Understand Six Key Trends in Middle-Market and Small Business M&A
By Kevin J. Mulvaney
What are the key trends now affecting buyers and sellers of businesses? What’s on the horizon that companies need to know about and plan for? These are two key topics we recently addressed in our annual study of merger and acquisition trends in the middle-market (companies with enterprise value of $10 million-$100 million) and larger small business (companies with valuation between $1 million-$10 million) markets. (Please see About the Survey for more details.)
Here’s what respondents told us:
1. Middle-Market Volume Strong, Small Business M&A Activity Growing Slowly
While large corporate deals have rebounded with the same pattern as other recovery periods (strategic buyers aggressively pursuing and closing acquisition deals), other sectors have lagged behind.
The middle-market has improved markedly in the past two years, and is projected to continue at sustainable, solid levels. The volume of middle-market deals is steady but in prior recovery periods showed continuous increases year-on-year. Our respondents project a continuation of the current volume M&A activity (80 percent) but a minority of respondents feels this volume might increase as the remainder of 2013 unfolds.
The strongest sectors in the middle-market continue to be in service industries. During the past year, deal volume has increased measurably in e-commerce, health and medical services, and aerospace and related industries.
In the small business arena, M&A volume has begun to grow only in the last year, and there has been a small increase in valuations at this level. Valuations are not projected to escalate measurably for the remainder of the year.
2. Valuations in Middle-Market May Increase Further but Small Business Valuations Lag
Last year, the survey projected a 1.0 times EBITDA increase in valuation multiples over 2011–2012 which, on average, did occur. The survey, this year, shows these strong valuations (about 1.0 times multiple of EBITDA away from historical cyclical peak valuations) will continue at the current levels. Small Business valuations should increase as average of 0.5 times EBITDA in 2013.
The environment for M&A activity is about the same as it was a year ago. Performing companies in the upper end of the middle-market (companies at or above industry EBITDA and revenue growth benchmarks) are and will stay attractive to strategic buyers. We project an increase in the number of private equity buyers in the next 18 months because of increased debt availability on more acceptable terms.
Underperforming or weak companies are virtually not saleable. The market is demanding revenue growth potential and predictable EBITDA performance, and is willing to pay a premium for these conditions. Companies outside acceptable performance parameters are meeting with lowball offers or limited interest from strategic or financial buyers.
3. Buyers Continue to Demand High Seller Assistance for Smaller Companies
Deal structure for successful transactions has not materially changed from a year ago. One of the trends our surveys have shown in all past years continues to be prevalent. The percentage of seller assistance (earnouts, deferred money, etc.) continues to be high. The smaller the company on our $1 million-$100 million survey scale, the higher the demands for seller assistance from the buyer.
Two years ago, it was not uncommon to see the deferred component of the purchase price averaging around 30 percent of the deal (differs industry to industry). The better news for sellers is this percentage has dropped to an average of 20 percent and one interesting trend spotted this year is sellers digging in their heels demanding a larger component of cash up front in deals on the market today. If this continues, the seller assistance component will lessen gradually in the coming years.
4. Time Frame to Complete Deals Continues to Grow
Post-recession, one of the major trends in M&A activity at all levels has been the length of time to complete deals. We defined the time frame from serious negotiations to close, as 6-9 months in prior surveys. Our responses this year indicate this has not changed, and a measurable number of respondents suggested the time frame may elongate by a month or two in 2013. The reasons for this are lengthy due diligence by the buyers because of concerns about slow national and global economic growth, and challenges to the revenue growth trends and potential for the target company. In addition, our survey found buyers are marshaling more expertise behind their due diligence efforts, and the expertise and experience of strategic buyer teams is materially stronger than in the past.
For the seller, this means incredible patience is needed, but, more importantly, the better prepared the seller is with information, ability to respond to buyer informational requests, etc., the higher the chance the deal can close of the lower end of the 6-9+ month spectrum.
In addition, our survey group continues to recommend a strong team behind the owner/owners. Sellers need to understand the importance of experienced legal and deal expertise and surround themselves accordingly. Sellers also are reminded by the survey experts that preparing your company for sale thoroughly and correctly has never been more important. The good news is advisers in M&A are seeing owners doing significantly more planning.
With this said, it is still a seller’s market for quality companies. Sellers ready to approach the market whether to sell or restructure capital, must develop a knowledgeable game plan and be very patient in evaluating options and possible deal partners.
5. Financing for Buyers Continues to Grow and Terms Are More Acceptable
As lenders recover from recessionary challenges, the availability and terms of debt improve steadily. This was the case in the last year. More financial organizations are making loans in middle-market deals, and, more importantly, the terms (covenants) surrounding these loans are moving to a fair balance between what the lender and borrower feel are acceptable.
Our survey projects more sources will be available for every type of middle-market financing. Eighty percent of respondents project increased loan availability in 2013 and 2014. This is good news for private equity buyers as they can now better balance leverage versus equity contributions for new M&A deals.
The same is true for financing for smaller deals. We measure the level of SBA guaranteed bank term loans as the metric for financing of small business M&A. There has been a strong rebound in SBA loans especially from community banks. This strong sign will be one of the foundation items to help grow small business deals in coming years.
One minor surprise in the small business observations by the survey group was an increase in the percentage of equity needed by qualified buyers of small businesses. This had been a minimum of 20 percent but some experts see an increase to a minimum of 25 percent. This might not seem like a significant item, but equity is always a challenge for a financial buyer in a small business deal. The increased equity demands from lenders may have contributed to the slow growth of small business sales.
Another indication of middle-market M&A stability is pressure on pricing for various components of the capital structure for a financial buyer. In addition to more borrowing availability, yields on mezzanine debt have dropped to 12-14 percent from historical averages of 15-20 percent. Bank financing costs also are declining as the volume of financial buyer deals increases as a percentage of all M&A. These trends will continue into 2014.
6. So, Where Are We Going in Middle-Market and Small Business M&A?
The M&A market for the past two years was expected to grow faster for middle-market deals than has occurred. The reasons are many—economic growth is still below what it has been in other post-recession recoveries; challenges in Washington on tax and estate issues; business owners willing to hold their businesses longer and risk age-related interruptions; and the debt markets were slow to recover.
Strategic buyers of larger companies have acted exactly as historically documented, and they continue to drive the M&A market. Large companies are holding the largest amount of currency for M&A deals in history (cash and equivalents on the balance sheet and value of public stock available for M&A). Private equity firms are brimming with investment funds ready for employment in M&A, but have focused on rollups and building scale in their portfolio industry companies.
If the uncertainty of the environment surrounding business owners and buyers were to settle and the economy shows an ability to get to historical strong levels, the M&A market will benefit.
If we look at the trends of number of companies available for sale versus the deal volume reported in major studies, we see there must be a significant number of quality companies on the sideline in both the small business and middle-market sectors. One of the biggest risks an owner can take is waiting too long to put the company on the market. But, it is understandable when we hear from owners that the ROI they are receiving from their business is more definable and certain than the uncertainty of investment markets after the sale.
During the next couple of years, the supply of strong companies for sale should increase driven by strong valuations, deep availability of quality buyers, and the ample capital availability.