What Is the M&A Market Telling You?
Author: Matt Klauser
In January 2015, the Alliance of Merger & Acquisition Advisors 2015 Winter Conference hosted more than 350 private equity (PE) investors, investment bankers, attorneys, lenders and other consultants. After several private meetings with other attendees and listening to panel discussions, one takeaway was clear: The level of due diligence is increasing in transactions. Buyers are conducting more detailed due diligence—sometimes by choice, sometimes by requirement—prior to signing a definitive agreement.
Why the Increase?
According to the February 2015 edition of Mergers & Acquisitions, middle-market transactions in 2014 totaled $315.3 billion, more than any year since 2007. Deal volume consisted of 2,303 completed transactions—125 more than in 2013. Middle-market deal activity benefited from improving economic conditions and credit availability.
Along with improving economic conditions, PE groups had a very successful fundraising year in 2014. According to the 2015 U.S. PE Breakdown report published by Pitchbook, 90 percent of PE fund closings hit their targets in 2014—the most in the last decade and significantly higher than the 79 percent and 69 percent rates in 2013 and 2012, respectively. These funds raised $189 billion during 2014, bringing the U.S. PE capital overhang to $535 billion, as shown in Figure 1 below. The increased demand from the capital overhang has been one factor leading to increased multiples on middle-market transactions over the last several years, commonly expressed as transaction enterprise value (TEV) divided by earnings before interest, taxes, depreciation and amortization (EBITDA), as shown in Figure 2 below.
The increase in TEV/EBITDA multiples has put more pressure on PE investors to select the right investment opportunities at the right price. The need for increased confidence in expected investment return, in turn, has led to increased due diligence. To properly model the business, PE investors need a thorough understanding of how the company makes money, which requires more than just a spot-check of historical financial information.
Rather than simply using due diligence to confirm the seller’s historical financial statements, our buy-side clients are consistently requesting help in understanding how the seller makes money through an in-depth analysis of the seller’s key performance indicators. In the past, a customer or product line analysis completed during due diligence only may have consisted of a sales report automatically generated from the seller’s financial reporting system. However, during the past few years, our buy-side clients have requested margins at these levels as well, which is often not provided by a system-generated report.
Rather than settling for the common seller response of “I can’t generate those reports,” we work with the seller to extract source data from various systems, allowing us to uncover and deliver seemingly inaccessible information to our clients. The raw data can be used to develop a variety of insightful metrics across multiple industries. Recent examples include:
- Analyzing the bill of materials for a manufacturer, which, when combined with sales and purchase order detail, allowed us to track raw material costs through finished goods and compute product profitability
- Using employee payroll and time reporting details for a service company, allowing us to calculate employee utilization and project profitability, which could then be summarized by customer, location and project type
- Evaluating fixed-asset detail and invoice register for an asset rental company, which allowed us to present revenues by asset number and category as well as equipment utilization and payback period
Sellers can proactively prepare for increased buy-side due diligence by evaluating key performance indicators before a buyer approaches them. This allows sellers to not only share their story, but also supplement it with meaningful supporting data. Increased due diligence frequently leads to more questions—both in volume and depth. Sellers prepared to answer the tough questions and provide data to support their responses can distinguish themselves from unprepared companies, which could affect their valuation and transaction closing time. When preparing a company for a transaction, the seller needs to remove its owner-operator hat and begin to “think like a buyer.”
For more information on these topics, contact your BKD advisor.