Prescott Nasser, Co-Founder & Board Member SourceScrub.
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Let’s not make a deal—at least, not just now. Not until prices are back to “normal.”
That’s a refrain private equity investors and corporate acquirers seem to be hearing more frequently from founder-owners of bootstrapped businesses. Even those otherwise ready to sell or accept outside capital cling to the belief that their businesses are still worth the sky-high valuations they might have commanded only months ago—before the sharp rise in interest rates, banking industry turmoil and economic uncertainty wreaked havoc on markets.
Data is trickling in, showing just how much this dynamic has caused both private equity deal-making activity and business valuations to slump. In the first quarter of last year, buyout firms struck 1,276 deals in the U.S. alone, worth $144 billion, PricewaterhouseCoopers recently reported. That’s more than 14 transactions daily. Fast forward to the fourth quarter of 2022, and the data shows deal flow had shrunk to less than half its Q1 size (with the Q4 total of 490 transactions valued at $54 billion).
The same trend is visible in valuations. The multiple of enterprise value over revenue fell 29% last year (download required), from 3.4 times in 2021 (the highest since at least 2012) to 2.4 times in 2022, in deals by middle-market PE funds (between $100 million and $5 billion in size), according to a March report by Pitchbook. Reflecting that, the median size of PE deals fell from $70 million in 2021 to $50 million in 2022, according to a report from accounting firm Cherry Bekaert.
What doesn’t surprise me is that we’re in the midst of a cooling-off period. Striking a mutually satisfactory deal requires both buyer and seller to believe that they haven’t left much on the table, and that’s tougher to achieve in a volatile and uncertain climate.
But what I find striking is the magnitude of that valuation gap between the two sides. Let’s toss diplomacy to the winds and call it what it is: a valuation chasm in the making. And everywhere I go these days, I hear people chatting or muttering about what it means for them.
Excess ‘Dry Powder’
On one side of the gulf sit private equity firms, atop a record amount of “dry powder,” capital they haven’t yet deployed. In the U.S., this totaled an estimated $1.1 trillion at the end of the year, and it’s creeping steadily higher. Globally, the amount of uninvested capital approached $2 trillion by year-end, up 21% over the 12 months. They’re highly motivated investors—especially since they unsurprisingly believe that we’ve moved into a buyer’s market.
But you can’t make a deal if the folks on the other side of the negotiating table aren’t willing. And the most attractive targets for deal-makers happen to be those companies with the least need to haggle. CEOs tell me they’re cutting costs to stay in line with revenues and avoid having to cut a deal at what they believe is the bottom of a valuation cycle. Some private equity deal-makers, tell me they view that optimism as a stubborn resistance to accept reality on the part of founder CEOs.
Indeed, psychology is a crucial part of the picture. Behavioral finance gurus have identified something they’ve labeled the “endowment effect,” or the tendency to put a higher value on something we already own (like the business we created and nurtured) than we’d ascribe to the identical asset if we were buying it. The greater the emotional attachment to that possession, the more stubbornly we cling to our assessment. And what founder CEO doesn’t view their business as exceptional?
That tendency to view even a humdrum goose as a swan clashes with the natural desire of PE investors to convince M&A targets to, well, just wake up and smell the coffee.
The psychological resistance to accepting a discount from peak prices is tied to the concept of “anchoring,” another behavioral finance term, as well as to loss aversion. “The anchor price is usually based on a peak price in the form of one sale during the hottest real estate market ever in that owner’s neighborhood,” wrote Hilliard MacBeth in the book When the Bubble Bursts. “That anchor price becomes the correct price for the house, and any sale below that price could be perceived as a loss.”
Still, private equity investors can do more than irritably pace up and down on the opposite bank of that value gap, waiting for the horizon to clear—or for founders to reset expectations. Instead, both sides can treat this unnerving period as an opportunity rather than a source of anxiety and frustration.
Bridging The Chasm
If classic M&A deals by private equity remain lackluster, creative deal-makers can proceed more thoughtfully.
We’re already seeing signs, for example, of growing flexibility on issues other than valuation of the part of some PE firms. In its 2023 market outlook for U.S. PE deals, PricewaterhouseCoopers reports seeing “novel strategies” to avoid being caught up in the financing crunch: minority deals, all-equity deals and private placement of debt. By minimizing financing needs or avoiding the syndicated market, acquirers can be more flexible in terms of valuation or find other creative ways to make bids more appealing.
Those deal-makers willing to dip a toe in the water by acquiring a minority stake in a target company, for example, may be able to bypass (at least for now) some of the most pesky valuation issues, while at the same time acquiring greater insight into the mindset of a company’s founders and its “true” value.
Those reluctant to strike any kind of deal today are still left with a rare opportunity to spend time refining their strategy and considering what kind of transactions make the most sense for them, rather than scrambling to grab that golden ring before someone beats them to it.
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