A PAUSE THAT REFRESHES?

Private equity’s thirst for tech coupled with the ongoing buoyancy

of entry multiples should underscore investors’ enduring optimism

even as deal flow wanes.

Private Equity Activity by Year P2

PE Purchase Price Multiples P2

M&A Multiples P2

PE Activity by Sector and Year P3

U.S. Information Technology M&A Multiples P4

Top 10 Largest PE Deals P4

MURRAY DEVINE SECOND HALF OUTLOOK2019

Economic uncertainty may have slowed deal flow, but did little to dent entry multiples

0

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6,000

$0

$100

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$900

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019*

Deal value ($B) Deal count

5.8x

4.7x

5.8x

5.4x

0x

2x

4x

6x

8x

10x

12x

14x

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019*

Debt / EBITDA Equity / EBITDA Valua�on / EBITDA

Source: PitchBook. *As of June 30, 2019

9.2x

10.9x

0x

2x

4x

6x

8x

10x

12x

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019*

Source: PitchBook. *As of June 30, 2019

Source: PitchBook. *As of June 30, 2019

Note: Yellow squares represent years with less than 30 datapoints.

In December 2008, the Boston Consulting Group published research estimating that as many as 20% to 40% of the 100 largest private equity (PE) firms would close their doors in the ensuing years. The report, “Get Ready for the Private Equity Shakeout,” was written with the premise that historically high purchase prices ahead of the global financial crisis—funded with record amounts of debt—would create enough distress that a significant portion of the PE universe would never raise another fund. Considering the market turmoil at the time, this prediction may not have seemed so far-fetched. However, 10 years later, the asset class has not only proven its resiliency, it has reached unprecedented heights as both general partners (GPs) and their investors have been rewarded for their patience and commitment to the PE model.

While there was plenty of fallout from the global financial crisis, it did not produce an overall fear of high valuations. If anything, sponsors may have gained more conviction in the long-term, patient nature of the asset class and have since adapted to an environment in which double-digit multiples have become the norm. This was evident in the first half of 2019, as economic uncertainty—ranging from an inverted yield curve to a decelerating of US GDP—may have slowed deal flow, but did little to dent entry multiples for sponsors.

According to data from PitchBook, the median M&A multiple, inclusive of both PE and strategic acquisitions in the US, rose to 10.9x EBITDA in the first half of this year, while the median purchase price multiple for sponsor-backed deals continued in the double digits at 10.1x EBITDA.* From a historical perspective, these median valuations imply that acquirers remain bullish even as economic and geopolitical threats emerge. The pace of activity did decelerate during the first six months of 2019, suggesting that the dealmaking landscape may be more unpredictable than at this point last year. In the US, sponsors completed 1,980 acquisitions in the 1H 2019 based on PitchBook data, worth a combined $264.6 billion, representing respective declines of approximately 25% and 18%, year over year (YoY).

In past valuation reports, we have highlighted a tendency that when deal volume and valuation trends begin to diverge—as deal flow slows and purchase-price multiples expand—it can signal a flight to quality on the part of investors. This dynamic can become more pronounced when all but the highest quality assets retrench from the market, amplifying buyer demand for companies whose prospects are less affected by economic or geopolitical headwinds. When further unpacking the data, however, this doesn’t seem to be occurring so far in 2019.

Perhaps most notably, valuations for PE deals appear to be mostly static, and within an elevated band established over the past few years. Moreover, since 2014, the number of PE-backed deals in the US have set new annual records each ensuing year, with a high-water mark of 5,185 transactions set in 2018. As such, the bar for what constitutes

US PE deal activity

US PE median EV/EBITDA buyout multiples

US M&A median EV/EBITDA multiples including PE buyout

2019 MURRAY DEVINE SECOND HALF OUTLOOK | W W W.MURRAYDEVINE.COM 2

normal deal flow has also been raised. The 1,980 PE deals completed in the first half of this year, for instance, eclipse the comparable six-month period of 2014, a record-setting year at the time, and remain on pace to easily exceed the annual deal counts of 2007 and 2008.

Given this perspective, the pullback in buyout activity so far in 2019 is probably more indicative of an asset class catching its breath after a long period of sustained growth. While that’s not to say there aren’t some clouds visible on the horizon, the slowdown in activity isn’t as ominous as it might appear when juxtaposed with 2018’s record-breaking numbers.

A Taste for Tech

If one trend stood out in the 1H 2019, it was PE’s growing comfort with technology as it became obvious even to casual observers. In fact, the number of deals in every other sector were well off their averages over the previous three years, whereas the number of buyouts in information and technology (IT) companies held steady and represented approximately 30% of PE’s total deal volume in the first half of 2019. To put this growth into context, the number of IT buyouts completed during the three years between 2006 and 2008 represented around 12% of the total number of PE deals during this period, based on data provided by PitchBook, with little variance from year to year.

This growth as a percentage of the total deal activity in part reflects isolated concerns impacting other sectors. Uncertainty over the government’s role in healthcare, for instance, is only growing as the 2020 election approaches. This makes the sector a little less compelling as a safe haven even against a compelling demographic backdrop. In financial services, the likelihood for a rate cut likely slowed activity during the first six months of this year, and in energy, uninspiring oil prices further muted buyer interest. Ongoing distress in retail, a holdover from the last downturn, may have contributed to a slowdown in the consumer sector.

PE deal flow in technology, on the other hand, showed no signs of decline. The pace and breadth of dealmaking in the sector reflects several key trends, including the fact that technology—thanks to an evolving business model—is increasingly being billed as a secure choice for investors.

Until recently, it was the cyclical nature of tech that scared off those who didn’t bring a specialized skillset to the sector. The rolling transition to a recurring revenue-oriented subscription model, however, has offered sponsors a level of comfort investing in software while also providing multiple-expansion opportunities for those able to help companies effect a Software-as-a-Service (SaaS) transformation. This alone is a rare find in a high-valuation environment.

Several deals over the past six months align with this thesis. Hellman & Friedman’s $11 billion acquisition of human-capital management solutions provider Ultimate Software in May and Thoma Bravo’s $3.7 billion buyout of cloud-based mortgage-technology solutions company Ellie Mae in April represent two higher-profile tech investments.

Perhaps more notable, though, was the sale of Prometheus Group by Francisco Partners, which underscored the scope of opportunity within the industry. Prometheus Group, which offers planning and scheduling software across a range of industries, was acquired by Genstar Capital for over $1 billion.

The appeal of technology to sponsors, beyond the inherent earnings quality of the subscription-based revenue model, illustrate that most companies are currently implementing technology into their business models or offering technology as part of their services; at least, they should be if they hope to survive. This is particularly true as companies consistently rely on tech to cut costs and drive growth in new markets, instilling a recession-resistant quality that didn’t exist 10 years ago for these assets. Moreover, the scalability of an asset-light, SaaS-driven model—especially for sector-agnostic applications—provides a compelling path to value creation for sponsors, which helps keep sector valuations elevated.

US PE deals (#) by sector

US PE deals ($) by sector

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100%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019*

Materials andResources

IT

Healthcare

Financialservices

Energy

B2C

B2B

Source: PitchBook. *As of June 30, 2019

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20%

30%

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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019*

Materials andResources

IT

Healthcare

Financialservices

Energy

B2C

B2B

Source: PitchBook. *As of June 30, 2019

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There doesn’t seem to be a fear of missing out that might otherwise drive irrational behavior in the eighth or ninth inning of a market cycle.

Even as investment activity in other industries slumped in the first half of 2019, GPs are still gaining exposure to all sectors through their tech investments without absorbing the more acute risk of investing in one company more directly exposed to specific threats. Given the mission critical nature of tech today, consulting firm Gartner expects enterprise software spending to grow by roughly 9% this year and another 8% in 2020.

Looking Ahead

To be sure the broader slowdown in dealmaking across the market reflects a sense of caution among acquirers. Even in technology—an area where buyers are generally accustomed to paying premiums—PitchBook documented a median purchase price multiple of 11.5x EBITDA* in the first half of 2019. This would represent a trough for valuations in the sector over the past five years (although, admittedly, PitchBook’s sample included a total of only 11 deals, so it may not be representative of the trajectory of valuations in the sector). Still, this discipline is evident when evaluating some of the broken deals from 1H 2019, particularly those outside of tech.

For instance, Apollo Management held firm on a reported $10 billion bid for aluminum parts manufacturer Arconic, a former Alcoa unit. And, in January, both sides walked away from the negotiations without a deal. While Arconic’s challenges, from tariff uncertainty to unfunded pension liabilities, may have helped encourage a potential sale, these factors also likely contributed to reservations around the price, especially for an investor like Apollo that is so well versed in making value-oriented investments.

Looking ahead, similar headwinds are indeed making it harder for prospective buyers to comfortably project growth further into the future. The ongoing trade dispute between the US and China, for example, is beginning to weigh on the economy, as GDP growth slowed to 2.1% in Q2.

If the public markets can serve as a proxy for corporate performance, the percentage of S&P 500 companies issuing negative earnings guidance for Q3 is also trending higher than usual. FactSet, as of August 2, reported that 72% of those offering Q3 guidance provided estimates that tempered earlier expectations. Earnings growth for S&P 500 companies, at least midway through the Q2 reporting season, were on track for the second straight quarterly decline. FactSet highlighted that this would represent the first time since 2016 that the index experienced two consecutive YoY declines in quarterly earnings.

US M&A median EV/EBITDA multiples in IT

11.6x 11.5x

0x

2x

4x

6x

8x

10x

12x

14x

16x

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019*

Source: PitchBook. *As of June 30, 2019

Note: Yellow squares represent years with less than 30 datapoints.

TARGET BUYER/INVESTOR SECTOR VALUE

Cruise SoftBank Transportation $19,000.0

ClariosBrookfield Business

PartnersEnergy Services $13,200.0

Ultimate Software GroupThe Blackstone Group,

Hellman & Friedman,

GIC Private, CPPIB

Software $11,000.0

StandardAero The Carlyle GroupCommercial

Transportation$5,000.0

Ellie Mae Thoma Bravo Software $3,700.0

KaseyaInsight Partners, TPG

CapitalSoftware $1,750.0

Definitive Healthcare Advent InternationalCommercial

Services$1,700.0

Eureka MidstreamEQM Midstream

PartnersEnergy Services $1,450.0

Symphony Communication Services

Standard Chartered,

MUFG Innovation

Partners

Software $1,400.0

Kyriba Bridgepoint Partners Software $1,200.0

Top 10 largest US PE deals in Q2 2019

Source: PitchBook. *As of June 30, 2019

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The pause in the first half of 2019, rather than rattling dealmakers, could alternatively refresh investors as they gain more clarity around what the future holds.

PE investors are less concerned about short-term turbulence, but as it relates to completing deals, hiccups in corporate performance can indeed rattle buyer and seller expectations. These dips can be even more pronounced in a high-valuation environment and as earlier catalysts (such as the 2017 tax cut) begin to recede. With that said, according to data from SS&C Intralinks, the percentage of failed or withdrawn deals in the first half of 2019, at 3%, was in line with 2018 levels, implying that most deals are progressing as planned from bid to completion.

Sponsors remain cautiously optimistic. The fact that the leveraged loan default rate remains below 1.5%, according to Leveraged Commentary & Data, certainly bodes well for ongoing liquidity in the capital markets, often the biggest factor influencing LBO activity. The Federal Reserve’s decision to cut interest rates in July—its first cut in 10 years—should also support PE valuations barring any surprises in the market.

*Data is as of June 30, 2019 unless otherwise specified. All data mentioned in this report, unless otherwise noted, was provided by Pitchbook. Please note that the data provider recently adjusted its methodology in calculating valuation multiples, which in certain cases has created discrepancies with regards to historical figures used in previous reports. The specific adjustments included, but were not limited to, a narrower scope (+/- 6 months) within which to apply reported company financials to a given purchase price, as well as a revised formula that requires a greater number of mandatory inputs to include a specific deal within a data set. As a result, data sets below 30 have a higher margin of error and thus are marked with an asterisk.

No investor believes the current upcycle will go on forever. Unlike past eras, however, there doesn’t seem to be a fear of missing out that might otherwise drive irrational behavior in the eighth or ninth inning of a market cycle.

If the last downturn taught investors anything, it’s that patience has served the asset class well. Patience, for instance, can explain the slowdown in activity as investors become more discerning; patience can explain sponsors’ comfort in transacting at historically high multiples, emphasizing the long-term secular trends that will support growth and value creation over time; and patience also underscores why the pause in the first half of 2019, rather than rattling dealmakers, could alternatively refresh investors as they gain more clarity around what the future holds.

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