When it comes to recessions, the middle market lives by a mantra similar to that of the Marine Corps: "First ones in, last ones out."
Just as middle-class Americans are usually the first -- and longest -- affected by downturns in the economy, so too are companies in the middle market. After all, these businesses tend to be tied more closely to the spending habits of average consumers than those in the S&P 500 index.
Not only are middle-market companies the first to feel a drop-off in consumer spending, but they are also among the earliest to sense a chill from lenders in a down cycle. As cash flows fall, smaller companies' lower margins make it harder for them to service debt. Refinancings are usually all but nonexistent in the middle market during recession.
"Fundamentally, middle-market companies are smaller, have less access to liquidity and are working off of smaller cash balances and less Ebitda, so typically, a small bump in the road can trip them up for [an extended] period of time," says the co-head of one middle-market investment bank.
Accordingly, many predicted that it would take years for the middle market to recover from the Great Recession. However, that has been anything but the case. If deal activity in 2010 is any indication, middle-market companies that survived the recession have rebounded just as quickly as their larger peers.
According to a November M&A report by midmarket investment bank William Blair & Co. LLC, there have been 5,212 announced mergers in the middle market (defined in the report as deals valued up to $750 million) year to date, up 57.3% from the same period last year, with the total reported value at about $289.3 billion, up 56.7%. The numbers exceeded their 2009 totals, and the percentage increases outpaced overall deal activity and value through the year, which were up 39.2% and 30.5%, respectively, according to the report.
Why the resurgence? A confluence of factors led to the sector's unusually fast rebound.
For starters, the credit markets reopened this year for most middle-market businesses. The investment bank co-head says that though larger companies were able to tap the high-yield debt markets sooner than those in the middle market, banks are becoming more aggressive in lending to companies around the $20 million annual Ebitda range. In addition, "larger syndicated players are coming down to the middle market now too," says the source, noting that these lenders are still less inclined to lend to businesses that generate less than $5 million in Ebitda.
Second, many corporations that hoarded cash during the recession are now deploying extra capital toward acquisitions of smaller peers in an attempt to expand businesses in an economy still muddling its way out of recession. As equity markets rebounded last year, public companies boosted their share of M&A activity, representing 28.3% of all acquirers over the last 12 months, compared with 24.8% in 2009, according to William Blair.
"A lack of definitive economic expansion is driving a lot of strategic combinations as companies search for ways to drive earnings growth," says John Huwiler, global head of M&A at middle-market investment bank Jefferies & Co. "If the economy stays in never-never land, strategics will continue to look at M&A alternatives in the absence of compelling organic top-line growth."
The emergence of strategic buyers, coupled with the fact that U.S. private equity firms are sitting on an estimated $400 billion to $500 billion in committed capital, makes for intense competition between strategic buyers and financial sponsors at auctions, leading to higher equity valuations. This, in turn, has pushed purchase price multiples of middle-market targets higher over the past 12 months.
"On the financial sponsor side, we have very receptive capital markets coupled with substantial dry powder at private equity firms, which needs to be put to work," says Huwiler. "As long as the capital markets hang in there, deal volume will continue."
Though acquisition multiples this year have been below the peak levels of the boom days of 2005 to 2007, they have rebounded significantly from recessionary lows. The average multiple paid for a middle-market target over the past 12 months was 9.4 times Ebitda, up from an average of 7 times in 2009, according to William Blair.
"The activity level isn't the same as it was in the '06 to '07 time frame, but now we have a broader-based, healthier M&A market," says Huwiler. "As a firm, we continue to see broad-based activity that is going to translate into substantial M&A in 2011."