How three private equity firms valued the same company

By Scott Bushkie

As part of our annual State of the Market M&A conference, held virtually this winter, we invited three private equity (PE) firms to review and submit an offer on a hypothetical company. They revealed their offers at the conference, and we held a panel discussion on why they valued the company the way they did.

We keep the invited PE firms confidential. They don’t know who else will be submitting “offers,” so there’s no collusion or comparing notes ahead of time.

Because they’re doing this as a public exercise, there’s a built-in disincentive to bid too low or too high. Value the business too low, and they’ll scare off future acquisition targets. Go too high, and future targets will demand a similar multiple. It’s a great educational experience to see “what is market” and to dig into deal trends, value drivers, and detractors.

This year, we based the deal on a real company that actually sold in 2018, fudging enough details to hide the company’s true identity. We provided a full memorandum and financial info and set parameters so everyone is reviewing the same info and providing the same detail in their Letter of Intent.

In the end, the winning bid came in about 10-20% higher than the company actually sold for. The lowest bids came in around 80% of value.

Why could one PE firm bid higher? As it turns out, they had previous experience in the space. The acquisition target did big capital product sales. In other words, large, mostly one-time sales without much recurring revenue. What this PE firm saw, though, was an opportunity to build new sales through parts, maintenance, and add-on systems.

They’d done something similar before and believed they could do it again. The target had a 100+ year history in the market and had some international sales, and they saw a great foundation to grow on.

Why did the other PE firms bid lower? They didn’t have experience with a similar operation. The nature of one-time sales turned them off. And though the target acquisition had made some international sales, they were to a country that has experienced political disruption—making the foreign market angle less attractive to these buyers.

Lessons learned:

Buyers have money to spend. These three PE firms alone have $500 million in dry powder or equity they need to put to work. With dry capital plus their current investments, they have a combined capital base of $1 billion.

That’s just three firms, and there’s an estimated 4,000 of them in the U.S. A lot of people are putting money into private equity right now because they’re generating stronger returns than traditional investments.

Management team matters. These firms said the quality of a company’s management team was typically their top consideration when evaluating a target. They want to see strong, proven management teams who will stay to guide the company after a sale.

Exit strong. Their second big requirement is to see a company on an upward, or at least stable, trend. They don’t want to see sales and profits dropping or yo-yoing with no rhyme or reason. They put the most weight on the trailing 12 months of performance, meaning an owner’s last year in business can be the most important year in their lifecycle.

Diversify. Another key value driver was customer and supplier concentration. These PE firms said they’re okay as long as the top customer is around 25% or less of sales. Once the top customer starts getting to be 30% or more, they’ll either walk away because the deal has too much risk or they’ll restructure the offer to include earnouts and other performance-based payments.

Second exit is a team decision. PE firms invest in businesses with the intent to sell. Some firms have “patient capital” and can wait 7 to 15 years for that exit. Others manage investments in 5 to 7 year windows. But the firms we spoke to said timing that sale often driven more by company management than the PE firm itself.

They depend on their management teams to tell them when they think the timing is right, and that becomes a group discussion. It’s generally not a top-down mandate, and that’s an encouraging thing for the remaining shareholders to hear.

Overall, the message was that the number of good quality deals on the market has declined and PE firms have money they need to spend. That’s a supply and demand equation in the business owner’s favor. Business relatively unaffected (or those positively affected) by COVID-19 are going to get some good, hard looks and are likely to pull in strong multiples right now.