There has been a lot of talk since the middle of last year about the encouraging historic precedents for deals struck when cycles begin to turn down. And yet, as a new survey shows, it would be premature to celebrate the 2008 vintage just yet.
Periods of apparent plenty for GPs – such as 2006 to 2007 – often turn out in retrospect to be the ones that most disappoint investors. There’s one very simple reason for this: prices go too high. In 2007, the average purchase multiple for global buyouts rose to 9.8 times, according to Standard and Poor’s. That’s significantly higher than any of the preceding 10 years, and compares with an average multiple of around 6 times in 2002.
The latest Alternative Assets Navigator report from Swiss asset manager Partners Group, which covers the first half of 2008, discovers an interesting phenomenon which it calls the “entry price conundrum”. This entails “a fundamental disconnection between financing terms and pricing” in global buyout deals completed in the first half of this year. The report finds that, although the cost of financing rose markedly in the early months of 2008 (the price of senior debt had risen from LIBOR+271 in the first half of 2007 to LIBOR+377 in the first half of 2008), prices of deals had actually increased to a record-high average purchase multiple of 10 times.
The report highlights three possible factors lying behind this. One has been much commented on: sellers not yet adjusting their price expectations to new market realities. Second, only high quality deals will be financed at the current time and, therefore, there’s an argument that assets such as these may actually merit the high prices being paid for them.
A third factor – and perhaps the most interesting – is increased competition in the upper mid-market. When the implications of the credit crunch were first being chewed over by industry professionals, the conclusion was widely drawn that the mid-market would be relatively insulated from the worst effects due to its avoidance of highly leveraged financing structures.
What was arguably not foreseen was that the larger funds, unable to undertake mega-deals, would end up migrating to the upper mid-market. This is the territory where deals are now being aggressively fought over. As the report notes: “As large deals are currently not coming to market, increased competition for upper mid-cap deals seems to be accounting for some of the price increases we have witnessed.”
The report concludes that “going forward…a new reality will lead to lower purchase multiples, a normalisation of equity contributions from the overshooting we are currently witnessing, an adjustment period in leverage to a level between the 2007 highs and the current lows, while holding periods should be at five years on average”.
Whenever this happy confluence of factors occurs, talk of a golden vintage will not be misplaced. For the time being, the “entry price conundrum” makes any such talk premature.