According to the quarterly recap by GF Data (compiled from over 200 completed private equity transactions valued between $10 mm – $250 mm), valuation and leverage multiples are at their high water mark in the lower middle market.
The seller’s market – with unprecedented valuations and aggressive debt availability being driven by non-bank lenders – continued unabated in the second quarter of 2017.
- Average valuation reached 7.4 x, highest in the 15-year history of the data base
- Transactions with above average revenue growth and adjusted EBITDA margins captured a 33 percent premium compared to other transactions.
- The average total debt of 4.2 x is also a high
This is great news for business owners in very active M&A areas such as IT Services/ Systems Integration, who report receiving a record number of phone calls or email solicitations from PE’s and strategic buyers.
They often ask us: is this the right time to sell?
Will the market continue to go up?
Will I get 20 percent more if I wait one or two years?
There are two parts to the answer we typically give business owners:
- Timing the market is hard to do and not even the pros can do it successfully and consistently; timing the market of a lower middle market company, with so many economic, industry, technology and local factors impacting its valuation, is virtually impossible. You also need to take into account that the sale process itself can take 6 – 9 months or longer. Some might get lucky trying to time the market, but a lot can go wrong too.
- We believe that the most important factors in determining the timing of a sale should be the personal factors – career, desire to do something else, the realization that the business has reached the maximum revenue and complexity the owner feels comfortable running and growing, the job isn’t as fun as it used to be, the need to take chips off the table and diversify; age, health, family situation, opportunities for the employees, succession planning, etc. Only after focusing on those goals should owners consider micro factors (their industry trends) and macro factors (US and global economy, interest rates, etc.)
Over the years, we’ve also seen that the market for a specific company, created when running a targeted M&A process, can differ not only from the broader market but also the average valuations in that specific industry.
We closed a very successful transaction – as both the buyer and the seller confirmed several years later – in 2009, a year with statistically very low average indicators.
So where are we in the current macro economic cycle?
There appears to be a consistent trend of longer economic expansion cycles coupled with decreased annualized GDP growth rates.
As M&A tends to follow and sometimes predict economic cycles, it might suggest that growth in valuations will also be moderate as we progress through the cycle.
We are now two years shy of the longest cycle in the last 50 years; and the economic cycle is a key driving factor behind the rich valuations we see now.
Having said that, it’s still nearly impossible to address all of the questions needed to forecast the macro environment.
Will this expansion last longer or shorter?
What does it mean for a business owner looking to exit in the next one to three years? Thus, it is crucial to ask if the potential increase in valuation over the next six to 18 months outweighs the risk of a cyclical downturn and then having to wait another four to eight years for an exit opportunity.
This is where the personal goals play a key role in determining macro risk tolerance.
What about the micro factors – the industry specific factors – that could impact valuations?
Here are several current developments we are seeing in IT Services:
- The consolidation continues at an increased pace, with large and very large transactions recently announced and others expected: ConvergeOne acquired Annese and SPS, Sirius reportedly in talks to acquire Forsythe, CompuCom and Pomeroy said to have entered merging discussions. These, and other anticipated transactions, will change the SI landscape and will create several multi-billion dollar players. The rush for scale might be driven by the goal of going public, considering the valuations ePlus, CDW and other leaders have recently achieved. Size matters and revenues above $1 billion seem to be the necessary threshold for companies in this industry to consider going public. This hyper-consolidation will reduce the number of potential strategic acquirers of companies in the $20 – $100 mm revenue range, who will most likely be too small to be interesting to the big players or able to fetch a premium when considering a sale.
- Top valuations are being paid on an historical basis but only where there is a perfect match. Buyers value a seller based on how much value the seller represents to them, and finding that perfect match requires work, a deep understanding of both businesses and perfect timing.
- The high valuations are supported – as the GF Data report indicates – by very high debt ratios. If and when interest rates will increase, what impact will the rate increase have on valuations?
- While valuations are strong, have they peaked for systems integrators with less than 10 to 20 percent recurring revenues? Exceptions will exist for sellers with unique characteristics – such as a specific geographic footprint, above average growth rates or vertical specialization – but will be rare.
- Managed services companies continue to attract buyers and see valuations higher than 1 to 1.5 x recurring revenue. But that market could reach an inflection point: smaller MSPs tend to service small customers (50 – 200 employees) while the larger MSPs or SIs, who would be the natural buyer, focus on the higher SMB and enterprise space and are less interested in small customers. In addition, many of the larger SI’s have developed internal services expertise and will not value it as high as some did in the past.
- High valuations paid for MSPs are based on the recurring nature of their revenues, which also typically leads to higher than average profitability. MSP’s with lower profitability are valued at a lower multiple.
In the last 12 to 16 months, we have seen a higher than usual number of transactions under letter of intent (LOI) fall apart or are being re-traded; after offering premiums in the LOI, buyers walk away when due diligence raises the smallest of concerns.
- We are seeing a change in demographics: The average owners’ age of sub $100 mm IT Services businesses is lower than it used to be five or 10 years ago, which could mean that to be motivated to exit at a younger age, they will expect higher prices. Will buyers continue to offer them?
For business owners whose time horizon for an exit is five to 10 years and longer, the best answer and advice to the question “is this a good time to sell my business?” is to continue to grow and enjoy running their business.
For those contemplating an exit in the next one to three years, it is time to review the personal goals and how the current micro and macro trends will allow them to maximize the proceeds when selling.
Cristian Anastasiu is managing director at Chapman Associates, a mergers and acquisitions consultancy that specializes in companies valued at $3 million to $150 million.