Are The Good Times Gone?
Oh what a difference a year can make. A little over 12 months ago, I was working feverishly to close the acquisition of a small kitchen and bath distributor. This deal would mark the 72nd transaction that I was involved in since joining Ferguson Enterprises in early 2000.
During this time period, Ferguson’s parent, Wolseley plc, was an acquisition machine. As reported in Mergers and Acquisitions, in 2005 and 2006, Wolseley was the second most acquisitive company in the world behind General Electric. Fast forward to 2007, however, acquisition activity at Wolseley had slowed considerably following a 2006 multi-billion dollar transaction in Europe. Outside of Wolseley/Ferguson, merger and acquisition activity during this time frame remained fairly robust.
The blockbuster HD Supply deal was completed in mid-2007, at a record (albeit re-traded) $8.5 billion figure. In early 2008, however, the large deal market became stagnant as the broader credit markets locked up. The big issues, of course, started in the sub-prime and collateralized mortgage security markets leading to the headline bank and insurance failures. Outside of Wall Street, however, the middle market (defined as companies with sales revenue less than $500 million) mergers and acquisitions marketplace remained resilient and fairly well insulated from much of the trauma taking place. Senior cash flow lending was available, and while valuations normalized a bit, transaction activity continued.
In April 2008, I departed Wolseley/Ferguson and joined Matrix Capital Markets Group based in Richmond, VA, to head up the firm’s building products and distribution team. Matrix was founded in 1988 as a middle market investment bank involved in both buy and sell side advisory services and capital raising for privately held businesses.
Mergers & Acquisitions TodaySo, what is going on in the mergers and acquisitions world today? For the year ended last Dec. 31, 2008, the trade journal Mergers and Acquisitions reported a total of 7,626 deals completed with an aggregate deal value of $994 billion. Overall deal activity (measured in the number of deals) was off about 20% from 2007, while deal value (aggregate dollar value of transactions) was off 45%, reflective of lower values coupled with lower volume.
The middle market held up better for most of 2008, but dropped off in September significantly as the liquidity and financing plague that was making headlines in the broader market finally reached the middle market. Cash flow senior bank financing effectively disappeared from the market in the fourth quarter of 2008 as senior lending became limited to asset based formulas (“ABL”). While transaction activity did slow considerably as a result, deal closings continued throughout the balance of 2008 thanks to creativity and perseverance in the capital markets. Mezzanine capital (or subordinated debt), a more expensive capital source for sure, stepped up to close some of the void; in addition, private equity groups increased their capital contributions to get deals funded. There were even instances in which equity groups funded 100% of the purchase price with plans to refinance in more stable credit markets. Finally, seller financing re-emerged in transactions as a way to bridge the valuation gap but not without risks that need to be carefully considered.
With less debt generally available and, when secured, at higher pricing, overall leverage ratios moved downward, bringing with it deal valuations and EBITDA multiples. At year end, the deals that were getting done were those that had a nice asset lending base (plant, equipment, inventory and receivables) to support an ABL senior credit facility. It is hard to generalize on valuations, but it is my experience that values have come down 1 to 2 times EBITDA. This is to say that a deal valued at 7 times EBITDA two years ago, would garner a 5 or 6 times EBITDA valuation today.
In the wholesale sector, Mergers and Acquisitions reported 230 transactions completed in 2008. McJunkin/Red Man Corp.’s acquisition of Labarge Pipe and Steel Co. and the private equity group Sterling Investment Partners’ acquisition of FCx Performance Inc. were some of the more notable transactions that were successfully executed in 2008. Traditional plumbing transactions were few and far between, with industrial and commercial PVF transactions much more prevalent. Oil & gas, petrochemical, and energy were sectors that proved resilient last year. Profitability in the PVF world was strong in 2008, driven by strong demand compared with businesses focused on the residential construction sector.
It was an extremely quiet year for the strategic consolidators. HD Supply, Ferguson, and Interline brands all reported just a single transaction each, while Watsco, Hajoca, and WinWholesale did not announce any closed deals for 2008.
Private Equities Sit and WaitThe initial public offering (IPO) market as an exit strategy for leveraged buy outs (LBOs) remained essentially closed in 2008. Across the globe, there were only 120 IPOs completed (down 78% from 2007), but the most telling statistic was that there were only 27 launched in the last six months of the year. In fact, in the U.S. three months went by in the second half of the year where not a single IPO was initiated.
In the distribution sector, many large private equity groups will have to be patient with their holdings until the IPO market becomes unlocked. In particular, HD Supply (Bain, Carlyle, and Clayton Dublier & Rice), Edgen Murray (Jeffries), and Red Man/McJunkin (Goldman) are all logical IPO exits at some point, but will have to await more favorable trading conditions and improvement in equity markets.
While valuations have come down and fewer transactions are in the market, deals are getting done as we move into 2009. Federal Flange was just acquired by KRG Capital and American Piping Products was recapitalized with the private equity group Edgewater Funds. While strategic acquirers are largely in cash conservation mode and unable to take advantage of lower valuations currently available in the market, private equity funds are flush with cash and continue to raise funds at near record levels. These newly raised funds remain largely uncommitted moving into 2009 and most groups have plenty of capital to deploy for platform transactions and bolt-on acquisitions.
Dow Jones Private Equity Analyst in October 2008 reported that U.S. equity firms had raised $222.6 billion in the first three quarters of 2008, up from $200.4 billion in the same period in 2007 and it is estimated that more than $1 trillion sits “on the sidelines” ready to be deployed. An emerging trend is new funds focusing on distressed and turnaround opportunities. Bottom line, private equity capital is available for deployment for well-managed high quality companies with reasonable valuation expectations.
When a quality company is brought to market today, we are seeing a high level of competition among the private equity sponsors. In the building products area, companies that are getting the most attention by private equity groups are those companies that have defensible competitive advantage, are positioned to take advantage of the federal government stimulus package, offer sustainability or “green” technology, participate in the energy sector, or are uniquely positioned to take advantage of regulations. The quality and transparency of earnings is more important than ever, as is a good story as it relates to why the company is being sold in today’s market.
While control investments (more than 50% of equity) have traditionally been most common, as the number of opportunities in the marketplace diminish, private equity groups are becoming much more creative in order to continue to deploy their capital. While most financial sponsors have historically required majority control in a transaction, they are now much more open-minded and flexible. This is a great thing for private business owners because it opens up almost limitless possibilities when considering a recapitalization of their business. A minority equity investment or recapitalization gives a business owner the opportunity to sell a portion of his business while still maintaining a significant ownership stake. This transaction provides an influx of liquidity into the business to pay down debt or increase cash balances to prepare for a growth event.
Unlike some strategic acquirers who have a goal of reducing overhead and redundancies, a minority equity partner is more of a collaborative relationship with a shared goal of taking the company to the next level. Finally, in an environment in which valuation levels may not be attractive to many owners, a minority recapitalization allows for partial net worth diversification today and retained majority control for a future exit. A minority recapitalization can achieve multiple goals and while not applicable in all cases, can be something to carefully consider. Recent minority recaps in the distribution market have been completed by All Tex Pipe & Supply and American Piping Systems.
A Slow ThawAs we look ahead into 2009 and beyond, I believe that credit markets will slowly begin to thaw and transaction activity will pick up. I do not see a quick rebound to the boom times with high valuation multiples and loose credit for some time.
2009 is off to a slow start with Mergerstat reporting only 750 transactions completed in the U.S. through February with total aggregate transaction value of $65.2 billion. In the wholesale and distribution sector, 37 transactions have been completed vs. 58 a year ago.
The appetite for transactions looks to be fed by only the best performing companies or distressed situations; however “best performing” has been redefined a bit and “flat” is the new “growth” in this market. Now does not appear to be a good time for mediocrity in the market. Of course, significant events with an owner or shareholder base will always give cause for a company to explore alternatives despite market conditions.
Advice To Would-Be SellersIf you are looking to sell your company in the future, I can offer a few select pieces of advice.
1. Understand your timing horizon. Carefully evaluate your short- and long-term strategies relative to your planning horizon such as to provide maximum growth and profitability in the time immediately preceding the anticipated sale date.
2. Seek a professional M&A advisor. In most cases, a business owner can come up with a short list of logical buyers and approach them directly. Approaching them directly (or thru a CPA or attorney) is regularly done. This self-managed short list approach is quickly interpreted, however, as a “test the waters” exercise with perhaps an uncommitted seller. When an investment banker is engaged, it demonstrates a firm commitment on the part of the owner to truly engage in a transaction. Also, capital markets, business valuations, and buyer’s fiscal and psychological strategies are very fluid. Having a professional advisor with expertise in navigating these waters will prove critical to you in the long run. Finally, the valuation of a business is multi-faceted including the cash at closing, holdbacks, inventory valuation, leases, contractual reps/ indemnifications, and many other items. Understanding the inter-relationships of these items is paramount.
3. Go broad in your search for buyers. While you as a business owner may be able to identify the “most logical” buyers of your business, a well-run sales process including both strategic and financial buyers will always result in the best price and terms for the seller. The world of capital markets is very large with over 2,000 middle market capital providers, with each of the groups having investment preferences such as geography, size of business, industry type, etc. The beauty of a well-run process is that buyers know they are a part of a process but not whether they are one of five or one of many more. This ultimately gives the owner of a quality business significant leverage. You, the business owner, have (in most cases) but a single shot to extract the maximum value for your most prized asset. Assemble a good team and good luck!