According to Lincoln International’s Middle Market Index (Lincoln MMI) declines in the enterprise value of private middle market companies in the first quarter were comparatively muted—declining 7.5%—compared to the sharp 16.0% decline of the S&P 500.
The Lincoln MMI measures changes in the enterprise values of private middle market companies over time based on a subset of Lincoln’s database of more than 2,000 portfolio companies, primarily owned by private equity firms.
As the recent economic shock waves hit the markets, there were no safe spaces to turn to as declines hit valuations across all industry segments. Decreases in the Lincoln MMI were most severe for COVID-19-impacted industries including industrials and consumer with an average decline of 8.6%. The technology and healthcare sectors were also impacted, down an average of 5.3%; and decreases in oil prices resulted in the energy sector declining by 18.0%, the largest of any industry in the Lincoln MMI.
Interestingly however, fundamental performance of middle market companies exhibited robust growth in the first two months of the year, the largest quarterly gain in earnings in five quarters. And while the coronavirus pandemic brought significant declines in multiples, enterprise values at the end of the first quarter aligned with the levels observed approximately one-and-a-half years ago, before the markets experienced a significant run-up.
And while it is difficult to determine where valuation multiples are headed, the negative impact of the coronavirus to middle market companies and the Lincoln MMI will not be completely determined until companies release post-COVID-19 earnings and revised budgets for the 2020 calendar year.
“The pandemic has not only created a global health emergency in the short-term, it has also led to significant economic concerns as well. As investors in private companies assess the performance of their portfolios during this challenging time, it is critical to note that private middle market companies have outperformed the public markets,” said Ron Kahn, a managing director and co-head of Lincoln International’s valuations and opinions group. “If there was ever a time for this data to prove essential for business leaders – it is now: the Lincoln MMI can serve as more accurate benchmark for private equity portfolio performance.”
The Lincoln MMI measures the variation in middle market companies’ enterprise values by analyzing the aggregate change in company earnings as well as the prevailing market multiples for over 500 middle market companies each generating less than $100 million in annual earnings. The index is calculated using anonymized data on an aggregated basis by Lincoln’s valuations and opinions group, which has insights into the financial performance of thousands of portfolio investments of financial sponsors, business development companies and private debt funds.
The methodology of the Lincoln MMI was determined by Lincoln in collaboration with Professors Steven Kaplan and Michael Minnis of the University of Chicago Booth School of Business.
“Since the Lincoln MMI’s infancy, we have observed that the enterprise values of private equity-backed, middle market companies exhibit lower volatility as compared to publicly traded equities. It is fascinating that the public markets recovered in April, suggesting that public markets may have overreacted. It will be very interesting to see what the Lincoln MMI yields with Q2 earnings,” said Professor Kaplan.
Credit Market Sentiment Shifts Amidst Uncertainty
With enterprise values declining and a lack of clarity on a company’s future performance, lenders to middle market companies are taking a more conservative approach when providing capital to these companies. Lenders often focus on loan-to-value when providing loans to middle market companies and, as a result of the declines in enterprise values due to COVID-19, Lincoln has observed a decrease in the amount debt lenders will provide of between one-half and one times their EBITDA. In addition, because of the increased demand for capital and continued uncertainty, lenders are requiring between 100 and 250 basis points of incremental spread over LIBOR along with tighter covenants for this debt.
“Over the past few quarters, we believed we were in the later innings of the ballgame. Still few, if any, could have anticipated such a rapid correction. Of importance, however, is that the COVID-19 impact on the middle market is not yet fully felt and will not be until companies’ performance subsequent to the start of COVID-19 is disclosed,” added Mr. Kahn. “As a result, until there is more visibility on the future performance of these companies, private equity groups and lenders will be cautious before deploying capital.”
Lincoln International specializes in merger and acquisition advisory services, debt advisory services, private capital raising and restructuring advice on mid-market transactions. The firm also provides fairness opinions, valuations, and joint venture and partnering advisory services on a wide range of transaction sizes. Lincoln has 21 offices in the Americas, Asia, and Europe and is headquartered in Chicago.
To download a free copy of the Lincoln Middle Market Index click HERE.
Private Equity Professional | May 8, 2020