The market for initial public offerings (IPOs) has suddenly cooled. Venture investment slowed 30% in Q4 (compared to Q3)[i]. One might wonder if this reflects a rationalization of the broader M&A (mergers and acquisitions) market.

Yet the bigger problem is there is no logical standard for valuations in today’s climate. Consider Warren Buffet’s acquisition of PCC last year. At the time I commented on the staggering 18x multiple paid for a manufacturer of metal components. PCC has been on a buying spree shaking up the aerospace market.[ii]. The market premiums being paid today seemed impossible just 2-3 years ago.

It appears as if Buffet had a strategy in mind, to roll up a fractured industry with many layers of industry suppliers.  Consolidation has been the impetus for M&A over the last decade, but how much gas could be left in the tank?

As the old axiom goes, a business is worth what someone else is willing to pay for it.  Such wild valuations are omnipresent, in a slow growth environment with low bond yields. Companies are desperate to find growth, and acquisitions are the path of least resistance to those with big balance sheets and access to capital.  While there has always been a relationship between scale and value, in today’s market, size matters…a lot.

With the large returns expected by private equity firms (35% or higher), one has to wonder when they will run out of runway[iii]. Further, it would seem logical that strategics would stop reaching for companies with valuations that cannot be justified based on financial rate of return. As interest rates rise (and they will have to eventually), valuations will have to come back into line.

I have been privy to some interesting conversations over the years. Investment bankers will give prospects a range of what a business could be worth. The truth is, nobody knows. Choose your advisors carefully, and make sure you have your ducks in a row if you are going to enter the fray.


 

[i] Venture Investors are Taking a Pause by Chapman and Wang-Bloomberg Businessweek

[ii] Janice Capital Partners

[iii] What ROI Means in Mergers and Acquisitions by Ney Grant, All Business