The Ballooning Valuations In Private Equity Deals
Private equity is getting increasingly expensive. As a result, the pricing of an average deal today, by the EV/EBITDA metric, is expected to be at a premium relative to the last decade.
The EV/EBIDTA ratio breaks down into two parts:
- Enterprise Value (EV): Adding debt to market capitalization, while subtracting cash gives us the enterprise value. This gives us the total value of a company.
- EBITDA: Earnings before interest, tax, depreciation, and amortization or, EBITDA, provides a popular way to look at earnings. By removing these expenses, we obtain a clearer look at operating performance.
Overall, EV/EBITDA shows the relationship between a company’s total value and its earnings, and is often seen as the price-to-earnings ratio’s sophisticated sibling, used to view companies the way acquirers would.
However, the EV component is not necessarily intuitive, so let’s expand a little on it:
Why is Debt Added Back to Enterprise Value?
To acquire a company completely, one must pay out all stakeholders in order to reach the final cost of the acquisition. This includes the stock (equity holders) and the debt holders, subsequently, adding back the market value debt to market cap does just this.
Why is Cash Subtracted from Enterprise Value?
Subtracting cash can also be seen as arriving at net debt. That is, the remaining debt after using the cash and equivalents on a company’s balance sheet to pay it down. In other words, if cash exceeds debt, enterprise value shrinks, and the cost of acquiring the company becomes cheaper. Whereas if debt exceeds cash, the acquirer would have to pay off more debt holders, thus making the acquisition more expensive.
What’s Driving Higher Valuations in Private Equity?
1. The Link Between All Equities
First, the public markets are often used as a starting point to derive valuations for deals. Generally, companies with similar business models and operations should be assigned similar valuation multiples. For instance, Lowes and Home Depot, or alternatively, Pepsi and Coca-Cola. Therefore, a company under consideration in private equity often has peers trading publicly.
Furthermore, the average multiple assigned to businesses in the stock market fluctuates through peaks and troughs. Today, they’re trading at a premium to historic averages, a result of a rallying prices and elevated investor risk appetite. Naturally, these public valuations spills over into the private equity space.
2. A World of Cheap Money
Second, asset markets move based on relativity and opportunity cost. A low interest rate environment pairing with the trillions in money printing is placing debt securities at unattractive levels. Hence, low rates of return on debt is resulting in money moving elsewhere.
For private equity though, debt is considered fuel. And in this industry firms use high levels of leverage to acquire companies. For this reason, low rates and cheap debt are a private equity manager’s dream.
But what’s true for one private equity firm can be true for all. Because access to cheap debt means more money chasing deals, and this heightened level of competition is reflecting in the higher multiples and expensive deals today.