7 JUL, 2023
By Constanza Ramos
David Schäfer, Managing Director at Munich Private Equity Partners.
David Schäfer, Managing Director at Munich Private Equity Partners provides profound insights into the effects of market conditions on private equity valuations, the adaptation of valuation methodologies, and the challenges and opportunities that arise for investors. With his experience and expertise, David offers valuable perspectives that shed light on the intricate dynamics of private equity valuations.
In contrast to the significant declines witnessed in public markets in 2022, we have not seen a similar draw down in private equity valuations in general. That said, there has been some variation across segments. Large caps, for example, have generally been more affected by overall market sentiment, given that private companies in this size segment are more comparable to publicly listed companies. Also, an IPO is a more likely exit route for large caps, making public valuations even more relevant as way of evaluating enterprise values. The lower mid-market, where we focus on, has been generally less affected.
Public comparables have a smaller impact on the overall valuation in the lower mid-market segment as valuations tend to be a more balanced mix of DCF, comparable transactions, and public peers. Also, lower mid-market companies are more likely to operate in attractive niche markets resulting in underlying financial performance also typically being less affected than that of their larger peers, which tend to be more dependent on the overall GDP development of an economy.
Valuation methodologies should not change significantly as they are widely accepted industry standards. Rather, it is the input that goes into the equations that has changed, such as higher costs of capital or larger discounts on future cashflows. Also, market participants might take a more critical look at the relevant past transactions, which might have been based on other financing conditions, and comparable public company when assessing the appropriate multiple for a company’s valuation.
Valuations might currently be somewhat depressed due to market uncertainty and limited availability of debt. This does not mean that a well-managed, growing company that is not for sale should be worth less in general. Hence, the answer to the question of a company’s fair value might be a bit more complex. Also, as sellers tend to delay exits where possible, fewer transactions also mean fewer relevant data points to validate valuations. However, especially investors with strong proprietary deal flow and a focus on founder-led businesses should be able to take advantage of the current environment and buy promising companies at attractive valuations. In these cases, founders might be actively seeking a partner to help them navigate through the next phase of their growth in the current more challenging environment instead of trying to maximize their short-term profits.
Looking at our portfolio of more than 100 buyout funds, and also taking the discussions with potential new managers into account, we do not have any broader or “structural” valuation concerns. Across our four fund of funds programs, we have recorded more than 83 exits to date within the lower mid- and mid-market in Europe and North America. And across all these realizations, the average sale price was 35% above the valuation two quarters prior to exit. This is in line with the findings of the latest Bain Global Private Equity Report, which found that buyout funds have exited assets at valuations exceeding their last quarterly mark almost 70% of the time.
In general, private equity should not be expected to fully correlate with public markets for several reasons. First, the asset class has historically outperformed public markets. The gap tends to be even wider in volatile times, which could last be observed again in 2022. This is partly because PE-backed companies are typically better resourced and have high-quality boards as well as majority owners who are not shy to change management teams or to restructure incentive plans in order to achieve growth targets. Second, the composition of private equity portfolios typically differs from that of public markets, with PE managers more active in growing niches. Public market indices on the other hand are mainly driven by a more limited number of large tech companies. And third, private equity valuations generally tend to be more conservative as LPs don’t like negative surprises. So, it could also be the other way around that we will see an uplift in valuations when the economy recovers.
The guiding principle is always to try valuing companies at their fair market price. Private equity managers typically use a varying mix of comparable transaction multiples, public market comparables, DCF, LBO return analysis, and, where appropriate, other techniques. Valuation methods are generally applied with varying weighting, depending on the situation, the asset, and the industry.
There is a saying that valuing a company appropriately is similarly an art as a science. So, while the valuation methodologies are mostly standard, there is potentially room on the input to distorting performance measures. For example, GPs might favor one metric over another to enhance their numbers, select less appropriate public companies as peers that are highly valued or make inappropriate adjustments to the underlying EBITDA to make their assets appear more attractive. That said, while it could be advantageous for fundraising in the short-term to inflate valuations, it will hurt long-term credibility of fund managers, which might severally negatively impact their ability to raise future funds.
When conducting due diligence, investors should pay attention to the unrealized portfolio of managers and stress test valuations. This involves a close review of the valuation sheets as well as discussions with the GP about relevant peer groups and valuation benchmarks. This, of course, requires a certain level of experience on the part of the investor.
Given our focus on the lower mid-market, we are most certainly a bit biased. However, investors should consider the structural advantages of this segment, which pay off particularly in volatile times such as lower entry multiples and leverage levels compared to the large-cap space as well as more exit opportunities due to a broader universe of buyers and less reliance on the IPO market. Lower mid-market companies also often have untapped growth potential and may be more open to partnerships due to founder-led structures. Founders, prioritizing long-term growth over immediate valuation, are more likely to look beyond price and therefore more willing to partner with an investor who can help them navigate and grow in the current challenging environment, even at a price that may be slightly depressed due to the current uncertainty in the market.