We have been hearing about a “bid-ask spread” issue in the lower middle market healthcare space for a significant time, and I wanted to discuss this and also mention another pocket of dislocation that I see.
First, by “bid-ask spread,” we mean that seller expectations are not aligned with buyer expectations when it comes to valuation. Of course, buyer and seller expectations are rarely aligned closely with each other, but the difference between buyer and seller expectations has been wide enough lately to discourage M&A activity.
I have heard several times that certain sellers, particularly those in healthcare services, are anchored to 2021/2022 valuations that were predicated on assumptions and financing terms that are no longer realistic.
I have heard a similar discussion when it comes to portfolio companies—long into their private equity hold period—attempting to go to market. Several processes have been terminated or stalled this year because of differences in buyer and seller expectations. I would guess the proximate reason is that the private equity firm’s (in this case, the seller’s) expectations for valuation are not aligned with the buyer’s.
However, I would argue that the root cause of the dissonance is that the business’s maturity has not kept pace with growth.
In other words, middle market buyout firms, which themselves typically take a much more hands-off approach, see a strong level of EBITDA and profitability but don’t see a commensurately integrated and cohesive business. These types of portfolio companies garnered high valuations in 2021/2022, but I think we are in a new environment in which buyers are looking for more professionalized businesses to match their size.
I would also argue that large strategics, even with their buy-and-hold strategies, are reticent to pay high valuations for businesses (even large, profitable ones) that still require significant investment to unify.
Another dislocation I see is the implied risk premium between equity and debt investments.
Right now, I am hearing that private credit funds are lending in the neighborhood of SOFR plus 6%, or over 11% total. At the same time, IRRs for private equity funds have not budged from 15%-20%, especially for vintages after 2016, likely the last vintage where capital was deployed before the run-up of 2021/2022. Trying to mentally control for the J-curve, I think it is safe to say that IRR targets for private equity funds have not budged from 20%-30%, implying only a 9%-19% equity risk premium between private credit and private equity.
Such a small risk premium hardly compensates investors for moving from the top to the bottom of the capital stack. I suspect that is another reason why deal volumes have stagnated or declined (depending on the sub-vertical).
With at least the Fed funds rate staying higher for longer, it seems that one logical way to correct this dislocation would be to optimize (lower) the entry point for private equity investments, which leads us right back to the first point on bid-ask. Clearly, other value-creation strategies are needed to bolster PE returns until interest rates begin to decline
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Jarrod Barraza
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