This week's chart focuses on finding value in the private equity middle market by looking at the purchase price multiples since 2004, as represented by Enterprise Value (EV) to Earnings before Interest, Taxes and Depreciation and Amortization (EBITDA), of companies whose enterprise values are between $100-$500 million (Middle Market) versus those valued at less than $100 million (Lower Middle Market). This is similar to looking at the difference in Price to Earnings (P/E) ratios of publically traded companies.
The chart shows that lower middle market companies have, on average, traded hands at a differential that is less than their larger counterparts by roughly a factor of two. While this differential is justified given the risk associated with a smaller scale business, it also presents opportunity.
A skilled private equity manager with experience building companies and a proven track record of growing earnings can take advantage of this differential. Take a company with $8 million of EBITDA at the time of investment; naturally, it will grow in value if the manager can set the company on a stronger growth trajectory. A manager with a strong operating background can specialize in helping companies in a variety of ways, including building out distribution channels, completing tuck in acquisitions, recruiting talented management teams and expanding a firm's geographic footprint. After the investment hold period, let's assume the manager was successful and now the company has grown to $16 million in EBITDA. Demonstrated below, at an 8x multiple the company has gone from a $64 million enterprise value to an enterprise value of $128 million.
$8M (EBITDA) x 8x (Purchase Multiple) =$64 million
$16M (EBITDA) x 8x (Purchase Multiple) = $128 million
In addition to the value creation from growing earnings, which is the primary value creation, the business may have scaled to a point where it is attractive to buyers in the larger parts of the middle market. Demand is strong in these markets, and the risk in the business is now less, which will generally command a larger purchase multiple as evidenced by this week's chart. This expansion of the multiple can serve as a second uplift in valuation and drive significant value for investors. If we revisit the prior example, and the company were to attract middle and upper middle market buyers, it could now be worth $160 million in enterprise value ($16M (EBITDA) x 10x (Purchase Multiple) = $160M versus the earlier $128 million). There is still an ample supply of capital chasing deals in the middle and upper middle market. In fact, according to Pitchbook, in the second quarter of this year, $76 billion dollars was deployed into 300 middle or upper middle market companies.
Key Takeaway: I look to target private equity managers in the middle and lower middle markets with proven sector expertise and the operating ability to grow a sub-scale organization to one that will catch the eye of acquirers in the larger parts of the private equity middle market. While most of the market is rich in valuation, there is still some opportunity for those managers who are willing and able to roll up their sleeves and build businesses of scale that are attractive to a crowded group of buyers whom have significant capital to deploy.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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