Buyout barons’ dirty secret shows hard times ahead
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
By Liam Proud
LONDON, Sept 12 (Reuters Breakingviews) -Private-equity dealmakers like to boast about the ways they improve companies, like supercharging growth or trimming costs. The evidence, however, suggests that buyout barons owe a large chunk of their success to rising valuation multiples instead. Since that boost seems likely to fade away, industry titans like Stephen Schwarzman’s Blackstone BX.N and Henry Kravis’s KKR KKR.N will have to work harder to keep pumping out the same level of returns.
The years of super-low interest rates and ubiquitous central-bank money printing, which followed the 2008 financial crisis and 2020 pandemic, sent stock-market valuations soaring. The median enterprise value to EBITDA multiple for the MSCI World Index .MIWO00000PUS peaked at almost 15 in 2021, compared with less than 10 in 2012, according to a McKinsey & Co. report. That phenomenon lifted returns for buyout barons, who often found themselves able to offload companies at a much higher multiple than the one they paid.
Take Carlyle CG.O and Hellman & Friedman’s ownership of Pharmaceutical Product Development, which runs clinical trials. The pair sold shares to Thermo Fisher Scientific TMO.N at a $21 billion enterprise value in 2021, or about 23 times trailing EBITDA. That compared with a roughly 13 times multiple they paid for it a decade earlier, according to Breakingviews calculations. The duo did manage to quadruple the company’s revenue to $5.9 billion during that period, but they were clearly also helped by rising markets.
It’s hardly a one-off. Consultants at Bain & Co. analysed deals struck between 2013 and 2023 to isolate the causes of any increase in a company’s enterprise value during private-equity ownership. The median contribution from rising valuation multiples was 47%, compared with 53% from revenue growth and practically nothing from increasing profitability. In other words, about half of the valuation boost that buyout barons got for their portfolio companies came from higher multiples. The proportion was even larger, at 64% and 71% respectively, in cases where dealmakers bought a division of a larger company or took a publicly-listed target private.
That should worry captains of the buyout world, like CVC Capital Partners’ CVC.AS Rob Lucas and Advent International’s David Mussafer, because a repeat of the post-2008 valuation runup seems unlikely. Central banks are cutting rates, but probably nowhere close to zero, and they’re generally still winding down bond-buying programmes that poured rocket fuel on multiples. The S&P 500 .SPX currently trades at 27 times trailing earnings, according to LSEG Datastream, compared with a 20-year median of 19, implying there’s little room for valuation upside. That means dealmakers will have to make up the difference elsewhere or accept lower returns.
The private equity industry still has a couple of tricks up its sleeve, though both are getting harder. Buyout barons have honed a strategy known as “buy-and-build”, which involves taking control of a mid-sized company and snapping up smaller rivals, exploiting the fact that tiny unlisted firms change hands at comparatively low valuations. These add-on transactions have accounted for about 60% overall U.S. private-equity deals since 2019, according to PitchBook.
The playbook allows buyout barons to manufacture their own valuation uplift, regardless of what stock markets do, because the larger bundle tends to get a higher multiple than any of the bolt-on acquisitions. One example is Vista Equity Partners's 2015 acquisition of British software group Advanced, which has scooped up smaller peers and attracted a 50% co-investment from BC Partners in 2019. LSEG’s M&A database lists 13 deals since 2016 where Advanced was the acquiror.
The problem is that this strategy typically relies on debt, as acquisitive companies need to lock in cheap and flexible funding for future deals. That is now in shorter supply and much more expensive. S&P Global, for example, last November downgraded Advanced’s credit rating to CCC. The average leverage multiple for U.S. buyout loans dipped below 6 last year from 7 the year before, according to LSEG LPC data reproduced by Bain & Co. The same consultancy estimated that, for a hypothetical buy-and-build strategy funded with debt equivalent to 7 times EBITDA, the cost of financing roughly doubled between 2020 and early 2024.
A second possible solution is for buyout barons to engineer a valuation uplift by changing the characteristics of businesses they own, for example by generating more stable revenue streams. EQT’s EQTAB.ST 2017 investment in waste-filtration business Desotec is a good example. The Nordic buyout shop turned the company into more a subscription-based business, allowing it to sell to Blackstone in 2021 for 18 times EBITDA compared with an initial acquisition multiple of 12.5, according to a person familiar with the matter.
Such transformative opportunities are rare, however. And there’s little evidence to suggest that buyout barons in general have a good track record of earning valuation-multiple windfalls by sprucing up their investments. McKinsey & Co. recently published an analysis based on StepStone data covering 2,512 deals from 2010 to 2021, which showed that the valuation multiples of private-equity owned companies rose more slowly than those of comparable public index benchmarks. The implication is that, on average, private owners didn’t add any extra juice to a market-wide re-rating that was happening anyway.
The upshot is that buyout barons can no longer count on rising markets. In fact, they are now factoring in significantly lower exit multiples when mulling possible targets, according to bankers. To replace what they’re set to lose on the valuation, then, private-equity firms will have to buckle down on boosting their companies’ profit.
Relying on cost cuts looks tricky. Public companies are increasingly focused on slashing expenses, and many businesses have already been through the private-equity wringer, and so have little fat left to cut. The other remaining lever is to boost revenue. Companies in fast-expanding sectors like software and healthcare provide an extra layer of protection since they have a better chance of growing their sales, and eventually make up any decline in the valuation multiple.
Buyout barons have a pretty good track record of upping portfolio companies’ top lines over the past decade, according to the Bain & Co. data. But they’ll have to do more than they have in the past to make up for less favourable markets. A widespread hunt for fast-growing targets, meanwhile, raises the risk of steeper bidding competition and therefore higher purchase prices. If that plays out, buyout barons could end up just swapping one valuation headache for another.
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Breakdown of median LBO value change, 2013-2023 https://reut.rs/3MBda4k
Buyout barons paid higher valuations as markets rose https://reut.rs/4giz3Dd
Leverage multiples for U.S. buyouts crashed in 2023 https://reut.rs/47cC1Fb
Editing by Neil Unmack and Streisand Neto
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