The general market environment has supported the steady climb in average transaction multiples in the European mid-market, but is this a financial bubble? The short answer is no. Not while acquirers remain highly selective and the cost of money remains low. The current transaction multiples are very consistent with the cost of debt and expected returns for institutional investors – in fact, 10x EBITDA could be the new market standard going forward.
Note that 10 years ago, PE houses typically valued targets by expecting a 20% gross IRR (2.5x multiple in 5 years), however most of the players in the mid-market now base their valuation models on a 15% gross IRR and 2x multiple over 5 years.
This decrease in expected returns is also well aligned with changes in the cost of money: comparing the 2017-2018 period to the former valuation peaks (2007-2008 and 2000-2001), Euribor has fallen from c. 4% to negative rates; and government 10y bonds from 5% to less than 1%. This means that PE firms with a gross 15% IRR enjoy stable expected spreads of c. 15% on top of the cost of money.
Note, that this expected 15% gross IRR implies a 10% net IRR for institutional investors (PE houses take management fees of c. 2% p.a. + their carried interest). And with this level of returns, the buy-out asset class still offers better returns than the stock market, real-estate investments and hedge funds, and also over time more stable returns and less volatility than the stock market.
To illustrate the impact of expected returns, we have run a valuation model for a company generating 15% EBITDA and 12% EBIT margins, growing at 5% p.a., financed 50% by financial debt @4.5% p.a. and 50% by equity. The implied EBITDA multiple stands at 10x EBITDA to generate a 15% IRR for the equity, but only 7xEBITDA to offer a 20% IRR.
The conclusion is that for unlisted mid-market firms decreasing returns expected by financial investors (and their institutional investors) have a major impact on transaction multiples: 2 to 3 points of EBITDA, meaning that 10x EBITDA today is comparable to 7 to 8x EBITDA 10 years ago!