In dealmaking, it’s often a case of monkey move up, says Peter Davies, managing partner at Stonehenge Partners Inc.

For example, the private equity firm bought a business for a multiple of 6.5. It sold it three and a half years later, taking back stock at 8 times EBIDTA. It later sold to an industry consolidator for 14 times EBIDTA.

But with multiples nearing the peak, investors today must do more to change the business complexion, he says.

“It used to be that in the private equity business you could buy a company right, sell it right and do really well,” Davies says. “You now have to buy it right and make significant changes in the middle — improve operations, improve margins, build a salesforce, expand geographically, expand your product set — and then and only then will you get that increase in multiples that a new buyer will come in and pay for.”

Davies spoke about what he’s seeing in M&A at the 2018 Smart Business Dealmakers Conference (formerly ASPIRE). Here are some of his insights:

How does this peak market compare to the last one?

If you look at the data, 2007 was the last peak we had. From 2007 to 2009 multiples dropped by 30 percent. It took five years to get back to those levels that we saw in ’07, and we’re currently at 25 percent above the multiples that we saw in ’07.

You can see how volatile multiples can be, and that has a real impact on valuations and returns. I think we have been here before, and vigilance in this market is important.

What lessons should be applied when investing?

We spend a lot of time when we look at businesses to invest uncovering what their performance was in the last recession. If revenues in the last recession went down 35 percent, say, that probably means that EBITDA would have plummeted 60 percent or 65 percent, depending on operating leverage — and those are businesses that we tend to stay away from.

We like to look at businesses that don’t have a lot of correlation to the economy. In fact, a couple of our businesses during the recession actually increased. What you won’t find us doing is investing in deep industrial companies where revenues will fall off the wagon and be detrimental to the overall potential survivability of the business.

How have private equity buying strategies changed?

Return targets in the private equity universe have come down. I still remember back in the late ’90s, we were structuring base case returns in our models that if it didn’t hit a 30 percent internal rate of return, we didn’t do the deal. We’re now structuring (where the) upper teens is our target rate for base case returns. So, I think return expectations have come down.

Some private equity firms are making the classic mistakes that were made back in ’06, ’07, but some are also taking a more reasonable approach and saying, ‘OK, let’s put more equity in these deals. Instead of 30 or 35 percent equity in these deals, let’s put 50 or 60 percent equity in these deals. Let’s form a safer capital structure to protect ourselves in a downturn.’ We know we’re accepting lower internal rates of return, but we’re willing to do that because we have greater safety in how we’re structuring these deals.

There’s a technique in which PE funds buy a portfolio company at a very high multiple, and then buy down the multiple over time with add-ons at lower multiples. What do you think of this strategy?

There are just a handful of firms that have been successful at that strategy. When they buy these companies, what they should be doing — and what the really good ones are doing — is buying a platform business that has excellent systems, that is a stable workhorse, so new smaller tuck-in acquisitions can be acquired and integrated. They have a very well-developed team, four or five people deep, that treat acquisitions as a business.

I think anything short of that, which I would say is 90 percent of the strategies, is really tough because making acquisitions is a very intensive business process that you have to get right. One acquisition can slow you down for the next 18 months if not properly integrated. There are a handful of firms that do it well.

We don’t employ that strategy. It’s hard. That has to be a specialized business within the business to do it right. A strategy that we often employ is buying a company and doing, say, two tuck-in acquisitions over a period of five years that expands the product set or gets us into different geography or vertically integrates in some way. That is a strategy that has worked and is not as difficult as these roll-up strategies.

What are some deal killers for you?

If we see a business and the largest customer is, say, 25 percent or more, that gives us significant pause. My rule of thumb is if you buy a business and one person’s decision can turn that business into a bankrupt company, I don’t want to do that deal.

So, I would say customer concentration No. 1, and then No. 2, when we look backwards at performance during the recessionary environment and that was a deep drop — again something that could take the business off the air — we would not be interested.

Do you think capital will stay on the sidelines if the economy starts to slow?

I think what will happen is the tail will be elongated. We saw that when fundraising was very high in ’06 and ’07 and then it plummeted 90 percent in ’08, ’09. That money was still deployed; it was just deployed over a much longer period of time. Instead of three years, it may have taken seven years.

There were private equity firms that, more often than not, would go to their investors and ask for an extension to put that money to work, but every now and then you did see that money being returned to investors. So, I think it will still be put to work — just over a longer period of time.