Advising sellers on the issue of valuation in a transaction has, historically, been relatively straightforward. With a fair degree of precision, one could rely on data from the capital market, debt providers and equity financing sources to establish a range for the fundamental financial valuation for a company.
Utilizing other available analytical tools, such as a discounted cash flow and synergy analysis, we could educate potential sellers with a reasonable level of confidence on what their asset might garner in a recapitalization transaction or strategic sale.
Recent market turbulence, a lack of transparency in transaction data and a myriad of assumptions with respect to growth prospects and tax code changes have made this task more difficult. As a result, many business owners have become disconnected from the market with respect to understanding what their asset is worth. This convergence of circumstance provides advisers an opportunity to set the record straight. Despite the perception, valuations are quite good for the right companies even in today's challenged market.
Several paradoxes are driving this reality. First, a slow-growth economy puts pressure on strategic buyers to acquire growth sources. For a buyer with strong strategic impetus, the appetite to be aggressive on valuation is much greater. Second, the relative value of growth increases in flat or declining markets because it's a scarce resource. Great companies distinguish themselves in challenging markets by growing faster than their industry and peers. Private equity firms and strategic buyers are paying substantial premiums for companies with these characteristics.
Generally speaking, strong-valuation environments require stock market expansion fueled by earnings growth, liquidity and leverage. Let's look at these individually to assess the current state of affairs.
While investor sentiment swooned in the face of the European debt crisis, 2011 was in fact a strong year for the equity markets. The stock market, as represented by the Dow Jones industrial average, generated a total return of 8.3% (price appreciation plus dividends) in 2011. Notably, earnings grew 15.6%. Strong earnings drove equity prices higher, increasing the likelihood that acquisitions would be accretive, but also improving the balance sheets of corporations, pensions, endowments and charitable trusts, the primary contributors to PE funds.
This trend continued through the first quarter of 2012, when the Dow gained a further 8.1%. Of the S&P 500, more than 80% beat estimates in the first quarter of 2012. While gyrations continue, the relative strength of the market -- as evidenced by equity price appreciation -- appears favorable.
From a liquidity standpoint, the market remains cash rich. As of the fourth quarter of 2011, the S&P 500, excluding financial institutions, had $1.21 trillion in cash on their balance sheets, representing 9.1% year-over-year growth in cash balances. PE funds raised approximately $100 billion in 2011, bringing total dry powder for financial sponsors to $425 billion. This hefty cash position resulted in strong M&A market dynamics in 2011 where total deal volume in the U.S. approached $986 billion, the best year since 2007. There is simply too much money chasing too few good opportunities. When strategics and PE firms compete, valuations spike.
Leverage is the piece of the puzzle that remains fickle. While more loans were issued in the U.S. in 2011 than at any time since 1991, $1.86 trillion, the vast majority went to large corporations. Despite this, loans to fund transactions by financial sponsors nearly doubled in 2011. Larger deals attracted much greater leverage, however, as evidenced by the fact that leveraged buyouts valued at more than $1 billion utilized 61% leverage in 2011 versus 46% in deals below this benchmark.
That said, overall buyout deal leverage increased nearly 35%, pushing average valuations up 25% in 2011. In fact, 2011 ranked as the second-best valuation year for leveraged buyouts in the past 10 years. When private equity can provide an attractive valuation alternative, it ups the ante for strategic buyers as well.
While there are few universal truths in the capital markets, the confluence of a strong public equity market, a cash-rich buyer population and available leverage means that attractive valuation outcomes do exist. Sellers tempted to sit on the sidelines because they hear valuations are not robust would do best to seek counsel appropriate to their individual situations.
Bryan Jaffe and Christian Schiller are managing directors at Cascadia Capital LLC, a Seattle-based boutique investment bank.