GF Data Resources began its latest quarterly report with the statement, “High valuations and abundant use of debt continued to mark completed deal activity in the first quarter of 2018.” Let’s dig deeper and get a better understanding of “high.”
Average multiples in this database in the first quarter were 6.9x EBITDA across all industries. There is a caveat in the report that fourth quarter multiples (8.0x) may be a bit high while first quarter closings may be on the lower side, so a 7.5x average is more indicative of the current state. That result is consistent with the second (7.4x) and third (7.5x) quarters of 2017.
So is 7.5x high? Strap yourself in for a little multiple deconstruction. For those of you who are not math geeks, skip to the last paragraph.
A few facts to begin: a) a multiple is an inverse of the capitalization rate, so a 7.5x multiple is a capitalization rate of 13.3%, b) the capitalization rate is a weighted average cost of capital, and c) the capitalization rate is the discount rate less expected long-term growth.
Average leverage multiples of 4.2x (also per GF Data Resources) imply an average debt capitalization of 56% (4.2/7.5) and therefore equity contribution of 44%. With me?
What do you want to use for interest rates? Let’s keep it simple and assume prime rate, which currently stands at 4.75%. If 56% of the capitalization is at a 4.75% cost, then the equity would have a cost of 24.2% (24.2% x 44%) + (4.75% x 56%) = 13.3%. According to Pepperdine University’s 2018 Private Capital Markets Report, private equity expected return rates range from 20-30%, so our 24.2% fits perfectly.
This is all predicated on the continued use of leverage at 4.2x and/or interest rates holding steady. Note that the current leverage level, the “abundance” which GF Data Resources notes, is higher than ever in recorded history. Well, maybe not, but you’re not going to look it up. We are seeing the highest leverage levels in years, made possible by the long period of low interest rates.
Keeping every other variable the same, a 50 basis point increase in interest rates would result in the EBITDA multiple dropping to 7.3x. Not a big change. How about a reversion to leverage of 3.5x as experienced in 2012? Then the multiple drops to 6.8x. A bigger hit.
Now let’s turn our attention to the cost of equity. We assumed that 24.2% made sense in the current state where real GDP growth is forecasted at 2.5%. Since our risk expectations as measured by the discount rate should be rather static, the appropriate capitalization rate will move up or down depending on changes to company growth expectations.
The math is done. Let’s welcome back the anthropology majors.
So is the 7.5x high? Not if you believe that interest rates will stay the same and that leverage ratios hold steady. Oh, and that the economy will continue at its current pace. Is the 7.5x low? I don’t believe there is much more upside to where we are now. Quality companies should expect to see pricing stay about the same, even with small increases in interest rates over the course of the year. Should capital markets start to retreat or the economy slow down, that’s another story.
