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Capital M&A Newsletter
M&A Market Activity Remains Strong Despite Economic Uncertainty
The first half of 2011 saw resurgence in the marketplace both in public equity market performance and a corresponding run-up in middle market M&A activity. However, the third quarter has been riddled with economic headwinds, creating uncertainty around a sustainable economic recovery. Despite the emergence of negative economic factors, BDO Capital Advisors believes the confluence of excess liquidity, acquisitiveness of buyer constituencies and scarcity premiums afforded quality companies will collectively drive continued M&A activity through 2012, albeit at a slower rate and with a more discernible eye towards “quality” assets.
M&A Activity Continues Through Q3 Across all Segments of the Middle Market
Third quarter middle market M&A activity reflected the restoration of modest acquirer confidence in the markets. The lower middle market, defined as transactions valued less than $50M, saw a continuing trend of increasing activity as buyers executed buy versus build strategies with the acquisition of core technologies, brands or geographic footprints. For Q3 2011, the number of deals valued less than $50M increased 12 percent from Q2 2011 and eight percent over the same period a year ago. In the middle market, defined as transactions valued between $50M and $250M, deal activity continued through the LTM period ended 9/30/11, increasing 14 percent from the same time period a year ago. Importantly, market confidence came through at the upper end of the market where deals valued between $250M and $750M increased 29 percent for the LTM period ended 9/30/11 compared to the LTM period ended 9/30/10, proving buyers’ willingness to augment organic growth with acquisition-centric strategies.
Recent economic factors including debates over the U.S. debt ceiling, inadequate resolution concerning the U.S. fiscal deficit and the European sovereign debt crisis have contributed to a deceleration of U.S. economic growth and a moderate slowdown of M&A activity. However, we at BDO Capital Advisors believe that there are adequate market fundamentals in place that will help to sustain market activity at its current level with a favorable environment for strong performing companies.
Middle Market Fundamentals Create Favorable M&A Environment
As indicated previously, the middle market tends to remain somewhat insulated from global volatility. Well-capitalized financial institutions, along with cash-rich strategic buyers and private equity firms, should support transaction volume and values for the near future.
Financial Institutions Are Well-Capitalized and Looking for Deal Flow
While the credit crunch helped drive market paralysis and the deep M&A depression of 2008 and 2009, today’s market lenders are actively seeking deal flow, albeit more selectively and with stricter credit terms than 2006 and 2007. At the end of September 2011, financial institutions held approximately $1.8 trillion in cash – record levels when compared with years prior. Although loan issuance was down 40% since Q2 2011, lenders’ appetites for transactions remain healthy, fueling competition for “quality” deals. This is evident in middle market leverage tolerances afforded transactions through the third quarter. For LBO-sponsored transactions with less than $50M of EBITDA, total leverage/EBITDA increased from 3.4x in Q1 2011 to 4.2x in Q3 2011. We expect the credit markets to remain at or somewhat near these tolerance levels for quality companies due to the pressure to utilize unprecedented levels of liquidity in the system.
Liquidity Abundance Fuels Corporate Acquisition Activity ... But is Selective and Targeted
The recession drove corporate America to right-size labor pools and drive efficiencies throughout their organizations. The result has been a reduction in utilized credit facilities and a build-up of war chests of cash. As seen in Figure 2, as of 9/30/11, nonfinancial U.S. corporations held more than $2.1 trillion of cash or 7.2 percent of total assets, up from $1.4 trillion in 2008. Based on recent historic trends, the normalized cash holdings of 5.1 percent for nonfinancial companies leaves corporate America with about 2.1 percent, or approximately $500 billion, in excess liquidity that needs to be put to work. Deleveraging efforts have also shaved significant portions off the total debt held by corporations comprising the S&P (excluding financials) since the height of the financial crisis in 2008. In 2011, total debt to EBITDA averaged 2.1x for this group compared with 4.2x in 2008. Additionally, as the economy improves, we have found through recent transaction closings that corporations are prudently exercising acquisition plans to invest excess cash holdings in an effort to augment stagnate organic growth and optimize shareholder returns.
Private Equity (“PE ”) Overhang Fuels Financial Sponsor Activity
During the recession and related credit crunch, private equity firms refocused their attention on their portfolio investments in a desperate effort to right-size and deleverage owned corporate asset balance sheets as well as mitigate impending distressed performance. Now, however, with a more stable economy and after raising unprecedented levels of capital between 2006 and 2008, PE firms struggle to find quality investments. To date, private equity has invested approximately 70 percent of dollars raised over that threeyear period. PE focus shifted to less risky, smaller bolt-on acquisitions characteristic of lower levels of equity capital being put to use. The result is a private equity overhang of approximately $436 billion at the end of the third quarter in 2011. As confidence in the marketplace rebounds to a more steady state and portfolio company performance improves, PE firms have responded with a renewed outward focus, aggressively, but selectively, seeking platform and follow-on acquisitions in an effort to reduce levels of uncommitted capital and hopefully drive higher fund returns. This dynamic has served to increase multiples afforded to PE transactions as seen in Figure 3. During the quarter ended 9/30/11, LBO transaction multiples averaged 12.0x while strategic transactions during the same period averaged 10.8x. Further to this point is data confirming financial sponsors’ willingness to pay higher than average multiples as represented in Figure 4.
Liquidity Chases “Quality” and Drives Historically High Multiples
Although historic levels of liquidity exist in the marketplace, economic uncertainty and global unrest will temper an M&A rebound and encourage a flight to quality. We expect PE firms and strategic buyers to remain active in the marketplace while being cautious and selective. However, as we have seen in recent transaction closings here at BDO Capital Advisors, both strategic buyers and financial sponsors are willing to pay strong purchase price multiples for quality investment opportunities. Companies characterized by their market leadership, defensible business models and impressive profitability levels will attract significant attention from both buyer constituencies.
As of 9/30/11, the average reported EBITDA multiple paid for middle market companies (<$100 million) was 9.8x, a 20 percent increase over the 10-year average of 8.2x (see Figure 5) and above historic highs. We expect this dynamic to persist for six to 12 months as supply levels of quality companies remain low. We believe the scarcity premiums in combination with a favorable tax environment through 2012 will serve as the underlying factors for business owners to seek liquidity and maximize shareholder value.
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