Despite global economic uncertainties and the looming possibility of a double-dip recession, middle-market M&A activity, particularly at the upper end, remains surprisingly active -- for now.
Several middle-market investment bankers report that their pipelines have not yet been squeezed by the ongoing European debt troubles because both strategic and financial buyers seem to have cash to spend on acquisitions and still have access to senior debt.
However, that doesn't mean there's not anxiety in the middle market and that the climate won't change quickly if Greece and other European economies either default or exit the euro zone, or more turbulence sweeps through the financial system. But for now, business remains pretty much as usual for advisers and lenders in the upper middle market, with most of them anticipating that dealflow will remain steady into 2012.
A broad sweep across the middle market reveals a few conclusions. Dealmaking is down, but deals are still getting done. The upper middle market, particularly the high end, continues to generate deals, both financial and strategic, partly because buyers have a number of financing options -- debt and loans, leveraged and unleveraged. That may end, however, if the European crisis worsens. Sizable firms that finance M&A with senior debt also seem to be active -- far more than companies lower on the food chain that depend on bank lending. The further down you drop, the greater the distress.
Statistically, the number of deals done across the middle market has slipped, though the total value of deals is up. According to data from Milwaukee-based Robert W. Baird & Co., there were 9,214 global middle-market deals (valued up to $1 billion) announced through Aug. 31, representing $586 billion in value. That is down from the 9,586 deals with $501 billion in value announced through the same period a year ago.
Those relatively fewer quality targets, combined with corporate cash hoards and sharpening competition among buyers, seem to be driving prices up. Buyers have cash. Both financial and strategic buyers had a combined $2.1 trillion in cash at the end of 2010, with $1.6 trillion held by strategics, according to a July report published by Dallas investment bank Allegiance Capital Corp. Those figures are slightly down from 2009, when buyers had about $2.2 trillion in cash, with $1.7 trillion held by strategics.
One factor keeping middle-market M&A relatively steady is the continuing availability of senior financing, particularly for deals valued over $100 million. "In the middle market right now, financing is not at 2007 numbers, but is certainly out there," says Martin Burkett, a shareholder at Miami-based law firm Akerman Senterfitt LLP. Akerman is advising healthcare network provider Continucare Corp. on its $416 million sale to rival Metropolitan Healthcare Networks Inc. That deal, announced in June, is being financed in part by a $355 million credit facility from GE Capital Healthcare Financial Services. The exact financing terms have not been revealed, and Burkett, who worked on the deal, won't discuss specific details.
"The marketplace has seen fewer transactions year over year," notes McGladrey Capital Markets LLC president Hector Cuellar. "Because of fewer transactions, the price being paid for deals has gone up."
Cuellar recently returned from Europe and witnessed firsthand the challenges that region is facing. He initially thought conditions would deteriorate even more. Still, he says, "I came back extremely concerned about credit availability [in the U.S.] based on what I saw."
"Middle-market deals are still getting done, particularly if there is a strategic component and particularly if it's in a sector like healthcare," insists one middle-market advisory source. "It's the large deals that require junk bonds in addition to senior debt that will have a problem getting done."
Harris Williams & Co. director Greg Creamer agrees. The market turmoil set off by a European debt crisis, he says, would mostly hit large-cap rather than middle-market deals.
What kind of deals are getting done in the upper middle market? In late September, New Canaan, Conn.-based buyout shop J.H. Whitney Capital Partners LLC acquired Julio & Sons Co., the operator of the Uncle Julio's Mexican-themed restaurant chain, from MapleWood Partners LP for about $100 million, according to industry sources. Golub Capital BDC Inc. provided financing. The exact terms were not revealed, but Golub typically arranges loans worth up to $200 million. Restaurant bankers say little has changed in the debt markets, although rates have risen.
Duff & Phelps Corp. managing director and head of retail investment banking Josh Benn says that if a restaurant chain has healthy financials and growth potential, it will attract buyer interest even at lower debt multiples. "The market will become more selective," says Benn. "If they have traffic, they will still get interest from buyers. There's still an appetite to get things done."
"You're able to get the deals when you have the financing committed to a close," says William Blair & Co.'s global head of M&A Mark Brady. "It's the transactions where the financing is under way -- in other words, haven't received financing commitments yet -- where you'll see some changes," notably higher interest rates and lower leverage ratios.
"Financing is out there for sure," adds another restaurant source. "Traditional bank debt, mezz funds and loan/hedge funds are all doing senior debt deals."
Another recent transaction involves Berea, Ohio-based polymers manufacturer PolyOne Corp., which said on Oct. 3 that it had agreed to acquire liquid colorants maker ColorMatrix Group Inc. from Boston private equity firm Audax Group for $486 million. The buyer is funding the acquisition with cash and about $300 million in long-term debt.
Also on Oct. 3, Duluth, Ga.-based agricultural equipment maker Agco Corp. agreed to purchase GSI Holdings Corp. from Centerbridge Partners LP for $940 million. The buyer received a commitment from Netherlands-based Rabobank NA to fund the acquisition and to refinance existing credit lines.
Several middle-market bankers also expect to see PE portfolio companies going on the auction block in steady numbers throughout the balance of 2011 and 2012 as buyout firms come to the end of their investment cycles.
And strategics are still active -- and even willing to buy in Europe. On Oct. 4, Chicago aftermarket automotive parts maker LKQ Corp. said it had agreed to acquire European counterpart Euro Car Parts Ltd., which works with brands such as Audi, BMW and Mercedes-Benz, for up to $432 million. LKQ will fund the acquisition by tapping its $1.4 billion credit facility.
However, some sellers who survived the 2008-2009 recession will not put themselves up for sale under current conditions. For instance, Paris luxury goods company PPR SA canceled its auction for its Redcats Group, which has operations in the U.S. and France, in September because potential buyers were unable to raise debt due to European market turmoil. Fort Worth buyout shop TPG Capital and Beijing-based CDH China Holdings Management Co. Ltd. terminated their $953 million bid for Chinese insurer CNinsure Inc., citing difficult economic conditions. "A lot of deals in negotiations won't get done, and a lot of deals will get done," says Benn. "There will be deals that will be affected."
"The final decision comes before you start marketing," adds Brady. It all depends on how financial conditions are when a target is scheduled to send out dealbooks, whether they want to go forward or pull the auction.
Creamer estimates there are three years' worth of postponed auctions and many companies on the block or ready to go to sale in the near future. "We're seeing owners that have delayed selling over the last 36 months," he says. "A lot of business owners are looking forward."
Despite activity in the upper middle market, the falloff from upper to lower is pretty stark. The Baird data shows that 2,551 deals valued below $100 million were announced in the U.S. as of Aug. 31, compared with 3,313 deals through the same time period in 2010. In the meantime, the number of deals valued between $100 million and $499 million increased to 531 in the U.S. as of Aug. 31, from 433 through the same time frame in 2010.
In the lower middle market, observers agree that companies should only sell now if they are in financial distress or their owners are looking to retire.
Allegiance handles 80% sell-side assignments with companies that have $5 million to $50 million in Ebitda and transaction sizes between $25 million and $250 million with mostly privately held and family-owned businesses. Allegiance tracks a database of about 100,000 privately held businesses, to which the firm reaches out on a regular basis to gauge their interest in possible transactions. The investment bank expects to have 50 new clients signed up by year's end, and president David Lonsdale is looking to boost that number to more than 70 by the end of 2012.
Ben Olsen, a partner and the director of operations for Kansas City, Kan., lower-middle-market shop DVS Group, says his clients are seeking more growth refinancing than outright sales because they believe they can grow if they get capital, but they aren't yet ready to sell.
"Regional banks are active in the lower middle market, but only up to a certain degree," according to a report from Atlanta-based lower-middle-market investment bank RKJ Partners LLC. "For the smaller deals, lenders are going to look at them more as a stretched asset-based deal rather than a pure cash flow structure."
The report says companies with less than $5 million in Ebitda will usually get less than 2 times senior leverage. Those with $5 million to $10 million in Ebitda can get up to 2.75 times senior leverage, and those companies with more than $10 million Ebitda can get up to 3.25 times senior leverage.
"Middle-market strategics and private equity can afford to lose some house money on bigger bets; individuals don't really want to do that from what we have seen," says Olsen. "There are enough small deals that need basic fixing that it doesn't make sense to bet the farm hoping for a home run when you get rich slower by flipping a couple of smaller deals in a less crowded market. We know there's a feeding frenzy in a lot of areas in the middle market, but at our shallow end it seems like it's too hard to pick the winners yet to want to get into the fight right now."
As William Blair's Brady notes: "Nothing has shut down at this point." At least not yet.