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In the US middle market, soaring valuations beget an add-on frenzy

Huron Capital never used to close more than two dozen add-ons in a year, but that's what it's done so far in 2019. In fact, its 26 completed add-ons represent a record in the Detroit-based lower-middle-market firm's two-decade-plus history. For Huron, 2014 trails in second place with 17 such deals—little more than half of this year's level.

Huron isn't alone in this increase, as a slew of middle-market firms are upping their add-on game. 2019's industry-wide spike underscores a high valuation market for sellers. Add-ons in the US middle market have steadily risen as a share of total deals over the last decade, but the past 12 months have seen transactions accelerate and prices soar like never before. As a result, competition among private equity buyers is heating up.

Once pursued by fewer investors and at a slower rate, add-ons are now a key tenet of many firms' strategy for the middle market, which PitchBook defines as including companies acquired through buyout transactions between $25 million and $1 billion. Through 3Q 2019, add-ons accounted for 68.7% of middle-market deal count and 57.6% of deal value. A decade ago, add-ons garnered only about 30% of middle-market deal value and less than 60% of deal count.
 
"More people are doing it than ever," David Andrews, CEO and managing general partner of Gryphon Investors said of this approach. San Francisco-based Gryphon, which Andrews founded in 1995, currently manages more than $5 billion in assets and has long pursued add-ons as a key strategy, unlike many of its peers.

The add-on route is growing in popularity among middle-market firms grappling with rising valuations, even with vast amounts of dry powder in the market, according to Heather Madland, principal, business development at Huron. That's because add-ons can blend down the acquisition multiple, effectively lowering the high price of platform companies.

Median PE EV/EBITDA buyout multiples in the US middle market are approaching 13x this year, according to PitchBook data. A decade ago, the same company might be valued at 7x or 8x. When buying a company at such a high multiple today, there's limited room for returns.
 
"I think one strategy of firms today is to average down that buy-in multiple," Madland said. "So some private equity firms are paying up for what they would consider the platform, and then they are using add-ons as a way to average down their buy-in multiple over the investment period." Buyer beware With more middle-market firms vigorously pursuing add-ons, the possibility for unsuccessful integration is high—especially among firms that have not historically relied on this deal type as a core strategy, according to Andrews.

"There are likely to be some that are not successful because they were not integrated properly," he said. "It's possible to make the high price that you paid for the platform even more expensive because you have a mess caused by the add-on acquisition."

In other words, the strategy can easily backfire for unprepared buyers.

And private equity firms must be careful not to lean too heavily on add-ons as a method to boost their exit value down the road, Madland cautioned.

"You can't have all add-on growth and no organic growth and expect to get an outsized multiple," Madland said. "I think companies coming to market need to show growth in both areas." Roaring 20s In total, US middle-market deal flow in 2019 is on pace to shatter last year's record high, with about $374.3 billion worth of deals spread across 2,687 transactions through 3Q. That's with the jump in add-ons, which tend to be smaller than other acquisitions.
 
According to PitchBook analyst Stephen-George Davis, next year will likely see more of the same—including an ongoing increase in add-on acquisitions.

"Going into 2020 and onward, we expect to see middle-market GPs continuing to utilize add-ons in order to complete lower-multiple acquisitions in an elevated pricing environment," he said.

That could translate into even more buyer competition, an environment flush with capital and add-ons galore. Thus, the need to be a good actor in the market is as important as ever, according to Madland:

"Having a track record of doing what you say you're going to do, having a positive reputation in the market, having your references check out, showing you're a firm that acts with integrity—those are critical differentiators."

Featured image via Tostphoto/iStock/Getty Images Plus
 

Related read: PitchBook's 3Q 2019 US PE Middle Market Report