Capital IQ’s July 2011 report on the Merger & Acquisition Market for Middle Market and larger deals (they look at 2 categories, less than $500 million and greater than $500 million) showed that strategic (industry) buyers have consistently been completing about 7-10 times as many deals as the financial buyers, and their dollar volume has been about 5-10 times higher as well. Essentially, they have been eating the financial buyers’ lunches. However, these 2 buyer groups have been trading places every other quarter or so in terms of which group is paying the highest multiple of EBITDA. The long term trend appears to be roughly a tie with no particular advantage in selling to either a strategic buyer or a financial buyer. By leapfrogging each other, the multiples being paid are up substantially compared to the lows of early 2009, and beginning to approach their 2007 peaks. They’re not quite there yet, and perhaps we won’t see quite such overheated multiples again, but they’re getting close and for any reasonable seller of a larger company today’s multiples have to look pretty darn good. In the most recent quarter financial buyers in north America paid an average of 8.3 x EBITDA for their big deals, while strategic buyers paid an average of 10.3 x EBITDA. In the prior quarter they traded places with financial buyers paying 11.0 x EBITDA and strategic buyers paying 9.6 x EBITDA. Compare these results to the first quarter of 2009 when strategic buyers were paying an average 6.5 x EBITDA and financial buyers were paying 7.1 x EBITDA. Peak multiples in the last quarter of 2007 were 12.0 x EBITDA for financial buyers and 11.5 times EBITDA for strategic buyers. Recall that the stock market hit a record in that same quarter, so that’s a pretty rarified atmosphere for the average M&A deal.
Private Equity Deals
Why do I so often provide statistics and anecdotal information on private equity deals and compare them to strategic deals? For a couple of reasons: 1) private equity groups are always in the market looking for platform deals (a “platform” is a company that can serves as the platform for growth that they can build into a much larger enterprise) or add-on deals (an “add-on” or “bolt-on” is a company that can be acquired by one of the private equity group’s existing platforms), and 2) a strategic or industry buyer isn’t necessarily always a good choice to meet the goals of my client’s owners. Couple these considerations with the fact that strategic industry buyers are not always in the market, and are potentially dangerous buyers, and private equity groups often make the most sense to meet my clients’ needs.
Most of the time it works like this: If you simply want to sell out and get the highest price without regard to the future disposition of your company and your employees, a strategic buyer is often (but not always, as indicated above) the best bet. However, if you still want to see your name on the door after closing, you want the company to succeed and grow bigger and better, you want a future and opportunities for management and employees within the company, you want to keep an equity investment in the company, you want to keep a personal involvement in the management or direction of the company, you want to provide an opportunity for management to gain equity in the business, then a private equity deal will often make the most sense.
As I mentioned earlier, there about 3,000 of these private equity groups seeking deals, and making deals. They do this all day, every day, just like I do, so they are ready to deal and they know what they’re doing. The communications are quick and easy, and they don’t waste anyone’s time, unlike some strategic buyers.
What circumstances would cause me to pursue private equity groups for one of my clients?
1. Client wants to take a substantial amount of money off the table but continue to run the business. This is the classic “two bite at the apple” transaction with the owner seeking to take the first bite now, and another bite in about 5 years when the apple is bigger and brighter. This type of deal often yields more in the aggregate for an owner, than an outright sale.
2. Client needs more capital for an aggressive growth plan. This capital could be used for multiple acquisitions, or it could be used for another type of investment – a new production line, or something else to grow the company. The private equity group can fulfill this capital need via a “growth capital transaction”.
3. Client is founder of a family-owned business, wants to retire and needs cash to fund retirement, but the rest of the family members working in the business don’t have the money to buy out the founder. Once again, the private equity group can provide the capital that the other family members lack, and become a new partner in the family-owned enterprise. These transactions are often called “family re-capitalizations”.
4. Client is founder of a business who wants to retire and the management team would like to buy the business, unfortunately like many management teams they have little or no money to invest, certainly not enough to buy the company. The owner likes the managers and wants them to have a shot at getting as much equity as they can, but the bank will never put up enough money, and the owner doesn’t want to lend the money to his managers. That just wouldn’t be a prudent risk heading into retirement. Again, the creative private equity group brings cash that the managers don’t have and sponsors a management buy-out.
5. Client is a partner in a business with another owner, but they’ve decided they don’t get along and one partner wants to be bought out. The only problem is that the other partner doesn’t have enough money to buy out the first partner. The private equity group solves this problem by becoming the replacement partner for the departing partner.
6. Client wants to retire from a business but doesn’t have a second in command who can take over the business and handle all of the aspects of the business that need to be handled. A private equity group that sponsors managers (often former CEOs and CFOs) seeking to acquire businesses in this industry could fill the bill for my client in this case.
If you have goals like these, a private equity deal might be right for you. Just call me toll free at 800-240-4609 or send me an email to discuss.
Can Mezzanine Capital Increase Purchase Price?
The answer is yes, but what is this “mezzanine capital” anyway? In his recent “On the Left” newsletter, Randy Schwimmer of Churchill Capital described mezzanine capital as “equity dressed up as debt or vice versa”. It has some characteristics of each. First of all it is junior debt, second in position to the senior lender (often a bank). The buyer has only so much equity to put into the deal, and the bank will only lend so much based on the asset base and the cash flow. Add them together and the equity from the buyer plus the loan from the senior lender and the price isn’t high enough to get a deal done. What to do? Bring in mezzanine capital to add another 1 x EBITDA or more to the purchase price. The mezzanine lender is second in line behind the senior lender, so if things go really badly in the future the senior lender has the collateral of the company’s assets, but the mezzanine lender has little or nothing to fall back on. In that regard the mezzanine capital provider is similar to a preferred equity holder.
Mezzanine capital is like equity in one more way. Too boost their returns, mezzanine capital providers get something else besides an interesting paying note when they put their money into a deal. They get warrants (something like stock options) that they can exercise at some future date to obtain equity in the business. The amount of equity obtained by exercising warrants will vary depending on the interest rate that they receive and on the model of the purchased company’s future value when the warrants can be exercised. So if and when the mezzanine lender exercises those warrants, it becomes a true equity holder in the business. Sometimes mezzanine warrants can be purchased back at a pre-set price by the company or its shareholders.
Interestingly, senior lenders are often willing to lend more, and thereby provide a higher price to sellers, if a mezzanine lender is involved. The reason is that they consider mezzanine lenders as equity holders, hence the equity/debt ratio is higher and the deal seems less risky to the senior lender.
A mezzanine lender can therefore increase purchase price in several different ways. At the same time, a mezzanine lender can increase return on investment for a private equity group that’s bringing the equity to the deal. Sellers of growing companies who will keep skin in the game after a private equity deal, should not automatically reject the higher interest rates and warrants of a mezzanine financed deal. In fact, as co-investors with the private equity group, they would be well advised to learn how mezzanine lenders support the initial purchase price and increase their return on equity when they take their second bite at the apple.
The Economy in Mid 2011 – Up, Down or Sideways?
Yes. Next question. J
Seriously, we need to keep our eye on this ball to see which way it’s going to bounce. Recent performance of the U.S. economy (and the world economy) has not lived up to expectations, but it is still growing, albeit slowly. It may not feel like we’re in an economic expansion phase but we are, and the economy has been growing for 2 years, since June 2009. Mostly when we talk about the economy we say we’re in an economic expansion phase when the Gross Domestic Product is growing. When it grows we’re in an economic expansion but when it declines we’re in a recession. By this measure, the Great Recession began December 2007 and ended June 2009, since the economy has been growing ever since.
Prior to that time our economy was in an absolute free fall with the job market losing jobs at 500,000 to 800,000 jobs a month. Now private sector jobs are increasing modestly in most sectors of the economy (except for construction) with the service sector, particularly professional services recently playing a leading role. At the same time government jobs are now being cut back sharply so the overall unemployment rate actually ticked up lately. With this many people unemployed, and employed people spending less and saving more, the engine of our economy (American consumer spending) is still sputtering as it climbs out of the Great Recession. The Federal Reserve has lowered its expected growth rate for 2011 to a range of 2.7-2.9% from their previous forecast of 3.1-3.3%. The Fed still expects economic growth to increase in the second half of 2011, as they and many economists attribute much of the recent slowing in economic growth to disruptions caused by the Japanese Tsunami, and also to the spike in oil prices that we saw earlier this year. However, a study by the Fed Bank of Cleveland says that the 3 percent premium between yields for 3-month and 10-year Treasuries implies economic growth of only 1.1% in the next 12 months through June 2012. That would not be good news.
The recession may have ended 2 years ago and the economy may be growing, but the effects of this devastating recession still linger. Employment growth always lags economic growth since it takes a while for businesses to ramp up and re-hire to fill the needs of an economic expansion. Still, historically we get back to normal pretty quickly, with most recessions seeing a return to peak pre-recession levels of employment within about 14-24 months after decline in employment starts. The longest time for employment to recover was after the recession that began in 2001. It took 46 months during that so-called “jobless recovery”. In the jobless recovery it took 29 months to see any decrease in the unemployment rate. This time we started to see some reduction in the unemployment rate after 26 months but it’s clear that we will not return to the pre-recession peak level of unemployment within 46 months of the start of the recession in December 2007. Realistically, no-one is predicting that we’ll even get there within 5 years after the start of the recession. For one reason, this recession was much worse and we suffered job losses that were more than 3 times greater, so the hole we have to get ourselves out of is 3 times deeper. If one uses a ruler to extend the current rate of job growth into the future, it looks like it could take nearly 84 months (7 years!) to get back to where we were (that means the end of 2014). The Fed now projects unemployment to be at 8.6-8.9% by the end of 2011, 7.8-8.2% at the end of 2012, and 7.0-7.5% at the end of 2013, and in the “longer run” to end up at 5.2-5.6%. At the current rate of economic growth, it will still take several more years to get back to where we were when the recession started in December 2007. Whether you pay attention to my ruler on the graph or the Fed’s more sophisticated? approach, we’re looking at 2014-2015 before our economy will feel normal again. In the aggregate, this time we suffered one of the deepest and broadest recessions we’ve ever seen. This was clearly the worst one since World War II. You may recall that the big one before WWII was called the Great Depression.
Private sector employment began to grow again in March 2010, but the rate of growth has just not been strong enough to significantly reduce unemployment. What’s wrong? My opinion: We’re not seeing any growth in construction employment like we should coming out of a recession. We’re hardly building a thing in this country. We’re certainly not seeing anything close to the housing construction we need in a healthy economy, and we’re not building any Grand Coulee Dams either. The housing and home building industry continues to be in a 5 year deflationary Depression that started in 2006. Instead of new construction of single family houses we’re seeing the continuation of a foreclosure juggernaut that has put millions of existing homes on the market and driven down prices year after year destroying wealth for all homeowners in America, and making them much less likely to spend money. This slow motion train wreck in the housing market continues to this day. Until it’s over, I don’t foresee any significant strengthening in job growth. We need to get through all the foreclosures and sell the foreclosed homes, get them occupied, then start building demand for housing that will put 2 million unemployed construction workers back to work. In the meantime, maybe we’ll find some other things for them to build. One can only hope.
OK. Time to dust off the crystal ball. What’s ahead? I think I see continued modest growth in the U.S. economy through 2011 and 2012, despite the best efforts of Congress to reverse the trend. I see the Fed continuing to keep interest rates as low as they possibly can for at least another year, since those low rates are the only game in town that can provide much stimulus to economic activity. I think I see a continued slow reduction in the unemployment rate because the growth in the economy won’t reach the levels needed to knock the unemployment rate down by even 1 % in a year, and because all the state and local government budget cutting is now also contributing to increasing the unemployment rate – running against the private sector tide. I see an unemployment rate of about 8.0 to 8.5% a year from now (under 8% if we’re really lucky). I see the housing market hitting bottom with prices stabilizing and beginning to rebound a year from now. I see housing and construction employment strengthening slowly thereafter with full employment (that is about 5-6% unemployment rate) by 2014-2015. I see another recession sometime after that, although certain shocks to the economy could push us into another recession sooner. Greece and Italy are hot topics now, along with the wild idea that the U.S. might default on our obligations for the first time in our history, but there is no shortage of other opportunities for something else to go wrong…disruption to oil supply, terrorist attacks, financial chicanery, you name it. Another recession will come someday, for some reason, but my crystal ball says we’ll not see that happen for another 3-4 years, maybe longer. Did I mention that my crystal ball is painted black and has a number 8 printed on it?
The crystal ball and I offer no warranties on these prognostications . The expiration date for all predictions is tomorrow, and do not try this at home. In other words, the crystal ball and I can’t do any worse than a professional economist, so trust us at your peril.
To put this into some greater historical perspective, a big recession started in August 1929. The stock market crashed in October that year. Poor Herbert Hoover had to live through a devastating drop in the economy that continued for the remainder of his term. The free fall in the economy finally slowed in 1933, Roosevelt’s first year in office when unemployment peaked at 24.9 percent. By 1934, the recession ended and Gross National Product grew by 7.7 percent and unemployment fell to 21.7 percent as recovery began. The economic recovery continued through the final year of Roosevelt’s first term in 1936. In 1937 the government cut spending due to concern about balancing the budget and another recession started just at the time when the unemployment rate had dropped by nearly half to 14.3 percent. In 1938 the GNP fell by 4.5 percent and unemployment jumped up to 19 percent. In 1939 the government borrowed a billion dollars and began to prepare for war. Manufacturing shot up by 50% between 1939 and 1941. The global depression ended as the world went to war. The numbers were different then than now, but over this 10 year period between 1929 and 1939, an apparently strong recovery was underway that subsequently turned into a second recession. Our current recovery is actually not as strong as the one Roosevelt had going in his first term in office. Food for thought!
Since it’s easier to see where we’ve been than where we’re going I’ve provided a link to the chart gallery at Calculated Risk, a finance and economics site. Check out a few of these graphs that illustrate the trends. Here’s the link: http://cr4re.com/charts/charts.html . If those charts don’t convince you that this was no ordinary recession, nothing will.
Why is any of this important to a business owner considering sale of the business? I think it helps provide some general perspective on timing. An owner should want to sell when there is strong demand from buyers and when multiples are strong, a time like now for example. An owner would want to avoid selling when the economy is weakening, like in the second dip of a double dip recession. If you didn’t sell out in early 1929 and had wanted to sell your business in the 1930s, a good time to sell would have been 1936 before government spending was cut and a new recession started. But maybe you thought the economy hadn’t fully recovered (it hadn’t) and everything would surely get much better in 1937 or 1938 because the government was cutting spending and balancing the budget (it didn’t get better, it got worse). Maybe history doesn’t repeat itself but it has echoes. Will the economy really start cranking on all cylinders because state and local governments are cutting spending and the federal government is talking about doing the same (again)? I’m not convinced, and I think we’re still at risk of the dreaded double dip recession. Changes in the business sales climate operate over rather lengthy 5 to 10 year periods. 2011 is a good time to sell, but I can’t answer for 2012 and 2013. I think we’ll be OK then, but we could easily be pounded down by another recession. It has happened before. Another recession, and maybe another big one, will almost surely happen sometime this decade. In my opinion smart owners will sell well before the next recession. A word to the wise…..
Top and Bottom 10 Industries For Growth
IBIS World published a list of the top 10 fastest growing industries (2000-2011) last month, along with a list of the bottom 10 laggards (2000-2010), industries that were declining sharply or dying. I thought you might be interested.
The Top 10 – Rapidly Growing Industries
- VOIP (voice over internet) Providers
- Wind Power
- E-Commerce & Online Auctions
- Environmental Consulting
- Video Games
- Solar Power
- 3rd Party Administrators & Insurance Claim Adjusters
- Correctional Facilities
- Internet Publishing & Broadcasting
The Bottom 10 – Dying or Declining Industries
- Manufactured home dealers
- Record Stores
- Wired Telecommunications Carriers
- Apparel Manufacturers
- Newspaper Publishing
- DVD, Game, Video Rental
- Mills (textile, sock and hosiery, apparel knitting, rug and carpet)
- Formal Wear & Costume Rental
- Video Postproduction Services
Value is created and destroyed in our economy daily, but let’s not break out the buggy whip manufacturer analogy. The Westfield Whip Manufacturing Company has been in existence since 1884, and has a flashy web site at http://westfieldwhip.com/ . Giddy-up, you slow movers!
Thank you to all of the attorneys, accountants, financial planners, bankers, business owners and others who have referred clients to us. We greatly appreciate the trust and confidence you have placed in us. If you would like to refer a business owner to us for value consultation, business purchase, business sale, management buyout, management buy-in, or re-capitalization, please be assured that all of our services are totally confidential. Call me today at 800-240-4609.
Dr. Campbell, Principal and Managing Director of the Portland-Vancouver office of ACT Capital Advisors, has over 30 years of business experience. He chairs the AM&AA Market Research Committee, and is principal author of AM&AA’s semi-annual “Deal Stats” survey. AM&AA selected Perry as its 2009 Member of the Year in recognition of his contribution to the profession
K. Perry Campbell, Ph.D., CM&AA
Chair, AM&AA Market Research Committee
Alliance of Merger & Acquisition Advisors 2009 Member of the Year
Principal & Managing Director
ACT Capital Advisors, Inc.
4400 NE 77th Ave, Suite 275
Vancouver, WA 98662
Phone: (360) 696-9450
Toll Free: (800) 240-4609
Fx: (503) 296-2452