March 01, 2015

“Growth is never by mere chance; it is the result of forces working together.”
— James Cash Penney, Founder of J.C. Penney

“No word was ever as effective as a rightly timed pause.”
— Mark Twain

As we reflect upon the mergers and acquisitions (M&A) activity in 2014 and contemplate what such activity foretells for 2015, we should carefully consider the two (seemingly unrelated) quotes above from two of the more influential citizens of the 19th century. Indeed, growth is rarely the result of chance, nor is its root cause typically one-dimensional. However, given the impressive run the deal market has experienced for the past twenty-two consecutive quarters, we would be well advised to pause for a moment and analyze whether the recent drivers of growth are still in full gear.

2014 saw a record of merger-related activity; total deal volume increased 3.3% over 2013 levels, and total value increased 16.5%. 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, which has resulted in…

6I Continued interest on the part of shareholders to seek liquidity.

While the supply and demand imbalance referenced in past updates has corrected itself, valuation multiples in terms of EBITDA (i.e., earnings before interest, taxes, depreciation, and amortization) remain at or near 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 EBITDA 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 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, the Federal Reserve (“the Fed”) said in January that it believes that economic activity has been expanding at a solid pace, with continued gains in jobs and a lower unemployment rate. The Fed also believes that household purchasing power has increased (primarily due to recent declines in energy prices) as well as business fixed investment. Inflation remains below the Federal Open Market Committee’s longer-run objective of 2%, but the Fed expects inflation to rise gradually over the medium term as the labor market further improves and the transitory effects of lower energy prices and other factors dissipate. Not to be overlooked, the Fed reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate, and that “based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy”. In other words, don’t expect the era of cheap money to end any time soon.

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, buyers willing to invest, and sellers looking for liquidity should all help maintain the momentum from the past five years, for the foreseeable future.

M&A Market Activity

Improved availability of capital, better and sustained company performance, and narrower valuation gaps have powered U.S. M&A transaction activity since 2010. The fourth quarter of 2014 appears to have not seen the same flurry of activity that typically coincides with calendar year ends, but given the volume of the prior four quarters, a slight pullback was expected.

U.S. Gross Domestic Product (“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%. This softness relative to the past two quarters was largely due to increased imports combined with decreased federal spending, decreased nonresidential fixed expenditures, and decreased exports.

Consumer confidence generally improves as the unemployment situation improves. Fortunately, unemployment has maintained 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 tailwinds through 2015.

As mentioned in previous 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) increased dramatically, with total number of deals completed up 10.5% and total transaction value up 13.7% in 2014 as compared to the prior calendar year.

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 appears post-recession has abated. Furthermore, evidence of the accommodative debt markets is clearly visible in the 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.

Conclusions and Outlook for 2015 and Beyond

Our view for the foreseeable future remains highly optimistic. Buyer appetites and resulting valuation multiples are at or near 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 … after pausing for a moment to consider the underlying forces, it would appear the momentum behind such forces bodes well for the near-term future.

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