There is a widely held belief by business owners and investors that valuations in the human capital sector follow a seven year cycle. We consider the validity of this below in the context of historic data and current market conditions and assess the implications for businesses.
The human capital sector has started 2014 in a buoyant mood with unemployment falling rapidly, permanent salaries on the increase and corporates in a positive frame of mind both in terms of appetite for investment and M&A activity. M&A transaction volumes in 2013 were 23% up on the previous year. Equity markets delivered impressive returns, as demonstrated by the Human Capital Index of 24 companies tracked by Gambit, which delivered a 63% increase in share prices out-performing the FTSE All-Share by almost 46% during the year, pushing average EV/EBITDA multiples to their highest level in three years.
Whilst all this is undoubtedly positive news for human capital businesses, cyclicality remains a key issue for companies operating within the sector. The prospects for the sector are inextricably linked to the wider economic cycle through business confidence levels, corporate investment and employee turnover. The key challenge for companies and shareholders is predicting where the sector is in its cycle and the optimum time to be making decisions on M&A activity.
The chart below tracks valuation multiples against EBITDA levels for human capital companies over the last 20 years. As the chart highlights, the colloquial seven year valuation cycle in the human capital sector is seemingly well established and predictable. The data suggests that whilst valuations will continue to increase in the short term, we are one to two years from the next peak in the general market, albeit there are significant variations dependent on the specific sub-sector.
With the current recovery based largely upon a somewhat fragile global economy and economic downturns becoming increasingly difficult to predict, correctly anticipating the timing of the next peak is of critical importance.
So what are the implications for shareholders looking to realise value from their investment or acquirers looking to increase scale or differentiation?
For owners looking to sell, maximising value from an exit is of profound importance as a one-off opportunity to generate a return from years of commitment and sacrifice. Valuations are on the increase and this is expected to continue for the foreseeable future, yet the time to the next peak will inevitably vary across sub-sectors. For certain specialist sectors such as oil & gas and engineering, the current multiples being paid do not appear sustainable in the medium term with a number of high profile assets having changed hands in the last two years, predominantly going to overseas private equity buyers and valuations in excess of 8x EBITDA. A significant number of shareholders have held on in recent years waiting for market conditions to improve. For such individuals the choice is clear – realise value now to take advantage of the rising tide in valuations or defer and gamble on the next cycle.
In terms of acquirers, conditions are ripe for acquisition activity as corporates with high levels of capital to deploy, and limited opportunities to deliver organic growth, look to increase scale and differentiation, both key drivers of valuation. There is also increasing pressure on a number of mid-caps to deliver growth in shareholder value through improved market ratings which will further drive activity levels. Nobody wants to buy at the top of the market, so for corporates, urgent attention needs to be given to reviewing acquisition criteria and priorities at the earliest opportunity given the lead time needed to find a suitable target and execute a transaction.
The clear advice is whether or not you are looking to sell or acquire in the short term, the next few months will be a critical time to carefully review strategic plans and objectives. There is a conscious decision to be made whether to act now and capitalise on existing valuations or “roll the dice” and be prepared to wait for the next cycle.