Tue, Jan 5th, 2010 Much of what we read suggests that deal-making has dried up in this challenged, credit starved economy. The economic turmoil experienced across many industry sectors has negatively impacted merger and acquisition activity during the past 24 months. A closer examination of small and mid-size family held, entrepreneurial companies, suggests a brighter picture.
Sources tracking M&A activity report that overall dollar volume has declined, yet demand for transactions with valuations less than $100 million has remained level. Business values in the lower-middle market, while slightly impacted, have held up reasonably well compared to larger firms.
Moreover, the degree of buyer interest has increased in the past six months. According to a report of recent privately held transactions completed in the private equity marketplace, valuations are edging upward when measured as a multiple of trailing twelve months EBITDA or adjusted earnings.
Some people will point to speculation about changes in capital gains and interest rates, however my opinion is that tax and interest rates, while considerations, are not the primary driving factors for M&A activity in the middle and lower-middle market. Lifestyle considerations that impact sellers, including: a desire to diversify investments (large percentage of a business owner’s net worth is typically tied up in the company); succession planning; and, threats posed by competitors with “deeper pockets” are primary drivers of M&A activity in the lower middle market. The leading motivating factors driving a business exit strategy or sale continues to be entrepreneurial burn-out and boredom. These factors motivate business owners to pursue transactions regardless of specific economic conditions.
There are a few universal truths that will always exist irrespective of the economy. Good businesses with a secure, defensible, and/or scalable market niche and the ability to withstand economic uncertainty continue to be attractive and in demand. Quality companies that have shown an ability to perform well in this economy, have maintained or in many instances increased their value, by demonstrating that the success of their business model will not be negatively impacted in challenging economic times. Another constant is that the greater the number of potential suitors available, and the better the “fit” with those potential acquirers, the higher the valuation that will be achieved.
In traditional financing, there has been a trend toward senior debt comprising a smaller percentage of overall transaction values. The amount of buyer equity in transactions, along with mezzanine debt, continues to rise. Interest rates for these types of loans have increased, due to the limited appetite and participation of senior lenders. Cash flow based lending is scarce; leverage multiples have continued to retreat while interest spreads and fees have increased. Buyers capable and willing to over-equitize and mitigate dependency on financing are in a favorable position in this market. Many have considered a position wherein they will commit greater equity now with a strategy to refinance and increase leverage once the climate changes with senior lenders. In addition to buyers willingness to bring more money to the table, increased seller financing has also been a contributing factor to the greater number of transactions closing.
When compared to past years, there has been a trend toward business owners selling at younger ages. Due to the increasing array of impacts from outside influences, over which an owner has no control, the thinking has been to “take some chips off of the table” and thereby monetize a portion of their achievement, protecting family future. This results in an increasing number of “sell and remain transactions”. In this scenario, the seller continues with the company through either minority equity retention, or securing a long term employment relationship with the buyer. Continued seller involvement reduces post-transition risk for the acquirer. It also enables the seller to concentrate on the best use of his or her skill sets by shedding the other responsibilities of ownership, and potentially provides financial incentives to the seller to help with future expansion opportunities.
Due to the longevity of the current economic downturn, coupled with the negative impact on traditional credit facilities, a mounting number of businesses have shown interest in being acquired by companies that are better capitalized. Larger firms have found it increasingly challenging to grow organically, or branch out into new revenue centers through trial and error. This has created a growth strategy through acquisition, which allows them to immediately capitalize on their investment and “hit the ground running” on day one. All of these factors are leading to a significant upturn in M&A activity.
An important consideration to be aware of is what types of firms are positioned to buy at this time. There are two types of acquirers – strategic and financial. Strategic acquirers tend to be larger companies that prefer to “bolt on” a fully formed business, product line, or technology rather than building a business unit from scratch. A company is willing to pay a significant premium to instantly increase their market share or obtain proprietary technology. Strategic acquirers tend to be less reliant on third party financing, when compared to financial acquirers. The downturn in private equity sponsored transactions continues due to their reliance on leverage.
All signs indicate that 2010 M&A activity in the middle and lower-middle market will increase significantly over that of 2009. This especially holds true when considering that M&A activity almost came to a complete halt at the beginning of 2009 when everyone became obsessed with the major swings in the Stock Market, along with the cessation of support from financial institutions. Many buyers have stockpiled funds, developed long-term business growth plans, and have the mindset that the worst is behind us. The logical conclusion is that the stage has been set and can only result in a continuation of the current trend towards increased activity.
