A Seller's Market

A Seller's Market

Finance by Janet Leiser | Senior Editor

The private equity market continues to set records, raising $44 billion in the first quarter, up 67% from last year. Growth is expected to continue well into 2008.

Business owners are receiving some of the highest multiples ever when they sell growing companies, thanks to the booming buyout market spurred by the ready availability of capital at low rates and good terms.

"Capital begets capital," says Tom Avery, a managing director for St. Petersburg-based Raymond James Financial.

This year is on track to be the fourth consecutive record year for the buyout industry, he says, with volume expected to grow for another 12 to 18 months - as long as there's not a catastrophic event akin to 9/11 or the Feds don't substantially raise interest rates.

The private equity market, also known as the leveraged buyout market, continues to set records, raising $44 billion in the first quarter, up 67% from last year, Avery says. With 80% of that going to the buyout industry.

Avery and three private equity managers were guest speakers at the April 19 joint meeting of the Tampa Bay chapters of the Association for Corporate Growth and the CEO Council. The discussion was titled, "How Will Private Equity Firms Value Your Business?"

"Since 2001, we've had almost a ten-fold increase in the volume of buyouts in the private equity world," Avery says. "Most of this growth, or a lot of this growth, comes from some of the private transactions you've read about in town."

Panelist Charlie Ogburn, global head of investment for Arcapita Bank B.S.C., a merchant bank headquartered in the Middle East with an Atlanta office, says: "If any of you are owners of good, solid middle market businesses and you are thinking about selling, congratulations! This is the best environment in my lifetime and I'm getting old."

Rob Palumbo, panelist and managing director for Accel-KKR, Atlanta, says his firm focuses on mid-market intellectual property and software companies, with revenue between $20 million to $125 million.

"Software is another area of the economy where it's a wonderful time if you're a business owner thinking about selling," Palumbo says. "The bad news is that 10 years ago, if you had a software business with $25 million to $50 million in revenue and growing profitably, you could probably take it public."

That's no longer a viable option.

Consolidation in the capital market makes it more difficult to take companies public, Palumbo says, adding, "We have become the surrogate for the IPO in providing liquidity to business owners."

Buyouts can obviously be quite complicated, but some are more intricate than others, says panelist Will Kessinger, a managing partner and chief investment officer at Parthenon Capital, San Francisco.

"Most of our deals are very complex and take a lot of time to close," Kessinger says. "We had one deal that closed last year that took us 18 months to close. It involved combining three companies, approving a management team, among other things, to make the transaction work. We try to create value through sweat equity."

Avery and the others say most private equity firms now become quite involved in the operations of portfolio companies. The days of handing millions of dollars and waiting years to realize a return on their investment are long gone.

Arcapita took pride in being a hands-off investor until about six years ago, Ogburn says, adding, "With the higher prices that we're paying, the higher leverage we're taking on, we think we have obligations to do more to create value during our period of ownership.

"Used to be when you bought it at a fairly modest multiple and through pay downs and possible capital expansion, you'd have the opportunity to make money without necessarily making dramatic improvements."

Avery says a soaring deal market isn't new to the U.S. economy. Remember the early '90s?

"Some of us are old enough to have seen this movie before," Avery adds.

Following is an excerpt of the panel discussion, edited for brevity.

What's different about this market that we don't end up with the same sort of correction that took place in the early 1990s?

Palumbo: I'm not sure it is that different. People in the capital markets, all of us, unfortunately tend to have short memories. Right now when you think demographically, you think about Baby Boomers, the economy, there's an unprecedented level of capital (endowments, pensions and stuff like that to fund your fund, etc.) They are overflowing with capital to put to work. It's a bit of a perfect storm because the debt markets are also providing unprecedented levels of leverage to the transactions you want to do.

I think when that economy turns and the credit market tightens, there'll be a lot of good deals that will have happy endings, but there will be some fallout.

Kessinger: I have to agree. From an investment perspective, we try very hard to avoid investments that are tied to the economy right now. We do invest in companies that have cycles or industries that have different cycles than the rest of the economy. The economy as a whole you are going to see a credit crunch at some point and that's going to have a severe consequence on the economy as a whole and on the capital markets as a whole.

Ogburn: I'm open up to remembering not only the early '90s deal market but also the late '80s deal market. Some things are the same. We have had a credit-driven expansion of the deal market and banks have had their house in order pretty well over the past several years.

They (banks) start to reach for earnings, they start to relax their credit stands, they start to do more aggressive deals, they start to lend at higher multiples, they start to relax covenants, and they don't see a lot of immediate deterioration in their credit quality or an increase in their default rate, then you get a fairly buoyant atmosphere like we have now.

Eventually that will change. There will be spectacular wipeouts, there will be people who start to miss covenants and go into default.

One thing that is different now is we have much more diverse debt syndication markets. The banks are not holding these loans for the most part on their own balance sheet. They are syndicating these out, not just to other banks like we had 10 or 15 years ago, but to this incredible hodgepodge of other investment vehicles, collateralized loan obligations, hedge funds, all kinds of other entities are helping to spread the risk around on your debt landscape.

You also have an international dimension, both in the financing side and the businesses themselves, which I think gives you a better integrated global economy, and when there is a hiccup, I think that creates opportunity for international buyers to come in, international capital sources to come in.

I think that's different.

What rates of return do the firms seek on their portfolio companies?

Kessinger: It very much depends on the risk profile. We're looking to create a lot of value outside the capital that we invest. We typically target three to five times our money over a five-year period.

Palumbo: We're very similar. That often equates to about 25%. One thing I would say about the megafunds, the KKRs and the Blackstones, is that market has changed fundamentally. Some of their investors want to write huge, huge checks and put a lot of money to work.

When you have that much money to put to work, frankly, it's almost impossible to get those kind of returns. I think the way that investors in funds think about investing large funds like that is really a spread over the S&P. And if you can get 400 to 600 basis points over the S&P, that is what's expected in those markets.

That is much different from a mid-market buyout fund which I'm part of where you're expected to get 20%, which will equate as to three to five times your money in five years.

Ogburn: I agree. We tend to target gross returns in the mid- to high-20s on our buyout transactions. But if you look at actual reported experience of the industry, the National Venture Capital Association publishes on their Web site, by asset categories, actual realized returns, there's some interesting reading there.

It definitely shows there has been an erosion in returns because of the great wall of money that has been coming to the market. In large buyouts, if they can return mid teens annualized returns to their investors, I think they're doing pretty good.

What influences valuation, in addition to earnings before interest, taxes, depreciation and amortization (EBITDA)?

Palumbo: Our business is an art, not a science. We look at return from growth, growth, market position, market profile and management team, among others.

Kessinger: In some companies, EBITDA is less relevant. They care less about what your profits do as to what they can make off that revenue.

Ogburn: Growth is obviously a big factor. But in addition there are a couple things I would stress. How proprietary is the company's product or service? Does the company own a patented product?

Some companies have high reported EBITDA, but they have very long receivables collection cycles and very high capital expenditure requirements so the business doesn't generate a lot of free cash flow. Free cash flow characteristics used to pay down debt.

It's very market driven, and the same business with the same market characteristics that may command a nine- or 10-multiple today would have commanded a six- or seven-multiple two years ago.

And to some degree, guys like us are like the people buying appliances, we say, 'How much is the payment?'

What are some of the characteristics of your best and worst investment?

Ogburn: Our worst investment (made before he joined the company), we invested in a quality company that had some fairly mundane electronic assembly businesses and a new product for collision avoidance for commercial trucks. And we believed that product was ready for widespread adoption. We believed the company had a proprietary advantage. We believed they already had a significant distribution system set up with a partner.

And none of that was true. The product was not ready for prime time and we spent years trying to find customers for it. We set some kind of world record for beta tests that did not turn into orders. We just made a bad call on that product.

Palumbo: Both instances (best/worst) came down to management. One of our disappointments was a company that was a very profitable business. It had lots of exit opportunities. It was growing quickly, taking on larger and larger customers.

Software implementation can be dicey, especially if you don't know how to handle it with larger customers. They got into trouble. That became their downfall. They wrote some bad contracts they weren't ready to handle.

For us it really came down to a CEO and management team that just simply did not scale with the business. We actually spent a lot of time and money and hired outside experts and management assessment firms.

Our best investment was a company that was a very small business, very profitable. A month after we bought the business, one of their competitors was for sale. It was three times as large but it was barely making money on a gross margin basis. In a year, they had turned this business around spectacularly. It had gross margins of 30% and was growing 20% a year. It's probably going to go public.

It easily could have been our worst investment if we didn't have the management team. We made a huge bet on an unproven management team a month into an investment.

There's a lot of luck in our business. It can make us look smart.

Kessinger: Early on we were more a generalist firm, we didn't have the industry focus we have today, and I think that really hurt us when you make investments without fully having knowledge of a sector. We made a very large investment in Atkins Nutritionals. That didn't work out.

On the flip side, we made 13.5 times our money on a company, which makes servers for high density computing. The thing we did well, we identified a very attractive niche market, a company that was well positioned but needed a lot of help to scale the business.

Basically, after we bought the company, the company doubled its revenue for five years in a row. It grew from $25 million to more than $600 million this year. It was a sector we knew very well.

With the multiples for companies going so far up, can you explain your thoughts in the bid process? Where do you decide we're going to go along for the ride and pay a higher multiple?

Ogburn: I'm going to commit an act of heresy here and say that we actually let the price creep above what we thought our maximum price was.

We run financial models, they are run on a five-year horizon. They tell us what a fair price would be under a certain set of assumptions. Like everybody, we look at management's best case, we look at the more conservative case that we think is more realistic and we look at a more severe downside case. We try to measure all those to figure out how our capital is going to achieve returns over time.

But if it's a really high quality business with the characteristics that we really value and a matter of a percent or two on the price, we have sometimes made the decision to reach and do that. And the case where we have done that, we have not been unhappy with it.

Kessinger: We have very research-driven methods. We relate it back to our own past experiences. We try to be an insider as we make those decisions, much the way a corporate buyer would proceed.

Palumbo: We know the software space extremely well. We understand what the metrics should be. We understand what the market profile, the growth profile should be. We'll take management's projections and develop our own. They may be slightly less optimistic, maybe not.

If it's going to take a higher number to get it done and it doesn't work for us, we simply walk.

In the heat of making the deal, there are a lot of short-lived victories out there, people who want to own a business so bad they'll pay too much.

REVIEW SUMMARY

Who. Tom Avery, Will Kessinger, Charlie Ogburn and Rob Palumbo.

What. Panel of private equity experts discuss valuation of companies.

Key. It's a good time to sell a growing, profitable business.