“It’s like déjà-vu, all over again.”
– Yogi Berra, Hall of Fame Catcher, New York Yankees
“The future ain’t what it used to be.”
– Also Yogi Berra
As we reflect upon the current state of the mergers and acquisitions (M&A) market, we can’t help but feel as if we’ve been here before. Was it 1999? 2007? Or maybe even 24 months ago? But the confluence of frothy markets, easy access to capital, and sky-high valuations should make us nervous… but yet, this time feels different.
Unlike in the recent past, there seems to be few naysayers shouting from the rooftop that the end is neigh, and we agree. Barring any significant external shock to the system (e.g., terrorist activity, North Korea nuclear attack, etc.) even issues such as the continued turmoil in Greece and slowing activity in China appear to have little to no effect on U.S. activity. What these issues have caused, though, is a significant pullback in the commodity markets, which — with the exception of companies in the oil and gas industry — have created a net benefit for most manufacturing operations domestically.
That said, given the impressive run the deal market has experienced for the past 24 consecutive quarters, we would be well advised to stop for a moment and analyze whether the recent drivers of growth are still in full gear.
This last 12 months saw record merger-related activity. In fact, total deal value was the highest ever, period. The continued robustness in the current environment can be attributed to
six main drivers:
1I Continued confidence in the U.S. economy, which drives…
2I Continued accommodative debt markets, which adds leverage to…
3I Continued ample dry powder within unallocated funds of financial (i.e., private equity) buyers, whose willingness to pay is enhanced by the…
4I Continued overabundance of cash on balance sheets of strategic acquirers.
Of course, in order to consummate a transaction, you need both a willing buyer and a willing seller, so to add to the above list of key factors:
5I Continued top- and bottom-line growth of potential targets.
But — and it’s a big “but” — as in the past, there appears to be an ever-increasing lack of sellers, or at least of the family-owned business variety; professional investors (read: private equity) can’t seem to get their mature portfolio companies to market fast enough. Thus counteracting the above growth drivers we see:
6I Somewhat slowing interest on the part of shareholders to seek liquidity.
This is consistent with our research as, although total deal value is up, total deal volume is actually down. Thus, the increase in prices paid by buyers has more than offset the decrease in available targets. Supply demand imbalance anyone?
Valuation multiples in terms of EBITDA (earnings before interest, taxes, depreciation, and amortization) are absolutely at all-time highs. Such valuation premiums — relative to more typical market environments — are difficult to quantify, though it appears to average (based on our proprietary analysis of non-public information of multiples paid) in the 1.0x to 3.0x range. Furthermore, just as remarkable (and even more difficult to quantify) is the widespread sentiment among dealmakers that even the most “storied” or difficult and cyclical companies are generating interest in the current environment.
Buyers are willing to pay these higher multiples, and chase such less-than-traditionally attractive targets, presumably because of a) concerns over a recession remain muted, b) the credit markets are, by some measures, even more aggressive than 2007
levels, and c) buyers of all types need to put capital to work in order to grow.
To that end, private equity remains a very viable alternative for owners wishing to exit their shareholdings. A collective $535 billion of dry powder, combined with approximately 7,000 (and growing) domestic sponsor-backed companies under private equity ownership, means professional investors remain quite active and relevant as both buyers and sellers.
On the macroeconomic front, unemployment continues its steady downward trajectory, consumer confidence continues its upward trajectory, and domestic gross domestic product (“GDP”) continues to exhibit signs of longer-term stability in spite of a soft fourth quarter (where such softness was attributed to increased imports combined with decreased federal spending, decreased nonresidential fixed expenditures, and decreased exports).
Regarding the federal funds rate, a recent poll by the Wall Street Journal found that 82% of economists surveyed believe the Federal Reserve will raise short-term interest rates in September. Recall that the federal-funds rate has been near zero since December 2008.
In summary, as we pause to reflect upon where we are in the cycle, we see that there are indeed multiple forces still working together to continue to propel continued robustness in the M&A market. Ample supply of capital and buyers willing to invest will continue to support record valuations, though exhausting the supply of sellers looking for liquidity appears to be a very real threat to overall market volumes.
Improved availability of capital, better and sustained company performance, and narrower valuation gaps have powered U.S. M&A transaction activity since 2010. The first half of 2015 shows significant strength and momentum in the M&A market with high volume of activity and highest value of deals in the past seven years.
U.S. GDP, often viewed as a proxy for the overall health of the economy, has recovered from the contraction experienced during the recession in the late 2008 and early 2009 timeframe. While few economists are predicting another recession in the near future, neither are forecasters predicting rampant growth. That said, GDP growth in the fourth quarter was a relatively benign 2.4%. The first two quarters of this year show relatively slow GDP growth with 0.6% and 2.3%, in Q1 and Q2, respectively.
Consumer confidence generally improves as the unemployment situation improves. Fortunately, unemployment maintains its steady march downward and sits at levels not seen since mid-2008. Consumer confidence remains buoyant which, combined with the improvement in the labor market, suggests a continued favorable tailwind through 2015.
As mentioned in previous M&A Market Update articles, data on lower middle market transactions is notoriously difficult to come by, but year-over-year comparisons can prove illustrative. Both volume and total value of deals falling within the lower middle market (in this context defined as transactions less than $250 million in total value) for the 12 months ended June 2015 increased only slightly over a similar period one year ago.
Both strategic buyers and financial buyers remain active.
The stimulus for strategic-led deals is a combination of lower organic growth prospects absent acquisitions, accommodative senior debt markets, and a record amount of cash and other liquid assets held by nonfinancial companies. The post-traumatic stress disorder that drove firms to hoard cash post-recession has abated. Furthermore, evidence of the accommodative debt markets is clearly visible in the rapidly rising corporate debt levels.
Complementing (from a seller’s perspective) strategic buyer interest is private equity, which remains a potent force in deal flow. Favorable credit markets and an estimated $535 billion capital overhang ($96 billion of which is nearing the end of its investment horizon) will continue to provide impetus for investors to remain competitive in transactions. Furthermore, it should be kept in mind that the capital overhang actually translates into $1 trillion or more in purchasing power, given the leverage available in today’s marketplace.
Nowhere is the increase in current valuation multiples due to the aforementioned factors more evident than in the prices paid by private equity during the past two years. Such prices are a function of debt providers’ continued willingness to lend but are also a direct result of sponsors’ willingness, for the first time in history, to lower their required return thresholds. Historically, financial sponsors promised their limited partners an expected compounded annual return of 20-30%; however, recent feedback from many in the private equity community (all of whom wish to remain nameless) is that returns are instead being modeled in the high teens. Such a reduction in required returns has the same effect as a reduction in yields on bonds; i.e., when rates fall, the prices that buyers pay for new investments rise as prices and rates move in opposite directions. The slight contraction in the reported multiples for 2014 may be a result of the increased targets available to be acquired; though it should be noted that the median multiple for middle market LBOs in 2014 still ranks as among the highest in recent history.
Our view for the foreseeable future remains highly optimistic. Buyer appetites and resulting valuation multiples are at historical levels, driven by strategic buyers’ large corporate cash balances, financial buyers’ ample dry powder, and banks’ ready willingness to lend to both. How long this will last is of course anyone’s guess; that said, there appears to be little to cause abatement except perhaps a lack of sellers willing to actually, well, sell their company.