M&A in 2013: A Seller's Market

This article was authored by James Frommelt, co-head of Mergers and Acquisitions at Craig-Hallum Capital Group LLC. Mr. Frommelt focuses primarily on sell-side mergers and acquisitions for both public and private businesses in the middle market.

The M&A market pendulum has swung strongly in favor of sellers in the last 12-18 months. Back from the depths of the Great Recession, where buyers (if any existed) held the upper hand, today several factors are driving strong buyer demand and valuations. This is especially true in the middle market, where certain critical value drivers favor the seller, including fewer deals in the market, a substantial overhang of private equity capital, strong lending markets and solid strategic buyer interest.

• Lower Deal Volume in 1H 2013. Despite generally healthy economic conditions and strong demand for deals from all buyer types (as well as lenders), the number of deals in the market in the first half of 2013 dropped significantly from 2012 levels. According to The New York Times and Thomson Reuters, total M&A deal values in the first half of 2013 were 13 percent below the same time period in 2012, while the total number of deals worldwide was the lowest since 2003. In fact, many of the private equity groups and strategic buyers we talked to in the first half of 2013 indicated that deal flow was as low as they had seen in years. By comparison, 2012 was the highest volume year that many middle market investment banks experienced since 2007.

A significant driver of this increase in volume in 2012 and subsequent drop in 2013 was deals that were pulled ahead into last year due to the perceived inevitability of capital gains tax increases this year. Entrepreneur and private equity sellers alike marketed businesses in 2012 that they probably would have held longer were it not for the potential risk of higher taxes. This shift in activity resulted in a disconnect between supply and demand in the first half of 2013, which in turn helped drive increased valuations. While deal supply and demand have been more balanced in the third quarter, a perceived lack of higher quality deals is sustaining values at exceptionally high levels, which continues to favor sellers.

• Private Equity Overhang. According to Cambridge Associates, the amount of committed capital that private equity groups had yet to call at the end of 2012 was approximately $325 billion. This "private equity overhang," while down from its peak of $445 billion in 2009, represents an enormous amount of investment capital spread across thousands of private equity funds. As a result, an enormous number of firms are chasing a limited number of deals, and they must compete aggressively with both strategic buyers and other private equity groups to put capital, the lifeblood of all private equity groups, to work. When coupled with a strong lending environment, this dynamic is helping to lower investment criteria while driving higher valuations and compelling terms for sellers.

• Lending Markets. Lending markets, especially in the middle market, are rapidly heating up to pre-recession levels. Much like private equity groups, lenders are flush with capital that they must invest in order to generate returns and subsequent profits. As such, they have been very aggressive, offering low interest rates and debt amounts at near-record multiples of debt-to-EBITDA, as well as creative and extremely flexible loan structures. To provide some context, we are routinely seeing smaller businesses, which struggle in most M&A environments to attract total debt of 3.0x EBITDA, getting interest from multiple lenders at up to 4.5x EBITDA. In another more extreme example, we know of a private equity seller that was recently offered stapled financing at 6.0x EBITDA for a cyclical oil and gas services portfolio company. Eighteen months prior, that same seller struggled to obtain financing at 3.5x EBITDA when they bought the business. Other solid indications of the frothy state of today's lending markets include lenders proactively offering to recapitalize private equity portfolio companies for the sole purpose of distributing dividends to shareholders, and lenders offering different variations of high-yield debt for companies with as little as $35 million of EBITDA.

• Strategic Buyer Interest. Over the last several years, strategic buyers have been very active, and the general expectation is that this trend will continue. Seventy-five  percent of the CEOs polled in PwC's annual CEO Survey expect growth in the next year, with some portion coming from acquisitions. In addition, nearly half of U.S. CEOs in the survey expect to do a deal within the next 12 months. Combined with strong equity markets and the fact that U.S. corporations have $1.29 trillion in cash on their balance sheets, and the natural conclusion is that strategic buyer interest will continue for the foreseeable future, helping maintain valuations at the levels we currently are seeing. Strategic buyers have also developed a better understanding of private equity, which represents the largest class of buyers for middle market assets, making it their primary competition for deals. In theory, strategic buyers that truly desire an asset should be able to prevail over any private equity player in any process, given their longer investment horizons and typically lower cost of capital, along with potential synergies. During the last decade, however, private equity investors consistently surprised strategic buyers with how aggressive they were willing to be, regularly trumping strategic players for coveted assets. Since then, strategic buyers have begun factoring private equity behavior more prominently into their thought processes, helping to make strategic buyers the more aggressive buyer for highly strategic assets.

The confluence of these compelling factors is driving a unique market opportunity for sellers of middle market businesses. It is extremely rare to have such a powerful set of factors driving seller-friendly market dynamics.