Studies

If you studied corporate finance or portfolio management 20 years ago, “political risk” tended to refer to a country’s stability in government and the transparency/integrity of its capital markets.

Those considerations still matter, but the deep polarization of government in the United States and other industrialized economies has given added weight to another kind of risk.

Business managers, investors and analysts now must assess the optionality of radically different standards in law, regulation and administration based on who is in power in a given jurisdiction.

THE PROBLEM

An article in The New York Times last month made the case well, at least as it relates to environmental policy:

“Government policies have always shifted between Democratic and Republican administrations, but they have generally stayed in place and have been tightened or loosened along a spectrum, depending on the occupant of the White House.

But in the last decade, environmental rules in particular have been caught in a cycle of erase-and-replace whiplash.

“In the old days, the regulatory days of my youth, we were going back and forth between the 40-yard lines,” said Douglas Holtz-Eakin, who directed the nonpartisan Congressional Budget Office and now runs the American Action Forum, a conservative research organization. “Now, it’s back and forth between the 10-yard lines. They do it and undo it and do it and undo it.”

Economists and business executives say this new era of sharp switchbacks makes it difficult for industries to plan. If there is anything that companies like less than government regulation, it is an unstable business climate…

In the past four months, the Biden administration has strengthened or restored rules that Mr. Trump had deleted, including regulations to cut greenhouse emissions from cars and oil and gas wells; to limit the pollution of toxic coal ash; to protect the habitat of the sage grouse and other endangered species; and to tighten safety controls at chemical plants. All of these rules are likely to be weakened or rolled back once again under a new Trump administration.”

This volatility is of course not limited to the environmental arena. Federal tax and regulatory policy have always featured some oscillation between Democratic and Republican administrations, but the pendulum swings are more pronounced than ever.

For clients of my M&A firm and other private business owners, there is always sentiment in favor of lower taxes and less regulation, but the strongest sentiment may be for greater certainty.

THE DATA

Measuring political risk is big business, but it’s difficult to find metrics that drill in on volatility, as opposed to the stability and functionality of political institutions and capital markets.

The World Bank’s Worldwide Governance Indicators (WGI) project “constructs aggregate indicators of six broad dimensions of governance.” One of the six – government effectiveness – “reflects perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government’s commitment to such policies.”

Here is the data for the world’s 15 largest national economies at five-year intervals through 2022, the most recent year for which data is publicly available. Estimates of government effectiveness range from approximately -2.5 (weak) to 2.5 (strong). Green denotes positive movement from 2012 to 2022, red negative movement.

Over the 2012-2022 period, Canada, Australia, the United Kingdom, Germany, the United States, France, and Spain maintained positive scores but saw a decline in government effectiveness. Among countries with 2012 scores above 1.0, only Japan, South Korea, and Australia improved their positions.

Policymaking Volatility Becomes a Macroeconomic Burden

The New York Times article goes on to cite Costa Gavriilidis, a Scottish researcher who developed a U.S. Climate Policy Index after watching the United States join, leave, and rejoin the Paris climate agreement in just over five years.

“[Gavriilidis’] research shows that whenever the index shoots up to about 50 points, it creates an economic shock of such magnitude that it leads to a 1.5 percent decrease in industrial production, a 0.4 percent increase in unemployment, a 2 percent increase in commodity prices and a 0.4 percent increase in consumer prices, reflecting the fact that producers incorporate the risk of higher production costs associated with uncertain climate policy into their prices.”

This, of course, is a non-diversifiable market risk.

Non-diversifiable Market Risk Translates into Higher Required Returns

Let’s take electric vehicles as an example. Over the next few years, will the United States continue to incentivize their production and purchase? Will there be a return to support for fossil fuels? What will be the federal government’s position on domestic mining of the rare earth minerals that go into lithium-ion batteries? The answers to all three questions depend on political outcomes.

Here are the current five-year Betas for two traditional car manufacturers looking to evolve into battery-operated vehicles, and the two principal electric vehicle market entrants.

Setting aside Tesla, the spread in Beta between GM/Ford and Rivian is about .35. Considering that market-neutral beta is 1.0, that is a substantial swing. The prospect of binary political outcomes is not the only factor contributing to the marked difference in perceived volatility – and thus in required return – but it is clearly one factor dampening the valuations of the publicly traded OEMs concentrated in a new and politically contentious industry.

THE IMPACT ON PRIVATE COMPANIES

Privately owned businesses are not subject to daily public valuation, but they are subject to the same valuation methods. Public comps come into play even more directly if a company’s owner is a private equity fund or other investment company required to do quarterly “mark-to-market” valuations.

What is the impact on private investment activity in businesses affected by policy volatility? There can only be two answers. First, if the impact on required return is moderate, valuations in a given sector decline; and second, if the impact is greater, investors wait until policy direction clarifies.

Between now and the November election, in politically contentious sectors like electric vehicles, the sidelines will be a popular place.

About the Author
Andy Greenberg is CEO of Greenberg Variations Capital, a mergers & acquisitions advisory firm based in suburban Philadelphia devoted to one-off or targeted transactions. Mr. Greenberg was founder and CEO of GF Data©, the M&A data tracking service, prior to its acquisition by the Association for Corporate Growth in 2022. For more information, visit www.greenbergvariations.com.

© 2024 Private Equity Professional | May 23, 2024

Capstone Partners has released its 2023 Middle Market M&A Valuations Index which shows that while equity markets largely shrugged off the rapid succession of interest rate hikes in 2023, middle market merger and acquisition valuations experienced downward pressure.

According to Capstone, elevated transaction costs, uncertainty over projected cash flows, and a reserved private equity buyer pool contributed to average M&A valuations falling to 9.6x EV/EBITDA in 2023, compared to 9.9x in 2022. Several transactions at premium valuations helped to bolster this average, while the median EBITDA multiple fell more drastically to 8.0x EV/EBITDA compared to 8.5x in the prior year.

While business owners encountered a challenging valuation environment, several bright spots of the market have provided optimism for resilience and recovery in transaction value in 2024. Notably, average three-year EBITDA purchase multiples in the business services, fintech and services, industrial technology, transportation, logistics and supply chain, and technology, media and telecom sectors improved on a year-over-year basis.

Many dealmakers are optimistic that 2023 marked a trough for both middle market M&A volume and pricing, with 2024 positioned to experience a rebound in purchase multiples.

Buyers demonstrated heightened discipline in middle market M&A processes in 2023, refraining from overextending themselves to acquire target companies. While high-quality assets still commanded solid buyer interest and competition in bidding, market clearing bids were less frequent than in prior years.

In 2023, 31% of transactions closed at 10x EBITDA or higher—a decline from 38% in 2022 and 43% in 2021. This may have coincided with buyers moving to lower levels of the middle market, a common occurrence amid market uncertainty. The average enterprise value of sold target companies amounted to $89.4 million, a substantial drop from $139.3 million in 2022. When buyers did pay premium multiples, typically these businesses had demonstrated gross margin defensibility, healthy revenue visibility, and sustained product or service demand.

Capstone further reports that many dealmakers are optimistic that 2023 marked a trough for both middle market M&A volume and pricing, with 2024 positioned to experience a rebound in purchase multiples.

Private equity buyers, facing limited partner pressure to generate returns, are expected to reenter the M&A markets in 2024.

Seller and buyer expectations are anticipated to become more aligned after such dislocation post-pandemic, when purchase multiples at times became detached from fundamentals. For the first time in nearly a decade, the cost of money is meaningful, and likely will be for the near future as the Federal Reserve works to meet its mandate. However, quality companies with sound financials and resilient end markets are poised to garner buyer appetite.

Private equity buyers, facing limited partner pressure to generate returns, are expected to reenter the M&A markets in 2024 after sitting on the sidelines for much of 2023. The valuation environment may take some time to recover, but the M&A and macroeconomic environment in 2024 is expected to present a favorable backdrop for many prospective sellers to achieve an optimal exit.

Capstone’s investment banking services include M&A advisory, debt and equity placement, corporate restructuring, special situations, valuation and fairness opinions and financial advisory services. The Boston-headquartered firm was acquired by Huntington Bancshares in June 2022 and has more than 175 employees.

To download a copy of Capstone’s Middle Market M&A Valuations Index click HERE.

© 2024 Private Equity Professional | March 26, 2024

Grant Thornton’s new Tech CFO Survey reveals how chief financial officers at technology companies plan to achieve growth in the coming years despite fierce competition and other challenges.

The Tech CFO survey, which polled 150 senior finance executives in the technology industry, also gauged sentiment on major topics like artificial intelligence (AI), cybersecurity and the technology workforce.

One of the survey’s key findings was the clear need for more capital. In fact, 91% of survey respondents said they will need to raise capital in the next two years, while nearly two-thirds (65%) said they needed to raise capital within the next 12 months. These capital raises are necessary to meet rising costs. For instance, 71% of technology CFOs said they expect IT/digital transformation expenses to rise in the next 12 months, while 61% said the same for their cybersecurity and risk management efforts.

According to the survey, private equity may be called upon to fill this capital need as more than 90% of survey respondents said they are seeking private equity investment.

The technology industry isn’t alone in its preparations for higher costs. Grant Thornton’s third quarter CFO survey, which covered multiple industries, revealed that 58% of CFOs expect to increase their spending on IT/digital transformation. That figure was the highest percentage in its category since the first quarter of 2021.

These cost expectations align with what technology CFOs describe as their biggest challenges over the next six months. Specifically, 56% of technology CFOs said their greatest challenge will be technology upgrades, while 51% said their greatest challenge will be cybersecurity.

“When I take a step back, what technology companies are trying to do is control costs and measure growth,” said Andrea Schulz, Grant Thornton’s national managing partner for technology. “A lot of what I’m hearing in the market is about increasing the margin on existing product and service offerings, getting net income up to either breakeven or beyond and making sure that companies are showing profitability and growth.”

According to the survey, private equity may be called upon to fill this capital need as more than 90% of survey respondents said they are seeking private equity investment.

When asked what moves they will make to enable growth in the next one to three years, more than one-third (35%) said they plan to merge or acquire other companies. But, according to the survey data, several strategies will be more popular than mergers and acquisitions.

The survey also revealed a clear focus on culture with 45% of respondents saying that improving their organization’s culture will be a key priority over the next 12 months.

Fifty-nine percent of technology CFOs said they plan to launch new products or services. What’s more, 57% said they plan to expand into new markets or geographies, while 52% said they are striving to increase market share or their customer base.

“All three of those strategies are very capital-intensive,” said Ms. Schulz. “And each one has very different risks. You’re basically starting from scratch if you’re launching a brand-new product or service — it’s a high risk at that point. If that’s your growth structure, you might need to step back and understand whether you have the customer base. It’s potentially a startup phase product line. It might not manifest the growth that you were envisioning in year one to three.”

When asked how they expect the economy to impact their workforce in the next six months, nearly two-thirds (65%) of survey respondents said a slower economy will lead to high retention rates. However, half (50%) of respondents said they expect continued difficulties in attracting and retaining the right talent, and nearly one-third (31%) said the state of the economy could lead to layoffs.

Still, survey respondents are clearly making moves to keep their people. Over half (53%) of survey respondents said attracting and retaining key talent was their top workforce priority, and nearly half (47%) said they will prioritize employee work/life balance issues. The survey also revealed a clear focus on culture: 45% of respondents said maintaining or improving their organization’s culture will be a key priority over the next 12 months, while the same percentage said managing a hybrid workforce will be a major focus.

Many people are running too far ahead of where AI currently is in its practical deployment. They’re envisioning what it could be.”

According to Ms. Schulz, a “salary reset” is in the works in the technology industry. “Technology companies are searching for top talent at a reasonable price,” she said. “Revenue per head is now also a very popular metric to help rationalize labor costs and show that companies are not overinflated on the labor costs that they have.”

Investment in AI
Part of a technology CFO’s strategy is, of course, investing in the right technology. In terms of which technology these CFOs plan to invest in, there’s a clear frontrunner: artificial intelligence (AI).

In fact, 61% of survey respondents said their companies will invest in AI in 2024, and the same percentage of CFOs said they will use AI to enhance customer experiences and engagement. Meanwhile, 54% of technology CFOs said they will use AI to improve their decision-making and insights, while a similar number (51%) said they will use AI to automate routine tasks and processes.

Ms. Schulz noted that companies are wise to look to AI for ways to strengthen their business, but she cautioned that the immediate ROI some companies seek may be further away than they think. “There is an opportunity for companies to transform and look more streamlined, but that might be years out,” she concluded. “Many people are running too far ahead of where AI currently is in its practical deployment. They’re envisioning what it could be.”

To download a free copy of Grant Thornton’s Tech CFO survey click HERE.

Founded in Chicago in 1924, Grant Thornton is the US member firm of Grant Thornton International, one of the world’s largest audit, tax and advisory firms. The firm has revenues of more than $2.4 billion and operates more than 50 offices with more than 600 partners and 9,000 employees.

© 2024 Private Equity Professional | January 18, 2024

The Lincoln Private Market Index (LPMI), which tracks changes in the enterprise value of US privately held companies, increased by 0.8% during the third quarter of 2023.

According to Chicago-headquartered investment bank Lincoln International, the increase was the result of persistent earnings growth but was partially offset by a decline in multiples. The LPMI’s increase contrasted with the movement of the S&P 500, which decreased 3.7% since the second quarter.

For leveraged buyout transactions that closed in the past two quarters, multiples declined by approximately 1.5x since the beginning of 2023. The lower multiples may reflect, among other factors, buyers’ need to lower valuations to offset higher interest costs and lower debt capacity to still meet their targeted returns. Even for higher-multiple industries such as technology, media and telecom, and healthcare, multiples have fallen.

Although slowing revenue growth may signal a pullback in demand and an inability to pass on increased costs, earnings growth was steady.

Amid Slowing Revenue Growth, Earnings Growth has Stabilized
In Q3 2023, private companies tracked by Lincoln’s database only generated approximately 8.5% revenue growth, marking the first single-digit revenue growth quarter since Q4 2021. Despite the slowdown, the Q3 2023 revenue growth compares favorably to the long-term average of 7.5%. Similarly, the percentage of companies that experienced year-over-year revenue growth was its lowest since Q3 2021, with only 72% of companies growing revenue in the third quarter compared to 78% in the second quarter.

Although slowing revenue growth may signal a pullback in demand and an inability to pass on increased costs, earnings growth was steady. In Q3 2023, across private companies tracked by Lincoln, LTM EBITDA grew 4.3%, similar to Q2 2023. Additionally, 61% of companies experienced year-over-year EBITDA growth in the third quarter, which compares to 59% in Q2.

Somewhat unsurprisingly, companies in the consumer industry were the weakest performers in Q3. While consumer companies were able to generate marginal year-over-year revenue growth of 2.4%, EBITDA declined 1.5%. Both these figures represented the low water mark across all industries tracked by Lincoln.

“Time and time again we have observed that the movements in enterprise values of private companies are primarily a result of their fundamental performance,” said Steve Kaplan, a professor at the University of Chicago Booth School of Business, who assists and advises Lincoln International on the LPMI. “Therefore, if we start to see slowing demand trends negatively impact private company earnings, we could see a reversal of fortune in private company enterprise values.”

Defaults Decreased on Sustained Earnings and Amendments, While Private Credit Values Increase Modestly
While earnings continue to rise modestly, high-debt service costs are plaguing portfolio companies. Covenant default rates declined modestly from 4.2% to 3.9% between the second and third quarters. The decrease in defaults is partially explained by Lincoln’s observation of more than 675 amendments executed in the first nine months of 2023, or over 15% of all companies that Lincoln tracks. Of the amendments, a significant amount included coupon increases coupled with sponsor equity infusions. The trend suggests lenders and borrowers continue to proactively work through impending covenant defaults due to liquidity constraints and declining fixed charge coverage ratios.

Despite the increase in amendments, the Lincoln Senior Debt Index (LSDI) grew moderately, with the average fair value of loans increasing to 97.8% in Q3 from 96.9% in the prior quarter and the index showing its highest average yield since inception at 11.8%, which is reflective of the current persistently high base rate environment.

For the most embattled portfolio companies—nearly 60 companies required multiple amendments in 2023—the impending liquidity crunch is too ominous to ignore.

These positive fair value trends were driven by modestly more competitive private credit activity and steady earnings growth. More specifically, larger transactions involving businesses with greater than $40 million of EBITDA saw spread tightening as lender competition for transactions involving high-quality and stable cash-flow generating businesses heightened. This trend manifested itself in 25 to 50 basis points (bps) of spread tightening for new issuances as well as tighter original issue discount requirements, which similarly tightened by 50 bps as competition heated up.

“The third quarter painted a picture of the resilience of the private markets,” said Ron Kahn, a managing director and co-head of Lincoln’s valuations and opinions group. “Despite a flurry of headwinds, private company performance has held up, and in turn, private credit investors have been the beneficiary as rising rates have led to higher all-in yields, which private companies have largely been able to withstand.”

Despite Positive Private Credit Trends, Portfolio Companies are Beginning to Feel the Pain
Not all borrowers are created equal in the current market. Most amendments in the third quarter were executed for deals that originated in or before 2021. These transactions were printed while market conditions allowed lower equity cushions and higher detachment points. Liquidity and cash flow challenges are now hitting these businesses the hardest. For the 2021 vintage, LTV has reached an average of approximately 45%, relative to 40% for 2023 deals.

“Over the last year, many predicted a decrease in enterprise value multiples, but it is only now that we are seeing that decrease in valuations for deals getting done.”

For the most embattled portfolio companies—nearly 60 companies required multiple amendments in 2023—the impending liquidity crunch is too ominous to ignore. Companies in the business services and consumer sectors accounted for approximately 50% of the companies that required multiple amendments. Additionally, of the repeat offenders, over one-third were 2021 vintage credits.

Fixed charge coverage ratios declined again in the third quarter to an average of 1.10x, compared to 1.13x in the second quarter. When sensitizing fixed charge coverage for 5.5% SOFR for one year, coverage falls to 1.06x, which exhibits a concerning trend. However, on the same basis, the ratio has been stable since the first quarter, when it was 1.04x as businesses and sponsors are working to combat thin cash flow coverage by peeling away capital expenditures, which have fallen by approximately 6% since the beginning of 2023, and focusing on strengthening EBITDA, which has increased by 1.4% since the beginning of the year.

“Over the last year, many predicted a decrease in enterprise value multiples, but it is only now that we are seeing that decrease in valuations for deals getting done,” added Mr. Kahn. “While the number of acquisitions continues to be lower and may not yet be of sufficient size to extrapolate to the wider universe of companies, it may also be a harbinger of things to come as the elevated base rates have a larger negative impact on valuations than the higher performance.”

The Lincoln Private Market Index (LMPI) was launched in 2020 and measures the variation in private companies’ enterprise values by analyzing the aggregate change in company earnings as well as the prevailing market multiples for approximately 1,500 private companies, each generating less than $250 million in annual earnings. The index is calculated using anonymized data on an aggregated basis by Lincoln’s valuations and opinions group.

The methodology used by the LPMI was organized by Lincoln in collaboration with Professors Steven Kaplan and Michael Minnis of the University of Chicago.

Also in 2020, Lincoln launched the Lincoln Senior Debt Index (LSDI) which provides insight into the direct lending market as a fair value index tracking the total return, price, spread and yield to maturity of direct lending securities. The index is developed using much of the same data as the LPMI and the methodology was determined by Lincoln in collaboration with Professor Pietro Veronesi of the University of Chicago Booth School of Business.

Lincoln International provides mergers and acquisitions advisory, private funds and capital markets advisory, and valuations and fairness opinions. The firm is headquartered in Chicago and has more than 20 offices in 15 countries.

Follow this LINK to see the full Q3 2023 Lincoln Private Market Index report.

© 2023 Private Equity Professional | November 10, 2023

Golub Capital has reported that its middle market private company index has shown the strongest earnings growth over the past two years.

According to Golub, middle market private companies in the Golub Capital Altman Index grew earnings by 13% during the first two months of the third quarter of 2023, the highest year-over-year earnings growth since Q3 of 2021. Revenue grew 8% during the same period.

The Golub Capital Altman Index (GCAI) is produced by Golub Capital in collaboration with credit expert Dr. Edward Altman. The GCAI measures the median revenue and earnings growth of approximately 110 to 150 private US companies in the loan portfolio of Golub Capital. According to Golub Capital, the GCAI is the first and longest-running index based on actual revenue and EBITDA for middle market companies.

Dr. Altman is the Max L. Heine Professor of Finance, Emeritus at the NYU Stern School of Business, and Director of Research in Credit and Debt Markets at the NYU Salomon Center for the Study of Financial Institutions.

“Middle market cash flow growth year-over-year was quite remarkable in Q3 2023 despite the reduction in inflation during the period. This suggests the companies tracked by the Index likely made cost reductions which helped boost earnings growth,” said Dr. Altman. “Technology stood out once again as the sector posted revenue and earnings growth nearly twice as high as the Index in aggregate. It is not surprising to continue to see the trend we highlighted in prior quarters: mission-critical providers of enterprise software are the beneficiaries of the pressure on businesses to increase productivity. Solid growth in the healthcare and industrials sectors rounds out the picture of economic resilience from our vantage point.”

“Growth exceeded our expectations in the third quarter of 2023. Middle market companies in general continued to demonstrate resilience and adaptability to the challenging environment. The strong results of the consumer sector are encouraging,” said Lawrence Golub, the CEO of Golub Capital. “Consumer sector revenue growth outpaced inflation and profitability held up well, despite the pressure consumers have faced from higher gas prices, higher interest payments on debt and dwindling pandemic-era savings. These are real headwinds, but we did not see their impact in Q3 results. Instead, we saw continued economic momentum.”

Golub Capital provides a range of products including unitranche financing, senior debt, second lien and subordinated debt, and equity co-investments. The firm underwrites and syndicates facilities up to $2 billion for companies with EBITDA of more than $50 million and will hold up to $700 million per transaction for companies with EBITDA from $5 million to $250 million. Industries of interest include software and technology; consumer, restaurant and retail; business services; aerospace and defense; specialty manufacturing; value-added distribution, transportation and logistics; financial services; and healthcare.

Golub Capital was founded in 1994 and has more than 825 employees with lending offices in Chicago, New York, San Francisco and London.

The companies in the GCAI operate in a wide range of industries and its results are provided for the total universe of GCAI constituents and by industry segment. To download a copy of Golub Capital Middle Market Report, click HERE.

© 2023 Private Equity Professional | October 17, 2023