Middle-Market M&A Outlook & Transaction Valuations – Will 2015 Top 2014?
On the heels of a robust merger and acquisition (M&A) environment for U.S. middle-market companies in 2014—measured by deal volume and transaction value—here are some trends and conditions expected to continue driving a healthy and possibly further improved market through the rest of 2015.
U.S. Economic Conditions
The U.S. economy grew at its fastest pace in the last 11 years in the third quarter of 2014, with gross domestic product (GDP) increasing at an annual rate of 5 percent, followed by an increase of 2.2 percent in the fourth quarter; for the full year 2014, GDP rose 2.4 percent. A majority of economists expect a sluggish start to 2015 coinciding with another harsh winter, but they forecast a moderate growth increase for the remainder of 2015, with broad consensus for expected growth of approximately 3 percent. The U.S. stock market also continues performing well, with the S&P 500 remaining near record highs, leading to optimism and confidence among corporate executives and investors eager to pursue strategic M&A.
- Consumer – With approximately two-thirds of the U.S. economy driven by domestic consumer spending, the state of the consumer is paramount in determining outlook.
- While some market participants point toward an uneven recovery, there’s no denying the level of employment in the U.S. continued improving in 2014 and into the first quarter of 2015. The unemployment rate remained unchanged at 5.5 percent after nonfarm payroll employment rose by 126,000 jobs in March, according to the U.S. Bureau of Labor Statistics. Although positive, this growth was below the average monthly job gain of 269,000 over the last 12 months. Job gains were primarily driven by improvements in professional and business services, health care and retail trade, while employment in mining—including support for oil and gas extraction—declined.
- According to the University of Michigan Surveys of Consumers, consumer confidence in March 2015 edged slightly lower to an overall index of 93.0, down from 95.4 in February. However, the index remains near its highest levels since the last peak in the cycle in January 2007. According to the March 2015 report, the slight decline in optimism following the 10-year peak reached in January 2015 was largely due to the moderate rebound in gasoline prices and the unusually harsh winter weather. However, widespread job and wage gains should translate into a continued rebound in consumer spending for the remainder of the year. Overall, housing starts and values also have begun recovering and, along with favorable mortgage interest rates, add to the overall “wealth effect” and positive outlook for U.S. consumers.
- Manufacturing – According to the Institute for Supply Management, the March 2015 Purchasing Managers’ Index stood at 51.5 percent, a decrease of 1.4 percent from February. While the growth rate has slowed in recent months, March’s reading indicated economic activity in the sector grew for the 27th consecutive month and additional capital spending likely will contribute to further economic growth in 2015.
The recent economic and capital environment has led to an active M&A market, with overall business valuations at levels not seen since before the recession. The plentiful availability of equity and debt capital and the state of the overall M&A cycle, as outlined below, continues driving elevated valuations across the majority of industry sectors. However, the market places a material valuation premium on companies with above-average financial and operating performance.
There’s also a meaningful premium placed on business valuations driven by the size of the underlying company. For example, from a private equity (PE) perspective, valuation multiples for middle-market businesses (defined as transactions with enterprise values of $10 million to $250 million) with earnings before interest, taxes, depreciation and amortization (EBITDA) less than $5 million traded at an average 6.4x enterprise value/EBITDA in 2014, compared to 7.1x for businesses with more than $10 million in EBITDA, according to GF Data Resources. In addition, the perceived synergistic value from strategic acquirers or attractive growing industry segments can drive multiples in excess of the average EBITDA multiple. Overall, average middle-market valuation multiples for PE transactions increased modestly to 6.4x in 2014 from 6.3x in 2013, according to GF Data Resources.
So, while valuation levels are perceived to be rising, it’s clear investors are remaining disciplined in terms of asset quality and selectively choosing areas to be most competitive. There are signs of a drop-off in M&A activity in the first quarter of 2015, but the balance of the year likely will see a return to 2014 levels—and possibly higher—driven in part by these conditions:
- Abundance of Capital
- PE investors in the U.S. middle market invested approximately $385 billion in 2014, an all-time record high. According to PitchBook, 1,748 transactions were completed in 2014, close to the all-time high of 1,816 during the buyout boom of 2007. The middle market was responsible for 78 percent of overall PE activity in the year. Aided by the strong seller’s market, PE firms also exited approximately $95.7 billion in investments during the year, another all-time high, and were able to raise a post-financial crisis high of $135.5 billion in new money—up 17 percent over 2013 levels—through 165 funds. With a limited time frame in which to invest this capital, PE firms will continue being active and competitive buyers in the market.
- Nonfinancial companies, i.e., potential strategic acquirers, have approximately $1.5 trillion on their balance sheets, according to Moody’s Investors Service. With uncertain economic conditions and lower growth outlooks in various international markets, this is expected to drive further domestic investment and consolidation.
- Credit Markets – Although the Federal Reserve is expected to gradually raise interest rates by the end of 2015, the credit markets remain open with traditional banks and alternative nonbank financing providers aggressively seeking opportunities to put capital in the market, including through M&A transactions. This relatively inexpensive and plentiful source of money for investors is at times allowing buyers to finance acquisitions at valuation multiples higher than what otherwise would be viable.
- M&A Cycle – Historically, there’s been a roughly seven-year M&A cycle in the middle market. We are essentially in Year Five of that cycle, which would indicate another expected 12- to 24-month window for this overall positive M&A environment.
- Retiring Baby Boomers – An estimated 10,000 baby boomers have reached retirement age each day since the beginning of 2011, a pattern that will continue for the next 15 years. Following the recession, many of these boomers who own businesses and delayed retirement—and who may lack direct succession options—will consider sale and transition solutions in this high-valuation environment.
There are, of course, a plethora of risks to the otherwise benign U.S. economic outlook, such as tensions in Russia and the Middle East, a slowdown in China, a stagnant Eurozone, rising interest rates and a significantly strengthening U.S. dollar, that will impact exporters. However, absent any unforeseen and substantial macroeconomic or geopolitical events that aren’t already priced in, we expect the very active and compelling seller’s market to continue in 2015. There is strong competition for quality assets, as strategic corporate and PE firms continue seeking deals to fuel growth and deploy capital. This activity is further enhanced by the record-low interest rates and surplus of M&A financing available in the debt capital markets. Companies that maintained or improved earnings over the past three to five years can be highly valued in today’s M&A environment and take advantage of this attractive window in the cycle—while it lasts.
For more information, contact your BKD advisor.