Following up on my last post, examining if private equity multiples were a concern, how most most GPs will tell you this is not a concern, and that they buy below the average, this post is the other half of that story.
In short, elevated multiples are a concern
The averages are high and will at some point come down. The situation is potentially exacerbated by “creative” use of adjusted EBITDA and for those GPs, and there must be some, who have bought above average.
LPs need to understand how and what their specific GPs are doing and with this assess the potential risk and impact to their own portfolio. GPs need to look critically at their investments and act thereafter.
Averages, are just averages, and averages can still be sky-high
The averages that GPs say the buy below, can be seen in Figure 1, for the US, and Figure 2, for Europe, showing the median buyout EV/EBITDA multiples alongside Debt to EBITDA and Equity to EBITDA.
There are quite a few take-aways from these two figures, but what investors should be considering first and foremost is:
“when the median or average itself has “run away” does buying below the median or average matter, and what, in this competitive environment, is it that you buy cheap?”
In the US the median EV/EBITDA multiple is at an all-time high
At 14.1x in 2020 this is well above the prior all time high of 12.7x in 2019 - a year that most investors back then (only a year and a half ago!) saw as eye-watering high and foreboding doom. Debt/EBITDA is also close to an all-time high, but, at least there is still plenty of equity.
Figure 1: Median US buyout multiples
Source: PE Compass, data from Pitchbook Q4 2020
The EV/EBITDA multiple in Europe is coming off an all-time high
At 12.3x in 2018, multiples of 10.2x in 2019 and 2020 seem almost benign in comparison. But not when we look at long term averages. Fortunately Debt/EBITDA has also come down substantially, which to a large extent explains the contracting multiple, and, as in the US, there is still plenty of equity backing .
Figure 2: Median EU buyout multiples
Source: PE Compass, data from Pitchbook Q4 2020
Putting this into some context. The 2006 – 2008 vintages leading up to the GFC, which is the usual industry benchmark for excess risk and subsequent poorly performing vintages, are starting to look quite conservative compared to the headiness of the last couple of years.
Averages can and do also go down
Europe most recently and history more generally, not least the post GFC vintages, illustrate this quite clearly.
Except as part of building a bigger and better company, multiple expansion is something almost no GP will admit to building into their investment cases. However, as also evident in Figures 1 and 2 this, even if not deliberately, is something that almost all GPs to some extent will have benefitted from over the past many years.
But this works in both directions. I.e. in adverse markets you would expect to see multiple contractions.
And this is perhaps the real concern
Look again at Figures 1 and 2. In the US it took six years after the GFC for the median EV/EBITDA multiple to reach the same level as just prior to the GFC. This took eleven years in Europe with multiples falling even more sharply.
In the in-between years, multiples were between 2 and up to 5 turns lower – in Europe up to 7! I.e. those GPs needing to sell, would potentially be doing so at much lower multiples. No matter how much value had been added this was significant headwinds for most GPs.
At this point, having bought below average and though (most) GPs work hard to create value in their investments, reality is that with any risk of multiples coming significantly down, GPs would need to realize investments, especially those of the most recent vintages, fairly rapidly or risk a potentially not insignificant haircut.
Two things exacerbate the risk of multiple contraction
Adjusted EBITDA. This typically inflates EBITDA thus artificially lowering the EV/EBITDA multiple making things seem cheaper. More on this in a future post.
And, averages. As unbelievable as it may seem, just as some GPs must be something other than 1st Quartile, someone must be buying at above average.
For LPs, worth considering both when they look at their GPs.
As a final thought, though Value is out of favour and many are quick to declare him outdated, investors, LPs and GPs, could do worse than heeding Warren Buffet’s adage to
“Be fearful when others are greedy. Be greedy when others are fearful”
If nothing else, Mr Buffet has a pretty impressive track, longer than that of most PE investors.
Not sure if Warren would agree, but
Stay illiquid!
Kasper