Will COVID-19 Provide Cover to Corral Value Multiples?
Last summer, we noticed a peculiarly interesting article about what had become a runaway lending environment. Debt capacity had risen as high as 6-7 times EBITDA. What’s more, EBITDA was fast becoming a proforma, go-forward, if-everything-goes-perfect figure. In other words, a substantially puffed up version of the truth that effectively added another 1-2 turns of EBITDA that lenders were willing to put up.
What was peculiar, however, is that it was the lenders themselves complaining about the loopy leverage – as if Svengali-like market forces rendered them incapable of resisting the siren call of cutting big checks.
Of course, they could. But competitive forces, uh, forced them to either pony up, or punt. And with so much money to deploy, and no other way to generate returns, the latter option was about as enticing as a root canal.
Now add to the mix similarly situated private equity groups that like to super-charge returns by deploying as much debt as possible. With funds flowing like beer at a fraternity keg party – and perhaps a bit of hubris born of a 10 plus year run of economic growth – they willingly adopted a last-man-standing pricing strategy that pushed multiples to levels we hadn’t seen since the period just prior to the global financial crisis of 2008-2009.
It was like lenders and buyers alike were playing a game of Jenga, completing record numbers on deals on an increasingly wobbly tower of debt and equity that was just one market flick away from sending it all tumbling down.
Well, that flick has come in the form of COVID-19. Lenders are suddenly more skittish than a cat on meth. Buyers are sitting on debt-laden assets that are reeling from unprecedented contractions in market demand.
Moreover, regardless of the economic realities, COVID-19 provides near perfect cover for lenders and buyers to collectively do what they were unwilling to do on their own. That is, reel back pricing to what the risk-return fundamentals, rather than the availability of capital, can support.
Unfortunately, with pendulums being like they are, the swing back from inflated valuations may swing right past rational to a period of overly conservative pricing.
The good news?
Eventually the market will once again forget the lessons of the past and convince itself that the unjustifiable is justified.
But it could take a while.