Lincoln International has released the results of its third-quarter middle-market index (Lincoln MMI) which tracks changes in the enterprise values of US-based privately-held middle-market companies—primarily those owned by private equity firms.
Lincoln’s new report is based on its database of over 2,200 private equity portfolio companies with median EBITDA of approximately $30 million and shows that the impact of COVID-19 on financial performance has been less impactful than expected, with the majority of companies now beating their COVID-19 adjusted year-to-date budgets and seeing their enterprise value multiples hitting historic highs.
When COVID-19 initially struck the market, portfolio companies’ management teams
produced budgets that were extremely cautious, if not draconian.
Lincoln’s analysis shows that most companies’ earnings are rebounding with financial performance recovering since the initial shockwaves of the global pandemic were felt. In the second quarter, the average 2020 estimated pre-COVID to post-COVID EBITDA budget decline was 23.4%. In Q3, this performance metric has improved to an average decline of 13.1%. Those businesses that managed expectations with conservative post-COVID budgets are now revising their budgets upward.
For transactions that closed during the pandemic, which tended to be for low-COVID-impacted businesses, multiples were strong. The average enterprise valuation multiple across all of Lincoln’s valuations exceeded pre-pandemic levels at 10.4x LTM EBITDA, a record high level. Also, EBITDA multiples increased approximately 10% from the prior quarter, the largest single-quarter increase since Lincoln began tracking the statistic over six years ago.
“When COVID-19 initially struck the market, portfolio companies’ management teams produced budgets that were extremely cautious, if not draconian,” said Ron Kahn, a managing director and co-head of Lincoln’s valuations and opinions group. “But by and large, month by month, portfolio companies have shown signs of a rebound—exceeding their budgets and adapting to what were once viewed as insurmountable circumstances. And much of the success boils down to the immense support of lenders and sponsors across their portfolio companies, paving the way for management teams to adapt to the pandemic conditions.”
Enterprise Values Recovering
As evidence of the swift recovery, middle-market company enterprise values rose 4.4% in the third quarter, bringing this measure in line with year-end 2019 levels.
Continuing the trend seen in Q2, the middle market recovery has not matched that seen in the S&P 500. However, the S&P 500 rally remains largely driven by the five largest constituents: Apple, Microsoft, Amazon, Google, and Facebook, which comprise more than 23% of the S&P 500. Excluding these five, which are generally not comparable to middle-market businesses, both the S&P 500 and Lincoln MMI are flat year-to-date, aligning with their respective December 2019 values.
The ingenuity and creativity by management teams, coupled with private equity firms
and lenders working collaboratively, overall performance through the pandemic is far better than most could have imagined.
The initial differences in COVID-19 impact across industries have been well-documented—with companies in hospitality, entertainment and travel struggling, and in many cases, expecting negative EBITDA for FY2020. Meanwhile, businesses in sectors from ecommerce to healthcare and technology fared well with earnings levels above prior year-to-date results for both the June year-to-date and July year-to-date reporting periods.
“While the bulk of businesses are recovering from the shock of shutdowns early in the pandemic, we see that the pandemic has delineated a stark bifurcation between the winners and losers in this unprecedented environment,” said Professor Steve Kaplan, the Neubauer Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago. “COVID-19 has magnified the discrepancies in industry performance. It’s a tale of two cities: the bad companies are falling further, the good have become shooting stars.” Professor Kaplan assists and advises Lincoln on the Lincoln MMI.
Lincoln further reports that with the potential of a second wave looming large and further government stimulus uncertain, portfolio company performance has become increasingly nuanced—hinging not only on COVID-19 impact and a company’s access to liquidity but also the ability of management teams to pivot their business strategies.
“Consider the profile of winners during COVID-19; it’s the clothing store that started making masks, the skincare product maker that began producing hand sanitizer, and the hundreds of businesses that shifted to facilitate operations,” added Mr. Kahn.
It’s as if the impact of COVID-19 on portfolio companies’ financial health has been
downgraded from a hurricane to a tropical storm.
The ingenuity and creativity by management teams, coupled with private equity firms and lenders working collaboratively, overall performance through the pandemic is far better than most could have imagined. In fact, leverage covenant breaches have declined quarter over quarter with only approximately 13% of portfolio companies breaching their total leverage covenant, and this is turn has led to fewer amendments.
“It’s as if the impact of COVID-19 on portfolio companies’ financial health has been downgraded from a hurricane to a tropical storm. It remains to be seen what may happen as a whirlwind of uncertainties—from the outcome of the election to a potential second wave and the timeline of a widely-distributed vaccine—impact companies in the months ahead,” concluded Mr. Kahn.
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.
Chicago-headquartered 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.
© 2020 Private Equity Professional | November 17, 2020