The Capital Bubble

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A blip in the in the U.S. private equity market is causing a valuation spike for some middle market companies, creating a flurry of activity among company owners and investors seeking to raise growth capital or to sell their companies outright.

The spike is the result of a bubble of capital that PE firms have at their disposal, but with a “use it or lose it” set of strings attached by the limited partners who pledged the capital in the first place.

The roots of the bubble lie in the extraordinary fundraising boom the PE industry enjoyed from 2006 to 2008. During that period, historic PE returns combined with the availability of free-flowing bank debt to create the prospect of attractive future returns.

That in turn caused limited-partner investors to pony up $541 billion in PE commitments in 2006, $657 billion in 2007 and $672 billion in 2008. Those record levels of fund commitments typically were made with a five year “investment period,” the time frame during which the PE managers could draw on the commitments.

But the difficult economy and crippled debt markets that dominated much of 2009 and 2010 have left an estimated $470 billion of the funds raised during that era uninvested, with only about 12 months on average on the PE funds’ remaining clock. When that investment period ends, the PE funds lose all possibility of earning a share of the upside on their deals, and also wave goodbye to the industry standard 2 percent management fee on the total amount of committed capital.

But PE funds aren’t just throwing capital at every opportunity they see. What has emerged is a bifurcated market: On one end, strong companies whose businesses are growing quickly, throwing off strong EBITDA margins, and which have recurring or at least clear visibility to their future revenues are meeting with huge market enthusiasm, multiple bidders and high EBITDA multiples.

The sale processes for such companies have at times over the past year begun to look like feeding frenzies. In a sample group of middle market M&A transactions we examined from the last 12 months for companies growing at least 15 percent per year with EBITDA margins of at least 15 percent, the average purchase price to EBITDA multiple was in excess of nine times. That’s fully 50 percent higher than the 2009–2010 middle market average EBITDA multiple of closer to six times.

On the other side of the bifurcation, companies where revenue, profitability and the strategic path forward are less clear, or are cyclical, are finding it tough to get the time of day from many funds. Those deals are taking much longer than expected to close, and in some cases not closing at all.

Unfortunately for those entrepreneurs and investors selling a company, this window will be short — only about a year at most. Because PE fundraising tailed off severely from 2009 onward, transaction multiples are likely to begin to contract as fewer bidders seek any given target.

There are a few cautionary notes for company owners seeking to sell or raise capital, however. Among them: so-called “Zombie funds,” PE funds whose mediocre track records led them to be unable to raise more current funds from limited partners. Zombie funds are considered less desirable partners for a middle market company since they don’t have dry powder to invest in new opportunities or acquisitions a company might uncover.

There’s also the danger of chasing the most aggressive bidder, because an investor who’s most willing to overpay for a minority or majority stake in an existing company may not be the best long-term partner for the management team.

Middle market companies face less liquid capital markets than their Fortune 500 public brethren, making a hot market all the more enticing. It should make for a very busy 12 months ahead as owners and investors scramble to take advantage of the moment.

Mike McGill is co-founder and managing partner at MHT Partners LLC, a Dallas-based middle market investment bank.

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