Bubbles, Cycles, and Business Values

Determining more or less the right time to sell a business at its maximum value is not always a luxury available to Middle Market owners, who sometimes find their hands forced by distress sales arising from family health issues or death, from partnership disputes, or from business difficulties. Fortunately, some issues that might motivate the sales of Middle Market businesses come naturally and can be anticipated: retirement age, the desire to change lifestyles, etc.

Timing a market to a certain degree is not entirely out of the question. Circumstances and conditions regularly arise that encourage sellers to make an educated choice. This is particularly true in regard to the “bubble” phenomena that arise irregularly in many Middle Market business sectors. Prospective sellers, recognizing that they and their companies are positioned in the right place at the right time, will try to sell into the bubble. During the mid- to late 1990s, for example, a number of industries experienced bubbles driven in large part by the dot.com and technology booms. For example, at the time, the outsourcing of professional IT services proved so popular, so “hot,” that it was for all practical purposes a gold rush. Firms everywhere recognized the need to jump on the technology bandwagon by transforming their in-house IT capabilities. Consumers of these services confronted a very limited supply of adequately-trained “techies” (who themselves understandably commanded high compensation packages) on one hand, and on the other hand they acknowledged their own reluctance to take on the expense of a permanent IT staff to address requirements they considered to be a temporary need. As a result, the investment values of IT staffing and IT project management firms skyrocketed. The IT staffing and IT project management industries—and the individual firms within them—began posting compound annual growth rates of 40% or better overnight. In turn, buyers of these businesses very soon began offering EBIT multiples of 10, 11, and higher to willing sellers (see Exhibit 6.1).

EXHIBIT 6.1 Timing the Deal or Waiting for Next Year’s Growth: A Potentially Costly Trap

Current Bubbles

But bubbles collapse, and when they do, they cause significant market devaluation of the business that originally benefited. From 2003 through 2008, the government contracting industry has been experiencing a bubble driven by dramatic increases in the industry’s M&A activity. In the aftermath of 9/11, federal government spending on defense and homeland security (among other areas) exploded, while government contractors, like IT staffing companies before them, realized double-digit growth rates that in turn generated investment valuations in the range of ten to twelve times EBIT—and in some cases much, much higher. As recently as the year 2000, it was quite difficult to sell a government contractor for anything more than four to five times EBIT.¹ This particular bubble is an unusually long one, as it was event-driven (by 9/11, the Iraq War, etc); however, beginning in 2007 and continuing into 2008, it is showing significant signs of weakening. Health care services and health care technology, as other examples, are also currently experiencing a big boom in growth, and consequently the multiples being paid. Timing is everything in these bubbles, and it should be considered carefully if a business finds itself in the midst of one. Bubbles are driven by sudden and rapid growth in an industry, and it is unrealistic to think that any industry can maintain a high rate of growth forever or even for long. This is especially true in the technology age where virtually all businesses and industries are seeing light speed changes in operating methods and whole market places and the ways they are serviced change almost overnight.

Bubbles are the proverbial flood tides that float all the boats in that particular sea. The key to surviving, even thriving in them is knowing something about bubbles—being able to recognize them and understanding the best time to sell during them.

Recognizing Bubbles

How does a business owner recognize that his industry is experiencing one of these cycles? Well, first of all, there is the “buzz.” It will be loud and clear, as people everywhere begin discussing the exceptional transaction values that companies in industry X are generating. Another clue comes from the Rules of Five (See Chapter 23), which argue that when Middle Market businesses sell for more than five times cash flow (EBIT, etc.), financial engineering roll-ups excepted, the higher multiple must be justified by some kind of near-term earnings growth that justifies it. This mindset may govern the sale of a single Middle Market business or any number of businesses in a “bubble” industry in which the overall growth rate is floating everybody’s boat. So the first key to a possible bubble phenomenon is the situation in which many companies (not just a few, as a single company may command a high multiple just due to its own high growth rate) within a single industry are receiving purchase multiples well in excess of five. Usually these will be found in the range of, say eight to twelve or higher as multiples of EBIT or EBITDA.

When EBITDA multiples do reach the eight to twelve range, Middle Market business owner/entrepreneurs should realize that the very peak of the cycle is approaching and the collapse of the bubble may well be drawing near.² EBITDA multiples of eight to twelve tend to be realized three-quarters of the way into the cycle, at which point buyers are likely to pay the highest investment values to be realized over the bubble’s lifecycle, because there seems to still be growth ahead, and buyers always buy the future. At the peak (end) of the bubble, most of the growth has been achieved; of course, buyers become aware of that, so multiples begin to recede rapidly back to five or so. Forewarned is forearmed: when buyers are willing to pay seven to twelve times EBITDA (there are, of course, exceptions in some bubbles, where even higher multiples can be paid, but seven to twelve is a good time to become keenly alert to the possible end of a bubble), they very likely are paying the highest purchase price they will on anticipated future growth of the seller’s business.

Bubbles and Their Duration

Bubbles tend to last for three to four years before collapsing.³ This was true of the staffing and IT staffing explosions, the dot.com boom (later “bomb”), the telecom industry bubble, and the roll-up era. Bubbles eventually collapse, because they inevitably lead to consolidation, and consolidators (the buyers) inevitably become satiated, especially as rising transaction valuations tend to wring the upside growth and profit potential out of successively more expensive acquisitions. The other factor, of course, is the consumption of the goods or services being offered by the bubble industry. Eventually, an equilibrium between supply and demand is reached. Bubbles, in short, are market hiccups.

As I have said already, Middle Market business owners who are fortunate enough to find themselves operating in an industry experiencing a bubble should give serious consideration to taking fullest advantage of the rapidly inflating business valuations before they inevitably collapse. Twenty/twenty hindsight can be extraordinarily expensive, and once the bubble has collapsed, it is unlikely to revisit the industry affected for a long, long time. To the extent it does, it will almost certainly be in a very different form, involving new business processes and technologies.

Bubbles, a Summary So Far . . . Catching the Wave

So what can we do with this information and how can we use it? Well, we can at least know the following things and then act accordingly:

• Bubbles are probably occurring when there is buzz and when many companies within an industry are selling for multiples that far exceed the norm in the Middle Market of about five times EBTIDA.

• Bubbles typically last about three to four years.

• The highest multiples are paid when the bubble is about three-quarters over. This is when there is still foreseeable growth left in the bubble curve and buyers are willing to pay for it.

• At the top of the bubble, multiples will usually recede back to somewhere around five times.

Bubbles and Recurrences

The extreme improbability of a bubble’s recurrence in precisely the same way in the same industry is due especially to the effects of the so-called “Information and Technology Age.” The Information Age effect may lead seasoned investment bankers to revisit the advice they might once have offered before the early 1990s as to who should and who should not have to seriously consider taking advantage of these high-valuation business cycles. Once upon a time, one might have considered the age of the seller to be a major factor in the sell/do not sell decision while a bubble was inflating. The argument, of course, would have gone like this: The 55-year-old owner contemplating retirement should seize the opportunity to exit at the top of the valuation cycle or as close to that as he can. But maybe the 25-year-old owner should stick around, waiting for the next cycle. After all, he has plenty of time to catch another wave. Does he not?

But age may no longer be a good—or wise—criterion, precisely because bubbles that have occurred after the early 1990s are so unlikely to recur in the same way in the same industry. Those Middle Market business owners fortunate enough to find themselves operating in an industry that is enjoying a bubble, seriously should consider selling, whatever their age. In client representation, of course, the art is being able to covey this to your client without being perceived as simply trying to sign up a new client.

Ambitious younger owners also may decide that they can lead their businesses through long years of growth and dramatic transformation that might well generate a significantly higher valuation down the road. But this is a very big bet, and clear-headedness is absolutely critical to the owner’s realistic assessment of his or her capabilities, the business’s potential, the industry’s mid- and long-term prospects, and his or her own staying power. One way to look at this is to consider that if an owner passes an opportunity to sell at the top of a bubble, at, say, a valuation of $25 million, then he is in effect making a $25 million bet that something better will come down the pike . . . if he hangs in there long enough (see Exhibit 6.2). The age of a business owner is clearly no longer a clear indication of whether to take advantage of a bubble.

From the other side, the buyers’ side, owners of mature buy-side businesses may want to stay in the game to benefit from the growth and values they believe they can achieve by acquiring market share during a bubble, even if they seem to pay dearly for it at the time. Such decisions should be approached with extreme caution because, as I have said, valuation multiples tend to peak in the third quarter of the overall cycle, and buyers who buy in the bubble will need to depend on generating their own values from sheer size, market domination, and economies of scale that result from bubble period acquisitions.

Other Timing Opportunities—Roll-Ups

In addition to industry bubbles, when the roll-up phenomenon returns (see Chapter 3)—as it inevitably will, in some form or other—Middle Market owners whose businesses operate in an industry that is being rolled up should also seriously consider the opportunity to sell out at substantial premiums that are unlikely to be realized elsewhere. Where roll-ups are involved, sellers benefit by sharing, at least as beneficiaries in part, the substantial arbitrage roll-up sponsors expect to realize between the private valuations paid for Middle Market companies and the value they can bring when sold into the public market via initial public offerings (IPOs). Roll-up promoters, in effect, are willing to share some of their anticipated profits with Middle Market businesses owners to ensure they can assemble an enterprise to bring to the public IPO markets. Carpe diem is usually the order of the day for sellers in these conditions.

EXHIBIT 6.2 Growth Curve and Optimum Selling Time

Chapter Highlights

Middle Market businesses hoping to sell their companies during a market bubble should be alert to the following:

• Bubbles are of finite duration, and usually last no more than three to four years. The highest investment values are likely to be paid somewhere in the vicinity of the third quarter of the bubble’s lifecycle.

• Bubbles are unlikely to recur, once they collapse—at least, never in the same way in the same industry. On the rare occasions when a valuation bubble does recur in an industry, it invariably reflects very different industry dynamics many years down the road.

• Roll-ups present another timing opportunity.

Notes

1 Once again I refer you to the Rule of Five discussed elsewhere in this book, especially in Chapter 23.

2 It should be mentioned here, though, that size alone may tend to drive multiples higher, as to very large Middle Market companies in the upper two thirds (values over say $150 million) of the Middle Market.

3 While the author makes no claim that they are exactly the same thing, it is interesting to compare empirical experience in individual M&A industry bubbles to Kitchin Cycles (Joseph Kitchin, Harvard Press, 1923), which identified economic cycles as lasting from about 39 to about 41 months. These are often interpreted as inventory cycles too.