Valuation Gap Surging in Middle Market

by Andy Greenberg, CEO GF Data

: published PEP Digest — GF Data’s Second Quarter 2011 Report reveals that the size premium – the reward in valuation for larger businesses over smaller similar ones – is now the defining dynamic in middle market M&A. The second quarter data shows unprecedented differentials in valuations based on deal size being applied to small versus large deals in the middle market, indicating the resurgence of an even more severely bifurcated market that is less accommodating to smaller transactions.

Despite the overall average valuation for the first half of 2011 being on par with 2010’s average of 5.8x trailing twelve months adjusted EBITDA, the valuations for deals in the $10 million to $25 million total enterprise value (TEV) range are averaging 5.2x while valuations in the $100 million to $250 million range reached a record-high average of 7.5x – over a full turn higher than 2010’s 6.2x.

In terms of deal volume, the 160 private equity firms currently contributing to GF Data reported 28 completed transactions in the second quarter of 2011, just down from the 32 reported in Q1, but significantly lower than the 63 deals completed in the fourth quarter of 2010. Deal volume remains sluggish largely due to the downdraft created by the scarcity of new product coming into the M&A market in the final four months of 2010, a record-breaking quarter for middle market deal-activity fueled by anticipated (yet never enacted) tax law changes.

“We began this year by predicting that the story of middle market deal activity in 2011 would be a resurgent premium for greater deal size joining the premium for better deal quality as a driver of value,” said Andrew Greenberg, CEO and Co-Founder, GF Data. “As predicted, size premium is now driving the market. The primary dynamic in this quarter’s data is not the tail off in deal activity, which actually was remarkably similar to Q2 2010, but rather that valuations are rising in the $50 million to $250 million total enterprise value range with little if any increase on smaller transactions.”

“The size premium also extends to, and to some extent is caused by, disparities in debt availability to larger and smaller businesses,” said B. Graeme Frazier, IV, Principal and Co-Founder of GF Data. “While this is not apparent in the overall data, when you look at Total Debt/EBITDA multiples for deals in the $10 million to $25 million TEV range they are on par with 2010 levels in the high two’s, yet for larger deals, Total Debt/EBITDA went from an average of 2.8x in 2010 to 3.9x in the first half of 2011. Essentially what we are seeing is a market that is far less accommodating to smaller deals, a trend that has been evident in our data since 2009, but was most exaggerated in the previous quarter.”

Additional Data Highlights:

  • In 2Q, the overall valuation average dipped slightly to 5.7x. GFDR believes overall valuations are in fact not declining—that this is more a function of the mix of deals reported—and that the first and second quarters of 2011 are best viewed jointly.
  • In 2009 and 2010, strong financial performers were valued more highly than other acquired businesses in both the $10-50 million and $50-250 million value ranges. However, in the first half of 2011, valuations across the $50-250 million range have surged from the mid-sixes to the low-to-mid sevens, while averages on the smaller deals remain in the mid-fives, demonstrating that the quality premium has been overtaken by a size premium.
  • Yet another sign of a market less accommodating for smaller deals is the incidence of earn-outs and seller financing. In the first half of 2011, in the $10-25 million TEV category, 79 percent of transactions utilized an earn-out or seller financing. This is a big jump from the normal average of 40-50 percent for all transactions every year since 2003 (2008 was an exception, with the figure rising to 61 percent).

GFDR collects, analyzes and reports on private equity-sponsored M&A transactions in the $10 million to $250 million value range. GFDR’s quarterly reports contain high-level valuation and leverage data. The firm also provides detailed valuation data in specific industry categories through its web site.

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