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 in 2015.
U.S. Economic Conditions
After a sluggish start to 2014, the U.S. economy grew at its fastest pace in 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 of 2014, GDP rose 2.4 percent. Most economists now forecast a moderate increase in the growth rate going into 2015, with a broad consensus for expected growth of approximately 3 percent this year. 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 dropped to 5.5 percent after nonfarm payroll employment rose by 295,000 jobs in February, according to the U.S. Bureau of Labor Statistics. This compares favorably to the average monthly job gain of 266,000 over the last 12 months. Job gains were driven by food services, professional and business services, construction, health care, transportation and manufacturing. The manufacturing sector added 8,000 jobs in February and an average of 16,000 jobs per month in 2014, compared with an average gain of 7,000 jobs per month in 2013.
- According to the University of Michigan Surveys of Consumers, consumer confidence in February 2015 edged slightly lower to an overall index of 95.4 from 98.1 in January. However, the index remains at the highest levels since the last peak in the cycle was reached in January 2007. According to the report, “Consumer optimism was affected by lower gas prices and an unusually harsh winter” with widespread gains in jobs and wages being “the underlying strength that has kept confidence at high levels.” Overall housing starts and values also have started recovering, adding to the overall “wealth effect” and positive outlook for the U.S. consumer.
- Manufacturing – According to the Institute for Supply Management, the February 2015 Purchasing Managers’ Index (PMI) stood at 52.9 percent, a 0.6 percent decrease from January. While the rate of growth has slowed in recent months, February’s reading indicated that economic activity in the sector grew for the 26th consecutive month and further capital spending will likely contribute to economic growth in 2015.
- Companies in the manufacturing space continue garnering strong acquisition interest from strategic and financial buyers. From a private equity (PE) perspective, valuation multiples for middle-market (defined as transactions with enterprise values of $10 million to $250 million) manufacturing businesses have returned to levels not seen since 2007—an average 6.1x enterprise value/earnings before interest, taxes depreciation and amortization (EBITDA) in 2014 compared to 5.9x in 2013 and 6.1x in 2007, according to GF Data Resources. Firms in growing markets focused on advanced and lean manufacturing, quality management and innovative supply chain processes will draw the highest valuations in sale transactions and growth capital investments. In addition, the perceived synergistic value from strategic acquirers, industry segment or operations size can drive multiples in excess of the average EBITDA multiple.
- Abundance of Capital
- PE investors in the U.S. middle market invested approximately $385 billion in 2014, an all-time record. Last year, 1,748 transactions were completed, according to Pitchbook, 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, now have approximately $1.5 trillion on their balance sheets, according to Moody’s Investors Service. With somewhat uncertain economic conditions in various international markets, this is expected to drive further domestic investment and consolidation.
- Credit Markets – Although the Federal Reserve likely will start gradually raising interest rates in 2015, the credit markets remain wide open with traditional banks and alternative nonbank financing providers aggressively seeking opportunities to put capital in the market, including via M&A transactions. This relatively “cheap” and plentiful source of money for investors allows 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’re essentially in the fifth year of that cycle, which would indicate another expected 12- to 24-month window for this overall positive M&A environment.
- Retiring Baby Boomers – There have been an estimated 10,000 baby boomers reaching retirement age every 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 be considering 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 potential slowdown in China, a stagnant Eurozone, rising interest rates and a strengthening U.S. dollar that could 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’s strong competition for quality assets as strategic corporate and private equity firms continue seeking deals to fuel growth and deploy capital. This activity is further enhanced by record low interest rates and the 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.