Investment Banking – Deal Flow Challenges
The challenge for all investment banks at any given time is cultivating quality deal flow. In this case, “quality deal flow” means businesses with these attributes:
- Growing revenue streams, (preferably recurring)
- Stable, increasing cash flow
- Non-cyclical products or services
- Low CapEx required to achieve growth
- An excellent management team
- A diverse customer base
- A motivate seller
With corporate valuations at historic highs (in 2018), business sellers operating “quality” businesses tend to have the mindset that they should hold longer. They delay an exit because cash flows are good, and the company continues to grow. Further, using the recent historical performance of their company to forecast growth prospects plus applying recent high valuation multiples, leads many company owners to rationalize that they should continue to grow the company because it will be worth even more in a year or two.
In parallel to the mentality described above, there are two macro-effects that counteract normal market conditions and help to create this sustained seller’s market we are now experiencing. One economic. One social.
Economic Factor – As monetary policies globally have made money inexpensive, there is an increased interest in alternative investment vehicles that offer the probability of higher returns. This interest in alt assets has infused the private equity market with enormous amounts of capital to deploy, thereby fueling demand for private companies to acquire. The increased demand from financial buyers has helped boost valuations for M&A transactions. There’s just a lot of dry powder for investment purposes right now.
Social Factor – Baby boomers were expected to exit in mass as they approached retirement age. M&A industry participants have been expecting this for years and have been looking forward to the increased deal flow potential this wave of business ownership transfer should bring. However, this trend largely has not been realized as the baby boomer generation continues to work past the historic retirement age. Business owners are holding their companies longer, restricting the supply of businesses for sale. The limiting of supply has also bolstered business valuations.
Combined, these macro-effects (increased capital on the buy-side with a limited supply on the sell-side), have created the sustained seller’s market.
It Always Cycles
Eventually, this trend will reverse (it always cycles) or at least revert to the mean for business valuations. Smart owners, who are considering an exit, should capitalize on the currently high valuations in the market. This will not last forever. Smart investment bankers should be consulting with potential clients about these trends to communicate the robustness and fragility of current valuations.