Guest comment by Aymen Mahmoud
The reduction in anticipated multiples, for the time being, will likely delay some sell-side opportunities until alignment is reached between the buy- and sell-sides of what a fair multiple is for a particular asset.
Volatility has created a challenging economic environment – ranging from the macroeconomic and geopolitical impacts of inflation, armed conflict in Ukraine and supply-chain issues, to more localised situations, such as UK political upheaval and budgetary impacts on foreign exchange rates.
This has in turn led to the capital markets being almost entirely closed. Even the booming private credit industry has taken a more cautious approach to underwriting, particularly in larger deals where one fund might have financed an entire stack a year ago, but that deal would now require a large syndicate of private credit funds.
Such disruption has extended to other types of transactions: a reduction in the number of recapitalisations has illustrated a growing desire from lenders to see private equity sponsors retain skin in the game.
As we know from the global financial crisis, the relative absence of credit makes for a more challenging private equity environment, but also causes lenders (and therefore associated borrowers) to closely examine the multiples being applied in any given valuation. Movement in the private markets has been facilitated by public equity markets, which have moved to revalue stocks in recent months.
Why then do the public and private markets suggest that valuation multiples are exuberant – and what has caused this? The answer is in something of a perfect storm.
Over the past few years, the sheer availability of dry powder within both equity and debt markets, coupled with a search for yield, has created a buoyant sell-side market.
This, and the growth of buyout markets, have continued to drive valuation multiples higher still, with buyers not wanting to lose out on buyout opportunities and relying on their exit valuations. The influx of interest in technology businesses that came out of a post-covid environment was key, with venture capital firms and founders a new and significant focus of the credit markets, looking to capitalise on a new and potentially huge area of growth.
As the markets have refocused, sellers are faced with a difficult task: how do I come up with the right valuation multiple for my business and how different is that from the valuation multiple which formed the basis of my investment thesis? If history is anything to go by, we can expect a period where the sell-side and buy-side views on valuation are first wide apart and then narrow over time.
While capital is patient for existing businesses and fund cycles can extend beyond a decade, we can expect to see a shift in new transactions to lower multiples than those seen historically, across both private equity and public markets. Given inflationary pressures and rising energy costs, coupled with 80 percent of investors still viewing venture capital as overvalued, investments are likely to be marked down in the near future. The volume of dry powder, however, may keep that future more ‘near’ than ‘far’.
As distinct from 2008, investors have funds to deploy, and are paid only when those funds are deployed. This will act as a considerable incentive for the period of disengagement on valuation multiples to re-engage at more amicable levels. For businesses with more fundamental issues, we are reminded of Warren Buffett’s words on valuations: “Only when the tide goes out do you discover who’s been swimming naked.”
Aymen Mahmoud is a partner and co-head of London finance, restructuring and special situations at McDermott Will & Emery