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Market survey: A thumbs-up for discipline

M&A activity is booming while leverage multiples fall, making a safe and productive environment for debt investors.

The M&A boom is apparent in the latest European Valuations Perspectives report from Lincoln International, the Chicago-based investment banking advisory firm, writes Andy Thomson. It shows global M&A deals reaching about €250 billion last year, the highest since 2011, and beating previous peaks of 2017 and 2018.

Richard Olson, Lincoln’s managing director in the UK and European valuations and opinions group, says he sees no reason why the boom will not continue given the “significant oversupply” of capital in private equity and credit. In private credit, he says there is two-and-a-half years’ worth of capital available for deals at the current pace of deployment.

The deals frenzy has led to speculation about whether market conditions might be getting out of hand, but Olson says looking at European deals’ enterprise values and EBITDA multiples suggests “extraordinary discipline” has been maintained. Out of five sectors analysed, the consumer sector saw leverage peak the highest at 6.7x in Q1 2021. But, by the end of the year, this had fallen to 5.5x.

The average leverage multiple for all European deals was 5.1x at the end of last year, down from a high of 5.5x in Q1 2021. The average enterprise value in European deals was 11.6x at the end of the year, compared with a high of 12.2x in the second quarter of last year.

Comfortable cushion

Also hinting at the safety of deal structures is the size of the equity cushion – here there is a high degree of apparent comfort. In the technology sector the equity cushion was an average of 62 percent at the end of 2021; in others it was within a range of 52 percent (industrials) to 60 percent (healthcare).

One area for concern in previous Lincoln reports was covenant headroom, which measures the amount of room for manoeuvre before companies breach covenants. This was down to just 6 percent in the consumer sector in Europe in Q4 2020 but had risen to a more comfortable level of 19 percent by the end of last year. Olson suggests this was on the back of equity injections and improved performance. In the other four sectors, headroom was between 28 and 39 percent by the year end.

The report gives a strong indication of improved operating performance of portfolio companies. In Q1 2020, some 20 percent of European valuations were at less than 90 percent of par according to fair value as companies experienced stress during the pandemic. By the end of last year, this had fallen to just 5 percent, with the average valuation at 97.8 percent of par (the same as for the previous quarter).

However, with higher inflation it is unsurprising that some cost pressures are becoming apparent. While the vast majority of companies in the study (843) saw EBITDA increase by an average 6.5 percent in 2021, 32 companies saw an average fall of 11.3 percent. Of these 32, 14 were consumer-focused companies, which dropped an average 23.1 percent.

The overall picture is undoubtedly of a resilient European market, despite fears expressed in some quarters around the level of competition, apparent weakness of some deal structures and the amount of leverage.

“Performance appears to be aligning with valuations and this looks sustainable, assuming inflation doesn’t bite too hard into performance,” says Olson.