Tackling rising asset valuations

Spend enough time talking with European private equity professionals and the question of a supply/demand imbalance in the current market - and its logical impact on pricing - is bound to come up. The issue of rising valuations has indeed been on the mind of investors for quite some time, as evidenced in the latest edition of the unquote" UK Watch. The survey of more than 100 key players in the UK private equity and venture capital markets found that more than 70% of respondents had witnessed an increase in pricing in recent weeks.

For Alex Fortescue (pictured), chief investment partner at Electra Partners, the phenomenon is the direct corollary of European private equity markets finally picking up the pace after a patchy post-crisis performance: "Higher prices are bringing more sellers to the table. Little got done at the notionally low prices in the aftermath of the crisis and I am not sure they really represented a market price anyway."

The factors behind the price hike are well documented - with perhaps the most potent combination involving fierce competition for the relatively small number of top-quality assets, significant amounts of dry powder that have been met with limited dealflow in the post-crisis environment and increasingly attractive financing options.

"Valuation multiples have risen, particularly at the top end, although they vary significantly depending on the transaction. The best businesses, run by exceptional management teams and with a strong investment case, continue to command a premium multiple," says Simon Tilley, managing director at corporate finance house DC Advisory in London.

Back on the radar
The UK market has arguably epitomised these converging drivers in recent months, but is far from being the only European market affected. Spain, which has come back on investors' radars in 2014, has seen multiples soar in the process, and the more settled markets in continental Europe have witnessed a similar trend. "The rise in valuations compared to one or two years ago is clearly noticeable, at least in the markets where we are operating. Renewed interest from international investors has impacted pricing in Switzerland and Italy, while French players have significant amounts of dry powder to deploy in a market where dealflow is still limited," says Gilles Mougenot, a partner at Argos Soditic.

Argos's own index tracking entry multiples in Europe, published in association with Epsilon Research, highlights the extent of the price hike, at least as far as the lower mid-market is concerned. The latest edition of the index revealed that multiples paid by private equity houses and trade buyers for lower mid-cap assets reached their highest level in nearly eight years in Q2 2014, at 8.3x and 8.9x EBITDA respectively.

While these levels are high compared to where the market was two years ago, the increase has been even more marked at the larger end of the spectrum, where assets changing hands for double-digit multiples is not uncommon - Skillsoft was acquired by Charterhouse earlier this year in a deal believed to value the business at around 13x EBITDA, while Chinese firm Hony Capital acquired Cinven's PizzaExpress for around £900m, or 10x EBITDA, in July.

Mark Advani, a partner at Isis Equity Partners, says things are different in the lower mid-market – with somewhat of a dislocation between the prices actually achieved and what is brought to market in the first place, which does not make investors' jobs any easier. "A lot of our frustration would not come from what we end up paying for businesses, but from the assets that have been brought to market and guided vendors towards a 10x valuation when 7x would be much more realistic," he says. "We have seen a significant number of aborted processes in recent months, principally because of this."

Price discrepancy
This discrepancy between the fair value of a business and its price tag is the crux of the issue. The fact that the best businesses command high prices is generally accepted as par for the course given the current market conditions. More worrying is when lofty multiples start trickling down to those businesses that are more of a gamble. "With investment period deadlines looming and very low levels of dealflow over 2012-2013, pressure is mounting on the buy-side," says Fabrice Scheer, head of the corporate advisory group at UBS France. "As a result, assets that are solid but not necessarily the best in their class are also starting to change hands at multiples that can seem surprising."

In the current market, the challenge in maintaining investment discipline might not necessarily come down to setting an entry multiple limit, but carefully selecting the most promising opportunities. "Isis has always been a house that will pay good multiples for very good assets – I don't think that has ever really changed and with debt coming back that has become slightly easier. Our average entry multiple has not moved very significantly, but the pitfall is how you allocate your time," says Advani. "If in order to get through to the first round I need to make a bid at 10x earnings (knowing full well I want 7-8x), how do I decide which cases are worth spending time on? Which processes I believe will abort, versus the ones I expect to ultimately settle at a sensible price? It's a very tough market to call."

Doing the groundwork
Isis is far from being the only firm paying particular attention to its sourcing strategy in light of rising entry multiples. Coming in as early as possible, pre-empting a formal process and doing a lot of the groundwork in advance is seen as a key way to avoid overpaying. Funds are also on the lookout for primary deals, where the asset is attractive but there is still transformational work to be done.

But dealflow of this type is limited, so relying on this approach is becoming increasingly challenging. "Corporates have, by and large, already rationalised their portfolio in the past few years," says Scheer. "Besides, the difference in multiples will never be that stark: you might avoid the bubbling effect that will see intense competition adding 1-2 turns of EBITDA in high-profile auctions, but GPs usually avoid underpaying for fear of missing out, so are ready to offer a fair value."

Electra, meanwhile, is aiming to take advantage of another market bifurcation it has identified when it comes to pricing: "Buyers are paying quite high multiples for growth and we are seeing assets with strong growth stories that can fetch multiples in the mid-teens. But, conversely, we are also finding interesting opportunities with classic cashflow-driven buyouts," says Fortescue. "These may not be the most exciting in terms of growth prospects, but cashflow generation is good and multiples are closer to the mid-single digits. There is certainly value to be found there and lower competition to contend with since the market seems to be really chasing growth at the moment."

And for the firm, the reflection around current pricing trends also extends well into the investment cycle. "One of the implications of prices being quite high at the moment is that we are particularly focused on looking at through-the-cycle multiples, integrating potential multiple contraction into the various scenarios that we look at," says Fortescue. "The other repercussion has been a particular focus on portfolio company bolt-ons. This has been really important for us over the past 12 months - these situations are usually less competitive to start with so prices are lower and the synergies that can be driven out can make these prices very attractive indeed." This increased focus on acquisitive growth strategies has led to six of Electra's investments in the past year being bolt-ons.

Cashing out
While current pricing levels require serious thought both prior to the investment and during the value creation phase, rising multiples must surely be music to the ears of GPs in exit mode – with Ardian and Motion Equity Partners, for instance, capitalising on growing appetite from corporate buyers by selling ingredients maker Diana to Symrise for 13x EBITDA earlier this year.

But again, preparation is key and not all assets are created equal – DC's Tilley advises vendors to really understand their buyer pool and the investment rationales at play early on in order to fine-tune the price point expectation. "It is difficult for UK-based private equity firms to ascribe a growth multiple to domestic businesses whose growth is largely driven by UK GDP – although these could be more attractive to overseas buyers that are confident of exploiting a nascent brand in emerging markets. On the other hand, clarity over developed markets' growth strategies, both organically and through acquisitions, has become even more important for British private equity firms."

In the UK, the sale of a stake in fashion brand Cath Kidston by TA Associates this summer and the aforementioned PizzaExpress deal can be seen as cases in point: both were acquired by overseas private equity houses for around 10x EBITDA since opportunities for expansion in emerging markets are alluring – but harder for UK investors to exploit. "No UK-based GP would have gone close to these multiples," says a market observer.

Keen not to repeat the mistakes that saw many high-profile processes stall or get cancelled altogether in the past couple of years, most M&A advisers also warn that running a broad auction process with a long list of bidders is a turn-off. The potential buyers that have not already done a lot of groundwork will not feel differentiated enough and will be unlikely to go the extra mile when it comes to pricing. "Arguably, it can be a more competitive process if one focuses on 6-10 bidders rather than 50," explains Tilley. "It is better to filter buyer interest ahead of a process rather than through it, enabling you to focus your efforts, and your management team, on the best bidders. You get much better bidder engagement and, ultimately, a better and lower-risk outcome."

Discipline and patience, it seems, are not just key skills to be developed on the buy-side. Fortescue says Electra has enjoyed strong realisations over the past couple of years, including Allflex and Esure, but argues that current valuations should not necessarily lead to a rush to exit. "We are also seeing really strong growth in the portfolio at the moment. As consumer spending improves and the economy begins to rev up, performance is really taking off," he says. "There is a trade-off between taking advantage of good exit opportunities at the moment and capitalising on future growth by holding onto assets for a bit longer. We have been doing both and it is not as straightforward as making decisions simply based on currently high multiples."

Be it on the investment or divestment side, keeping an eye on the big picture is a theme that resonates with those managers who have seen their fair share of peaks and troughs in the cycle. Argos's Mougenot highlights the importance of replacing the current pricing trends in a wider context: "The current low-yield environment will make private equity stand out in the long run: even if GPs are paying more for assets at the moment and we therefore assume lower returns compared with the golden years, private equity will still outperform other asset classes in the current cycle." Time and future LP allocation strategies will ultimately tell if managers found the right balance.

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