting for about half of the differential.
We conclude that for a $100 million to $250 million transaction, about 1.2x in value is due to greater debt utilization, and thus “at risk” to a contraction in debt availability.
In the $25 million to $100 million TEV range, the “at risk” piece is about .7x (see footnote below). While the GF Data universe is capped at $250 million in TEV, we assume that the same methodology would show greater amounts at risk on larger transactions.
This brings us to the second question – what is the basis for thinking that a debt-driven market move is likely to be moderate?
The assertion in the original article was based on: (1) the amount of capital available; (2) the range of capital providers serving the middle market; (3) the generally positive economic conditions prevailing in the United States; and (4) expectations for corporate performance in the industries in which our data is concentrated.
One of our contributors asked if this view took account of the current financial condition of the publicly traded Business Development Corporations (BDCs) that have assumed such an active profile in the swath of market we cover. He raised the frequently cited concern that a number of BDCs are trading at market valuations below their book value.
This is getting outside of our own core expertise, but it got us curious. The chart below shows the market performance of BDCs with TEVs in excess of $1.25 billion since the beginning of this year.
The two rightmost columns show stock price in relation to book value. We find it interesting to note that among these eleven companies, the five largest are currently valued at discounts to book value, the six smallest at premiums. BDCs with lesser enterprise values based on their current stock prices are generally trading at less than book value, with a handful of exceptions.
What exactly this means with respect to individual companies and the BDC sector, we will leave to those who follow the industry more closely. For now, we will stick with our view that the middle-market transaction finance industry is varied enough and capitalized sufficiently to retrench in a measured, rather than dramatic, fashion.