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— Deals —
The economic recession coupled with the credit crisis has taken a predictable toll on middle-market dealflow. But after hitting rock bottom at the start of the year, M&A has slowly begun to pick up. Dealmakers are cautiously optimistic but fear the continuing paucity of credit could derail any middle-market rebound before it gets properly started. "We're not in a free fall," says Mary Lou Malanoski, head of investment banking at New York-based Morgan Joseph & Co. "We hit the bottom, but it's now a question of how quickly we can go back up." That is a substantial improvement from even six months ago. Howard Lanser, director of mergers and acquisitions for Robert W. Baird & Co., calls the fourth quarter of 2008 and first half of 2009 "the most difficult we experienced in M&A." According to Baird, the number of global middle-market deals is off about 25% from last year -- which was not a particularly good year, either (see chart). In fact, 2009 is on track to be the worst-ever year for middle-market M&A in the 10 years since Baird began tracking it. "People don't appreciate what a serious shutdown of the marketplace took place," says Hector Cuellar, president of Los Angeles investment bank McGladrey Capital Markets LLC. From November 2008 to March 2009, as a troubled banking sector
deleveraged, virtually no credit was available to finance midmarket
M&A. The transactions that did happen were largely small add-ons,
normally financed with cash on hand, or so-called event-driven M&A,
including divestitures of noncore assets. "This time last year, folks were in a bit of disarray," says John Neuner, managing director at Richmond, Va.-based Harris Williams & Co. Middle-market deals had been "chugging along until September." Then came the government takeover of Fannie Mae and Freddie Mac, the near failure of American International Group Inc., the implosion of Lehman Brothers Holdings Inc. and a deep recession. Many deals were postponed or canceled altogether.
"A lot of things didn't get done," adds Neuner. "Everyone was trying to manage their balance sheets at the end of the year." The problem persisted into 2009. "People didn't have a good feel for the new norm. At the end of the first quarter, fear was out there, and it kept buyers at the sidelines," he says. But the picture has slowly started to change, says Landon Smith, managing partner at Riveron Consulting LP, a Dallas firm whose primary clients are private equity shops in the lower-middle market. Smith says he has seen a substantial uptick in deal-related work since Labor Day. While dealmaking often increases in the fourth quarter, Smith says he can identify a few issues that point to more secular growth. Chief among these, he says, is "price rationalization between buyers and sellers." Especially in the lower end of the middle market, sellers have held out about as long as they can and now need a transaction. Some buyers, meanwhile, have backed off from making fire-sale-or-nothing offers. A few are even willing to pay market rate or above -- depending on the business, of course. "Most buyers are back now," adds Brent Gledhill, head of global corporate finance for William Blair & Co. LLC. But much of the activity remains in backlogged deals, including those in the works before Lehman Brothers failed. Bargain-basement shopping is still the norm. And middle-market M&A remains largely a cash market. For the deals announced since Labor Day, Riveron's Smith sees larger equity checks being cut than in 2008. As recently as a year ago, debt could represent up to 80% of a deal's capital structure. Now, according to Joel Magerman, managing director at New York middle-market investment bank Bryant Park Capital Inc., the debt-capital ratio is hovering in the 40% to 50% range. "You have to put up more equity to generate the same returns, resulting in a lower purchase multiple," he says Indeed, bank lending remains the paramount issue for middle-market M&A. "There is less activity on the bank side in terms of lending on new transactions," Malanoski says. A flight to quality has taken many banks upmarket to large-cap transactions and left the middle-market without one of its primary sources of financing, particularly for M&A (see related story "Where have all the lenders gone"). The issue, then, is not buyers and sellers agreeing to make deals but finding ways to finance them. The Nov. 2 bankruptcy filing of CIT Group Inc. has certainly not helped matters. But it hasn't made them hopeless, either. "It's never a good thing to lose a market participant, says Baird's Lanser. "But it's not going to break or make M&A. My expectation is the gap will be filled from other lenders out there. Other lenders will step up. A new source of capital will form." Meanwhile, active lenders are choosing to err on the side of caution. "It's better to say no to a deal that is not a clear winner and not make a mistake than to say yes and sort of risk making a mistake, even a small one, and being taken to task for that by an LP in the future," Magerman says. As a result, strategic buyers who have capital have an advantage over financial buyers who can't get financing, says Morgan Joseph's Malanoski. Private equity firms, therefore, have largely contented themselves with "tending to their flock," explains Smith. Add-ons, which have made up a higher percentage of middle-market PE deals, are normally financed through existing lenders or through sell-side financing. "Seller notes are more typically involved these days to provide the debt piece," says Smith. As a result of the nonavailability of credit, Magerman sees the market bifurcating: "Pristine deals are getting a high level of interest at above-market multiples. However, anything that has a little hair is being more severely punished than in the past on valuation multiples," he says. "Investors want to feel they're being handsomely rewarded for taking any risk." And even when everything does work out, it takes significantly longer to close deals than it did pre-Lehman Brothers. Deals that used to take an average of four to five months from the time they went on the market to close are now taking six to seven months, says William Blair's Gledhill. Financings are also taking months to complete. Magerman recalls a $50 million debt financing his firm closed in August. "A 45-day closing period turned to 120 days," he says. The financing conundrum exists at some level in virtually every sector of the economy -- and globally. "I thought there might be something unique to cause one region or country to [hit trouble], but we're seeing a lot of these things impacted almost universally," Magerman says. The worst-hit sectors are financial services and consumer industries. Aerospace deals have been sliding due to delays in platforms, but should improve by next year, says Cuellar. Healthcare and technology have seen less of a negative impact, especially in biotech. Malanoski sees activity picking up in the industrial sector. For Smith, it is not a company's sector per se but the nature of a company's leadership that determines its readiness to deal. "Things holding up the most are entrepreneurial businesses," he says. "Small business owners and entrepreneurs tend to find a way to make things work." Smith has identified many growth situations where "a business needs capital and needs to make a move." For the rest of the middle market, it all comes down to the banks. "Where the banks go is probably issue No. 1," says Smith. "When and to what degree do they come back to lending? When does that credit free up? There's obviously a lot of issues that flow into that equation, but right now there's a lot of uncertainty around inflation, tax rates, regulation, commercial real estate fallout -- a lot of uncertainty with banking in general. Hopefully, if those issues start to firm up, they'll be able to get back to the business of lending." For some, the question of whether banks will re-enter the middle market is not a matter of if, but when. "The last 90 to 120 days, people went to saying the doors were closed to saying they were open and they're looking at things," says Magerman. "When will they start doing business at a more reasonable level?" Perhaps as soon as the first quarter, he estimates. By then it will be about two years since the credit slump onset and 18 months from the start of the recession. Smith, for one, is "cautiously optimistic deal activity is going to improve," though "with a high degree of certainty that things will not kick up to 2007 levels for some time down the road, if ever." That should be clear to everybody. Demitri Diakantonis contributed to this report. Related features
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