Chas Craig, BridgeTower Media Newswires
“What is smart at one price is stupid at another.”
— Warren Buffett
An interesting graph from Strategas recently showed how the trailing 12-month enterprise value-to-EBITDA multiple for the Russell 2000, a benchmark of relatively small capitalization publicly traded American businesses, had recently been eclipsed by the average enterprise value-to-EBITDA multiple paid in recent private equity transactions.
This is noteworthy for two primary reasons: A significant premium, probably mostly owing to liquidity, has been placed on the Russell 2000 vs. private equity multiples historically and this is only the second time this relationship has inverted during the series, (dates to 1996) the other time coming just before last decade’s Financial Crisis.
Now, earnings before interest, taxes, depreciation and amortization is a metric not in conformance with generally accepted accounting principles. While measuring the combined value of a company’s net debt and equity (enterprise value) as a multiple of EBITDA has its flaws as a valuation metric, it is a reasonable way to compare aggregate valuation data where significantly different capital structures are used. Therefore, we view it as a meaningful barometer of the relative valuations between the Russell 2000 and the average valuation paid in private equity transactions where more debt is typically employed.
There are smart-sounding arguments explaining why private equity valuations are justified and not as alarming for investors in that area as we’re inclined to believe they are. However, we’re of the opinion that the best time to own private equity and other alternative assets is when investors are paid handsomely for assuming the limited liquidity typically associated with such investments. Given the valuation disparity, it appears to us that, far from being paid for the lack of liquidity, investors are currently paying for it.
We can think of a few reasons, none of them rational, why investors would choose to pay higher valuations in private rather than public markets:
• Investors seem to crave the prestige of purchasing assets in private markets now rather than the old-school exercise of analyzing and investing in publicly traded stocks. One might dub these private market premiums “cool kid club fees.” No doubt, there are plenty of exceptions to the preceding generalization, but we think we get this directionally correct.
• Some investors may consciously pay higher multiples in private markets to avoid the mentally taxing exercise of marking their investments to market each day as in public equity markets. It is also reasonable to question if private equity valuation methods understate the volatility of underlying cash flow profiles compared with publicly traded securities because the assets are not marked to market daily, augmenting the multiple private buyers are willing to pay.
• Closely related to the comments in the previous point, institutional portfolio managers have become increasingly focused on managing down quantitative risk metrics such as beta (a measure of risk relative to a benchmark like the S&P 500) and volatility. While these figures should not be the alpha and omega of any risk evaluation, as they often are, they can provide useful guideposts for evaluating a portfolio of publicly traded securities. However, when such metrics are used to evaluate assets that are marked to market only periodically like private equity, completely fallacious conclusions pointing toward lower risk than economically exists are a likely outcome.
Bottom line, combining the high valuations described herein with high and increasing financial leverage, heightened and unflattering political attention and prospects for a slowing and someday contracting economy, there is plenty of tinder for bad outcomes in the private equity space.
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Chas Craig is president of Meliora Capital in Tulsa (www. melcapital.com).
