Overall M&A Activity
Clearly M&A transactions have slowed substantially during the last two quarters, with Q1-2009 being the slowest quarter for deal closings over the past 12 quarters. First quarter 2009 M&A activity is off 39% when compared to the recent peak of Q2 2007. However, if we stop and recognize that M&A transactions were getting completed at a historically blistering rate in 2007, we gain a bit of perspective. In fact, with all of the doom and gloom and economic meltdown, it is astonishing to see that M&A activity in Q1-2009 was off only 16% when compared to a more moderate time of M&A in Q2&3 2006. We fully expect that Q2-2009 also will be slow, but we’re starting to see signs that the last two quarters of 2009 could possibly be more active than the first two. With a 6-8 month cycle for typical transactions getting completed, look to the first two quarters of 2010 to be back at a pace more in line with historical averages.
The following two charts show quarter-by-quarter M&A activity (all deal sizes) from Q2-2006 thru Q1-2009.
Chart 1 – Transactions Per Quarter*
Chart 2 – Transaction Size Per Quarter*
The Middle Market
It really is no real surprise that the overall transaction volume in the middle market is down as well (as seen in Chart 3 below). Overall deal volume in the middle market dropped 68% from a peak in Q4-2007 to a bottom in Q1-2009 (so far). What is actually very surprising is that the transaction volume in the middle market is off substantially more when compared to the overall market. Traditionally the middle market has been far more stable and predictable than the overall M&A market – which includes mega mergers and extremely large publicly traded deals.
Why the change? The change can be attributable to three major factors: PEG’s moving to the sidelines, credit drying up, and sellers believing that only distressed deals are being done in this environment. Below we take a deeper dive at each of these three reasons:
PEG’s Moving to the Sidelines – The PEG’s in the business cycle appeared to be ahead of the curve in slowing down investments in new prospects. We saw as early as late last Spring that PEG’s were becoming ever more cautious based upon information coming out of the housing and banking sectors. When PEG’s move to the sidelines, transaction volume slows, multiples go down, and they focus on keeping their portfolio companies healthy.
Credit Drying Up – With the onslaught in the credit markets, banks had very little capacity for new loans. Solid deals were still getting completed, but deals that were not so strong suffered from buyer’s inability to leverage their balance sheets and get funding for new acquisitions. In fact, even traditionally solid companies and conservative deals found that they had to approach multiple funding sources to be successful. More likely during this period these deals were presented to 30-40 banks before being funded.
Sellers Believing the Hype – With all of the bad news circulating in the financial markets, middle market companies desiring a capital event believed that buyers were only bottom fishing. Sure we discussed the exit of PEG’s and a lack of credit, but this ignores the best category of buyers from a seller’s perspective – Strategic buyers. We found that many Strategics had their own cash and were willing to invest in good companies and were not doing so on the cheap. In fact, Focus Bankers has closed 3 internet/software deals in Q1-2009, all with strategic buyers and at very respectable multiples.
Outlook for Remainder of 2009
By many accounts, the economy has hit or is near the bottom. We expect to see a modest increase in middle market M&A activity over the last two quarters of 2009. The middle market is overwhelmingly driven by one major driver – the business owner’s personal lifecycle. Experience shows us that the vast majority of middle market firms are privately held by one or two owners and the majority of these firms are sold when the owner seeks to either retire or at least set up his wealth diversification strategy. Certainly owners will weigh economic conditions when considering a liquidity event, but are older owners, 60 to 65 years, willing to wait another five to seven years for an M&A cycle to peak? We believe this is unlikely. In fact as baby boomers reach retirement age, more and more companies will be seeking an exit strategy. The pent up supply built over the past two quarters and the growing age of baby boomers are likely to cause a significant increase in buying opportunities over the next 3 to 5 years. The question for owners thinking about exiting should be – do I want to be ahead of this trend or along for the ride?
Companies that don’t fall into the personal lifecycle exit scenario are also likely to see an uptick in M&A activity. This will be driven by two trends – pent up demand for strategic assets and financial investors continuing to conserve cash. Financial players are likely to continue to be cautious over the coming quarter before they jump head first into this environment. The lack of a robust credit market also makes this market proportionally more difficult for Financial Investors. We expect a two to three quarter lag before balance sheets appear stronger after the economy begins to improve. In the interim, financial investors will continue to focus on their core operations and work to improve their underperforming business units. Growth equity PEG’s and VC’s will continue to look at their cash-burning portfolio companies and startups as risky places to place their precious cash, likely resulting in asset sales of intellectual property to strategic acquirers.
The following charts show quarter-by-quarter M&A activity from Q1-2007 across the middle market economy (deal size < $100M) for closed deals.
Chart 3 – Middle Market Transaction Volume*
Table 1 – Summary of Reported Middle Market Deal Closings*
*Source: CapitalIQ
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