Posted by John Slater on October 16, 2014
We’ve previously reported that 2014 has witnessed a strong market with record valuations for many middle-market merger and acquisition transactions. This market strength has coincided with a powerful boom in public equity valuations as the S&P tripled from its 2009 lows. As the public equity market takes a breather, it’s time to consider the possible impact of a more significant equity market correction on middle-market M&A.
First, let’s take a look at the reality of the current situation – we are not in bear market territory for the overall market. That requires a 20% decline in value for the major Averages and as of this writing (October 14, 2014) we have only seen a drop of approximately 6%-7% in the broad market indices (S&P and Dow). For some specific sectors, however, this situation is not so sanguine. The energy sector, as measured by the XLE Energy Sector SPDR is now down more than 20%, offsetting gains in other sectors from the reduction in energy prices.
We certainly don’t have a crystal ball: while there is plenty of reason to believe that the current sell-off will continue for a while, we can make a good case that the market will move to new highs following the current sell-off. This has happened before; following the collapse of the Russian Ruble in 1998 and amid fears that one of the leading hedge funds of the era, Long Term Capital Management, would fail, the S&P suffered a precipitous 20+% drop from about 1200 to 950 in the summer of 1998. Yet the market quickly recovered and over the following 19 months the S&P climbed approximately 60% to an all-time high of 1500 in March of 2000. A similar trajectory today would show the S&P at 2500 and the Dow at 22,000 by the spring of 2016.
With that backdrop, what does this mean for the M&A market? In the most likely scenario, the public equity markets will likely not have that much impact on M&A in the short term. A 15% decline in equity valuations would take us to levels witnessed a year ago when M&A demand was already quite strong and, if this is a typical mid-cycle correction, it would be reasonable to expect the market to recoup lost ground fairly quickly and move on to new highs.
M&A valuations in the mid-market are driven by a number of factors but today’s strength relies on two pillars:
- Resurgent corporate acquisition demand
- Historically high levels of capital available to the Private Equity community
Another important factor includes a recent dearth of quality sellers, creating feeding frenzy behavior when a good company comes to market.
Corporate America has had a fantastically profitable run over the past five years, based primarily on cost cutting and increased operational efficiencies. Having trimmed all the fat it can, corporate America will depend on revenue growth to fuel profit growth going forward. In a slow growth economy, most firms are unwilling to risk meaningful capital on new facilities in hopes that the sales will be there; instead they increasingly view M&A as their best bet to accelerate revenue growth. Over the past several months, we have had an increasing number of conversations with business owners considering industry “rollups” and other acquisition strategies. Major corporations are flush with cash and strong private firms enjoy more favorable access to bank and private market leverage for acquisitions. As a result, there is pent-up demand for add-on acquisitions and corporate buyers frequently grab the sweetest prizes by making preemptive bids at historically high valuations.
For the Private Equity community, middle market M&A demand depends on the availability of capital. Private Equity firms continue to store a large amount of dry powder. When we got into the business in the 1980s, buyers wanted to see the potential for annual equity returns of 25-30% on their acquisitions. Today expected returns in the teens are often the norm and continued LP demand has the potential to drive anticipated returns down even further. There is a great deal of capital in the marketplace looking for a home and uncertainties in the public equity markets will drive more capital to Private Equity as a standout performer.
Private Equity demand is driven by the availability of low cost leverage. For a number of years following the crash, PE firms typically structured deals with at least 50% equity and often more. Over the past two years, tremendous amounts of capital have been allocated to private market lenders including CLOs, BDCs and SBICs. These companies now compete directly with the banks for the PE sponsor’s business. In response, banks have returned to the acquisition financing market with very cheap leverage and increasingly aggressive credit standards. With this glut of capital, leverage ratios of 70% are once again common, putting further pressure on potential valuations.
Putting this all together, we see a strong middle market M&A environment over the next 12 to 18 months as the most likely scenario. Today’s high valuations will likely continue or even be exceeded as corporate and PE demand continues to grow. We doubt that the equity market sell-off will have any lasting negative impact on M&A; on the contrary, a price decline could actually increase Private Equity demand as public company valuations return to ranges that support an acceptable return on capital.
Looking out further, we can say with a fair degree of confidence that today’s heady valuations will eventually fall. The equity market bubble of winter/spring 2000 was followed by one of the sharpest equity sell-offs in history and a virtual collapse of the M&A market for several years. History may not repeat, but it often rhymes.