It seemed very logical that the run up in equities in late 2017 in anticipation of lower corporate tax rates would significantly raise the value of privately held firms and ESOPs. The basic math of valuation dictates that higher free cash flows equals higher values. A no-brainer. However, we're starting to see data and anecdotal evidence that maybe valuations have remained more stable than we thought.
The drop in the top federal corporate tax rate from 35% to 21% was seen as exerting upward pressure on values as investor get to keep more of the cash flow. The stock market sure reacted in late 2017 with a big run up widely attributed to tax reform. Although many ESOP-owned companies pay reduced or zero effective tax rates, valuations of these companies are done on a tax paying C-Corp basis. Lower tax rates mean more free cash flow which increases the values. Early this year, ESOP appraisal firms gave indications of year-end valuation increases of 15% or more based solely on the lower tax rates, but cautioned that other factors such as growth rates and interest rates would be impacted by tax reform.
While there is no index of valuations, my conversations with appraisal firms indicate YOY increases in the 8-12% range for most ESOP companies based on the EOY 2017 valuations. The more modest increases are due to a combination of projected higher interest rates, slightly lower growth assumptions and the cap on interest deductions to 30% of EBITDA.
EBITDA multiples on public companies began a significant increase in late 2017 based on expectations of the lower tax rates and values on private companies are following. The EBITDA multiples increased from about 9.5x to 10.3X as tax reform became a reality. Early this year, we all assumed that prices paid for private companies by PE firms would follow the price increase of public companies. Interestingly, in Q1 2018, EBITDA multiples in middle market buyouts don't show that bump . According to GF Data, multiples for $10-250MM deals returned to about 6.9x after spiking to 8.0x in Q4 2017. 6.9x is consistent with 2017 averages. First quarter data is notoriously fickle and quarter to quarter variances can be wide, so it is a bit early to call a trend based on Q1 2018. However, I would not be surprised if valuations for private middle-market companies proved more resistant to increases than originally expected.
There may be a bit of a governor on deal valuations driven by a few factors. Private equity (PE) is the primary market maker in setting prices. PE buyouts usually rely on debt financing for a majority of the capital. I think it is likely that a combination of availability of debt capital and the new limitations on deductibility of interest is tending to cap how high EBITDA multiples can go. Due to regulatory pressures (and common sense) banks are loathe to exceed 2.5-3.0x in senior debt and 4.5-5.0x in total debt. The junior lenders may also have a ceiling around 5x either due to leverage or coverage limitations. Prices and leverage were already at very high levels in 2017 and any increase in purchase multiples would need to be 100% equity financed, driving down returns. Couple that with the limits on interest deductions to 30% of EBITDA and you could see an offsetting downward pressure that could keep multiples in check (although at a relatively high level).
We'll keep an eye on how this plays out as 2018 progresses. Should be interesting.