Origination: tackling the valuations conundrum

Private equity has long prided itself on being able to unearth value in hidden gems. Beyond the prospect of unlocking a business's organic growth potential, the lower-than-average entry multiple has a crucial impact on the eventual returns. But judging by the pricing levels witnessed in competitive processes from the beginning of 2014, this narrative is increasingly in danger of becoming a thing of the past.

The list of European transactions valuing targets at double-digit multiples of EBITDA has kept growing in the first half of 2015, with private equity players benefiting handsomely from the market's frothiness and trade buyers' ability to deploy significant amounts of cash. Gilde Buyout Partners and Parcom Capital sold Belgian mattress producer Bekaert Textiles to Haniel in May for an estimated 10x EBITDA (which stood at €50m in the previous financial year), while, more recently, Star Capital sold German cable television operator Pepcom for €608m to competitor Tele Columbus at a similar entry multiple.

Seller's market
On the flip side, prices paid by private equity houses themselves have continued to creep up, with the latest Argos Mid-Market Index (looking at median entry multiples in European €15-500m deals), shooting up to nearly 8.5x EBITDA in the first half of the year.

Andy Currie, managing partner at advisory firm Catalyst Corporate Finance, highlights the supply/demand imbalance at play: "There is a surplus of capital over opportunities and liquidity pressure outweighs traditional business logic. If you are the owner of a business today, you have more options than you have ever had: a very competitive private equity market, a buoyant alternative credit market, increasingly sophisticated family offices and high-net-worths, and trade players that in the main have strong balance sheets."

On the sponsor side, this is compounded by the fact that leverage options remain both plentiful and cheap, enabling GPs to be more aggressive on price, while still sticking to their equity sweet spots. "There is still a fairly large amount of debt capital on the sidelines, which enables people to leverage deals at a higher rate and therefore push up the prices of assets," says Ryan McNelley, managing director at Duff & Phelps. "In the private debt markets, we see players chasing higher leverage ratios and lower rates of return for a given level of risk. To a certain extent, this has been driven by US investors seeing an opportunity in Europe and expecting a tidal wave, when it has so far turned out to be more of a trickle."

This theme of too much capital chasing too few opportunities is, of course, a major factor at play for the sponsors themselves, especially for those chasing assets in European private equity's engine room, the generalist mid-market. Mitigating rising asset prices by shifting strategies on an existing fund is often not viable, as GPs promised specific exposure to their LPs. This leaves them with the option – often encouraged by the more long-term-focused LPs – of exercising restraint and waiting for the market to settle down. "We are not quite there yet – sponsors are still optimistic that they can find good deals selectively. Whether or not that will prove to be the wisest decision is hard to ascertain. We will have to wait and see the returns in five years' time," says McNelley.

Going all in
This resonates with Charlie Johnstone, origination partner at ECI Partners – a firm that was comfortable to strike a deal believed to value UK cycling retailer Evans Cycles in excess of 10x EBITDA in May. "We've had a long-term strategy of being happy to pay the right price for quality businesses, where we can bring value to the table. The proof is in the returns and you only know that when coming out the other end," he says, before adding that careful origination is key to justifying current pricing levels. "We have got better at focusing on these companies where we can bring real value; businesses we tend to gravitate towards are the ones where our strengths and experience really resonate with the owners or the management team. Therefore, we are able to pay the full price needed to win these opportunities."

But Johnstone highlights how this committed approach, which is now more widely espoused by mid-market players, is also contributing to higher levels of competition, with a predictable impact on valuations: "What is new is that we are starting to see this behaviour from firms that did not previously exhibit it. While some GPs were previously known for hunting value and chipping prices, there has sometimes been a complete reversal in recent months where these same players are now outbidding everyone in processes. It is undeniably making things more competitive."

Catalyst's Currie has witnessed first-hand how committed sponsors can be in auction processes for the right asset: "An inflexion point in the market was when 3i bought Aspen earlier this year. They were in a competitive process, but then, relatively early in the process, they said they could complete in a week because of the work they had done upfront and the money they had spent on doing extensive due diligence." It is important to note that 3i paid 10x EBITDA for Aspen, judging by the company's 2014 results. "They had put themselves in a position where they were highly deliverable so from a seller's perspective it was not only a good price, but also low-risk because of how much work they had done."

GPs' willingness to go all in on what they perceive to be the right asset will remain a feature of the market until either the supply (attractive investment opportunities) or demand (the dry powder of both private equity players and debt providers) are affected in a significant way. In the meantime, Currie expects more of the same for the remainder of 2015: "We don't see any reasons why prices should fall, but there are equally no signs that they should get any better." Whether or not asset prices in Europe are at a peak or have simply plateaued is a different matter – the latter could prompt fund managers to rethink their approach to deal origination even more thoroughly in the longer term if they do not wish to be caught up in the arms race.

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• Topics
• GPs
• Buyouts
• Origination Series
• Top story
• ECI Partners
• 3i
• Inflexion Private Equity
• Gilde Buy Out Partners