Middle Market M&A on the Rise

Prices are rising, and deal volume is getting closer to precrisis levels. Is this a true recovery or a blip on the M&A screen?By KEN TARBOUS, Investment Dealers' Digest
September 12, 2010
Ridgemont Equity Partners, a Charlotte, N.C., financial sponsor, has been an active buyer of companies worth $10 million to $100 million this summer and it has plenty of company.
Last month, Mill Road Capital of Greenwich, Conn., completed a $91 million acquisition of Rubio's Restaurants Inc. of Carlsbad, Calif., and Austin Ventures snapped up YRC Logistics, a Kansas unit of YRC Worldwide, for $38.7 million.
Dealmaking has picked up from a year ago and it is expected to remain lively at least for the rest of this year. Sponsors are allocating more money to lower-middle-market businesses, and improved debt markets are allowing buyers to borrow more. Also, some market players cite concerns about potential changes in federal tax policy as a reason for the pickup in the pace of transactions.
According to Thomson Reuters, there were 72 deals worth $4.8 billion in the lower middle market last month, compared with 65 deals worth $3.7 billion in August 2009. (These mergers and acquisitions generally involve companies worth $10 million to $250 million.)
Private-equity firms have $400 billion of capital on hand to invest, according to Deloitte Corporate Finance LLC, and more than 75% of the firms that have raised funds this year are targeting middle-market companies.
"We've got improved debt markets, you've got an inventory of deals that has built up during the economic downturn that people couldn't really sell, and you've got an improving economy that's incentivizing people to take that inventory out to the market," said Travis Hain, a partner at Ridgemont. "And finally, you've got potential tax incentives, depending on one's views on capital gains, and obviously there's a predominant view that capital gains is going up."
His firm, which Bank of America Corp. spun off last month, invests in basic industries, consumer and retail, energy, financial services, health care, and telecommunications, media and technology. This week, it announced it had bought a majority interest in the data network provider Unite Private Networks, and last week it said it had sold its interest in the fiber-optic broadband provider Fibertech Networks.To some degree, the pickup in activity may be exaggerated by the sharp decline in M&A transactions that took place during the credit crisis; while the debt market conditions have improved, there is a cap on how much a sponsor firm can borrow. Others say the activity is being propelled by the simple fact private-equity funds get paid to put money to work.
In the second quarter, according to Thomson Reuters, there were 257 U.S. deals worth $17.7 billion involving companies with enterprise values of between $10 million and $250 million. A year earlier there were 199 such deals worth $10.7 billion.
GF Data Resources, which collects data from more than 150 private-equity firms on transactions valued between $10 million and $250 million, reported a similar pattern among the financial sponsors it covers. In the second quarter, these sponsors closed 26 deals in the lower middle market, versus 16 in the first quarter and 15 in the second quarter of last year.
Private-equity sponsors and M&A bankers say that even though this year's volume does not match that of the heady days of 2005 to 2007 (a three-year period when, by some industry estimates, buyouts totaled more than $1.6 trillion), there are "record or near record" numbers of companies up for sale now, and those companies have a goal of closing deals this quarter or the next.
"If even a fraction of these deals get done, it will be a very interesting couple months," said Justin Abelow, a managing director of the financial sponsors coverage group in the New York office of Houlihan Lokey. "I think one of the things that's going to happen is that there'll be a tension between getting some of these deals done as M&A deals and just doing dividend recaps of one sort or another, particularly where people think they are not going to get their prices."
Hain says the backlog and the rush to market have a positive side.
"The good news for everybody is that this inventory of deals that built up over two or three years, they're all quality companies," he said. "The first companies that come out in this environment are the best companies. We're tending to see better companies, and there are some companies that, in certain circumstances, you can afford to pay higher prices for, depending on what a buyer thinks that you can add to the equation as a buyer and investor."
Valuations are returning to what dealmakers call more realistic levels. The multiples paid for companies in the lower middle market are on the rise, according to GF Data. The average multiple climbed from 5.1 times EBITDA in the third quarter of last year to 5.2 in each of the following two quarters to 5.6 in the second quarter of this year. Companies sold in the second quarter of last year fetched an average of 6.7 times EBITDA.
Hain says improved conditions in the debt markets have provided an impetus for deals this year. "The debt markets are facilitating transactions very actively, whereas the debt markets were a real impediment to deals last year."
In addition, the equity and debt structure of the deals has been stabilizing. Debt as a percentage of the average deal's capital structure increased to 42.4% in the first half of this year, versus 28.2% for all of last year, according to GF Data.
The equity percentage dropped from 59.0% last year to 53.3% in the first half of this year, but that's still "a high number by any kind of historical standard, so it shows that the overhang of equity capital that is still to be invested that has been raised by these private-equity sponsors, that there's a lot of pressure to deploy that capital," said Graeme Frazier, principal and co-founder of GF Data.
Market participants, citing proprietary data, pitch count and new assignments, say there might not be enough middle-market bankers and private-equity professionals to handle the plethora of deals in the market, and processes may be truncated as a result.
"This is as busy as that market has ever been, after a time of relative inactivity, and there may not be as many people in all parts of that market as there used to be, but there is much more activity," said one market participant, who asked not to be identified. "I think people are trying to push a lot of water through a relatively narrow pipe, and I think that pipe is near a bursting point."