March 13th, 2013
in Op Ed
by John Slater
Business owners time their exits for many reasons: health, retirement planning, availability or lack of family successors, competition, technology change and many more. Yet overwhelmingly the question we are most often asked as a financial advisor to entrepreneurial companies is "What's my business worth?" All things being equal, a rational business owner will presumably choose to sell at a point of optimal value for his or her interest in the firm. For the reasons outlined below, we believe that the next eighteen months may see the highest pricing for good middle market companies in the thirty years I have been in the M&A advisory business.
Historically the market for mergers and acquisitions is one of the most volatile on the globe. In our experience the market is very cyclical with three to four years separating peaks and troughs and six or seven years to cover a full cycle. The last bull cycle for M&A peaked in 2006-2007 and the market trough was witnessed in 2009-2010. 2011 and 2012 witnessed some moderate improvement, with Q4 2012 being particularly strong. 2012 was Focus's best year since 2007.
2013 has started with a bang with large announced deals for Dell, Heinz, and Virgin Media just to name a few. Many observers predict that these are not isolated deals and that 2013 will witness a resurgence in M&A activity. While the M&A market could be derailed by a major decline in the equity markets or further chaos in Washington, we believe that the odds favor a strong market for sales of middle market companies through sometime in 2014. By then a correction will be overdue and the likelihood of a cyclical bear market in equities may become increasingly high. Generally a serious decline in the stock markets leads to a precipitous fall in M&A activity.
The next 12-18 months will almost certainly be a highly favorable period for business exits. If this proves to be a cyclical market top, the next favorable period for businesses owners wishing to sell may not come around before the 2020s. In 2020 today's sixty six year old Baby Boomer will be seventy-three and today's fifty eight year old will be sixty five and studying Medicare options.
2012 Middle Market M&A Values Back to 2006-2007 Highs
In 2012 Focus witnessed a strong recovery in sell side M&A values, with seven closed sales and average pricing above seven times EBITDA. Several recently issued reports indicate that our experience was consistent with the overall market. For example, GF Data Resources, which tracks middle market M&A values based on data provided by more than two hundred private equity firms, recently reported that for deals in the $10-250 million range:
"Valuations averaged 6.2x trailing twelve months/ adjusted EBITDA, the highest mark in five years. Among major business categories, health care services and technology set the pace, both with average valuation multiples in excess of 7x"
We are again seeing heated bidding wars and multiples exceeding 10x for great companies in hot industries. One important driver for the valuation jump in the middle market is an increase in total leverage available from a range of 2.5 - 3.25 times cash flow immediately following the 2007/08 recession to a 2012 range of 4-4.75 times. Companies with steady, highly predictable cash flow are seeing leverage multiples of up to 5 times cash flow and even more for companies with EBITDA over $20 million. As a result sponsors were able to reduce their equity commitments from the fifty percent range typical in 2010-2011 to a range of 35-40% of total capital in 2102.
Financial Market Liquidity Could Drive Values to Historic Highs
With their various QE programs, the world's central bankers have created a tremendous overhang in global financial markets. Individual investors have begun to grab for yield, pushing "junk" bond yields to levels formerly reserved for A rated credits. Thomson Reuters LPC reports that leveraged lending for private equity backed deals reached $70 billion in 2012, a hair's breadth shy of the 2007 record of $71 billion. Private equity funds are aggressively pushing to fund finance companies and other direct lenders that were previously off limits to all but a few specialists. PE firms' limited partners are even creating their own direct lending teams to enhance their yields. There should be a great deal of leverage available to support PE M&A deals in 2013.
Bain and Company has recently predicted that global capital assets will grow to $900 Trillion or approximately ten times predicted global GDP for 2020 of $90 Trillion. The chart below predicts a financial market pyramid that most readers will find quite frightening.
Bain suggests that this capital overhang will result in more frequent bubbles forming in particular asset classes as wealth managers race toward particular sectors which they believe promise stronger than average yields. We expect that middle market M&A is a likely sector to experience a rapid increase in asset allocation this year and that this should be reflected in a move to record sales multiples for the many companies over the next eighteen months.
In discussions with a number of wealth managers, we have heard a consistent refrain. "Over the past decade the endowment funds that ventured early into alternative assets have achieved superior returns. We are recommending that our clients increase their allocations to alternative assets and particularly to private equity where the endowments have witnessed their best performance." This was recently confirmed in a study commissioned by Mergermarket, which recently published a report entitled Alternative Investments Outlook 2013: Limited Partner Survey. Based on interview with 100 active private equity limited partner investors, they reported:
"According to the LPs interviewed, private equity has successfully rebounded from the crisis, and is positioned for a strong 2013. Nearly half of respondents say that their PE investments have surpassed their expectations and, of those who plan to adjust their allocation to private equity within the next year, the overwhelming majority (95%) expect to increase the amount apportioned to the (private equity) asset class."
Private equity funds have an overhang of $100 Billion of commitments that must be invested in 2013 or lost. Since fund management fee income is directly proportional to committed funds plus investments, failure to use this money would have very negative consequences for many PE groups. Thus many of these funds will find themselves under tremendous pressure to do deals, even if they find that doing so requires an increase in their valuation expectations.
The biggest wild card remains the banks, which have become more aggressive in their pricing but have not yet returned to the wild days of the mid 2000s in terms of leverage and coverage ratios. Should they do so "Katy bar the door" we may be in for a wild ride indeed. Even without the banks, the major commitments being made to business development companies and PE firms to fund cash flow based loan facilities and other growth capital funding may be sufficient to drive leverage multiples higher. Should the PE firms react to the new influx of LP investments with an increase in equity allocations to their deal funding, the stage could be set for a lively auction market that pushes middle market purchase multiples to levels never before seen.
How Might This Impact the Markets?
"These trends could bode well for the M&A market to again become a meaningful source of new capital for the equity markets worldwide. Renewed strength in M&A would have highly positive implications for the equity markets as a whole. Investors will be well served to follow trends in M&A over the coming months, as the direction of the M&A market may provide an important indicator of future direction of the equity markets."
With the equity markets breaking into record territory, at least in nominal terms, investors who followed the pickup of M&A activity in the fourth quarter would have remained bullish and have been well rewarded. For now we see no trends in the M&A market that run counter to continued optimism. Certainly, however, M&A is an indicator that investors should watch carefully as the year unfolds. The collapse of the last M&A boom in summer 2007 heralded much pain in the years ahead for the equity market.