Last year, private equity and investment banking firms experienced a post-COVID boom of inbound interest and deal activity like never before. 2021 saw nearly $6 trillion in transaction volume and more than 63,000 deals.
Unfortunately, 2022 hasn't followed suit. International tensions, a sputtering supply chain, and sky-high inflation rates have led over two-thirds of analysts to predict a recession in 2023. Deal activity has already begun to slow, and firms that invested in platform companies at peak multiples are preparing for less than ideal returns.
Private equity firms need to find ways to lower their portfolio's average entry multiples, and add-on acquisitions may be the answer to how to close the valuation gap. Let's dig into the valuation gap meaning and how dealmakers can leverage data and direct sourcing to build a promising add-on strategy.
A valuation gap is when the sellers of a company want a certain price or multiple from buyers or investors, but the purchaser has a different number in mind. Private equity firms sometimes experience valuation gaps during dealmaking because a founder wants too high a value for their company than a firm is willing to pay.
Other times, it's because of the situation facing firms today: less revenue, reduced growth, and even potentially negative cash flows for the platform companies in their portfolios. What results is a portfolio that is no longer valued at what your firm may have purchased it for. If you were to try to sell any of those companies, the gap between what you could and what you should sell it for to make the investment worthwhile may be very far apart: a valuation gap.
One solution lies in acquiring smaller, private"likely bootstrapped "companies to help bridge platform companies'growing valuation gap. These are known as add-on acquisitions. Before we dive into how to find this type of deal, let's first define an add-on acquisition vs. a platform investment.
"Platform companies" refer to foundational investments firms make in high-growth industries or emerging categories. They typically have decent market shares, resources, and revenues in their given space.
In contrast, "add-ons" refer to faster, cheaper, and lower-risk investments firms make in smaller companies to help enhance the value and accelerate the growth of platform acquisitions. This makes add-on investing a perfect strategy to help firms bridge the valuation gap.
As previous Director of Business Development for Serent Capital and Sourcescrub's own Co-founder and CEO Tyler Fair said in a recent interview, "It's a good time to focus on add-on acquisitions. In a lower valuation market, this will help bring down your overall entry multiple. If you bought a platform company for 10x revenue, ask yourself where you can deploy additional capital into your portfolio through add-on acquisitions at lower multiples than what you paid for your platforms."
However, traditional methods for identifying, researching, and closing add-ons are highly manual and time-consuming "a process that's even slower and more stressful when you're up against a rapidly changing market.
That's why modern dealmakers are turning to the latest technology to take a data-driven approach to add-on investing. Building accelerated, purposeful, and precise add-on strategies can be broken down into two distinct steps.
Having an up-to-the-minute understanding of current market dynamics is critical to identifying ideal add-on candidates for platform companies. This requires firms to map out each player in a platform company's current and/or prospective space to gain a deeper understanding of where they fit and the opportunities that lie within the larger ecosystem.
It involves detailed market mapping and segmentation based on size and health. This process allows dealmakers to develop deep domain knowledge and expertise before pursuing an add-on acquisition, which ultimately sets them apart from other dealmakers in today's highly competitive market.
Modern firms are using new data services that offer a wealth of information about private, non-transacted add-on opportunities, including 9 core data signals that indicate investment readiness. Some tools are even able to surface companies with comparable signals to help build out market segments in minutes.
At this point, it's critical to determine how to close the valuation gap with the help of your acquisition. Will its goal be to grow revenue or enter a new market? Perhaps your platform company will gain additional product functionality or expand its geographic customer base. Historically, pinpointing the add-ons that best fit your goal has meant dredging Google and making hundreds of phone calls.
Newer approaches use lead scoring to automatically rank add-ons according to how well they match your criteria. The latest technologies not only empower firms to enter their precise needs and assign values to each corresponding datapoint, but they also automatically apply these scores and sort lead lists accordingly. This allows you to spend more time directly sourcing opportunities with real potential and the highest probability of balancing your market entry multiples.
Once you have identified the appropriate add-on acquisitions for your platform companies, it's also important to use the data and tools you have to get the best purchase price. After all, your goal is to lower the overall multiple for your firm's portfolio. Securing the best purchase price possible "potentially even overcoming a valuation gap within the deal itself "will be critical to weathering the upcoming storm.
As the saying goes, what goes up must come down "but your firm doesn't have to ride the recession rollercoaster. Developing a data-driven add-on strategy provides your firm the opportunity to thrive through uncertainty and maximize returns over time.
To learn more and see how leading firms like Copper Run and Boathouse are building a data-driven add-on strategy, download our free guide: Bridging the Valuation Gap with a Data-driven Add-on Strategy.