Middle-market dealmakers have been extremely active for the last year and a half. In the first three months of 2015, they completed 542 mid-market transactions worth a total of $70.8 billion, according to data from Thomson Reuters. That's pretty much on par with the $72.5 billion of transactions that closed during the first three months of 2014, which was a record-breaking year for M&A. Additionally, dealmakers remain bullish about what's on the horizon for the industry. Numerous factors that have led to such a robust M&A market: macroeconomic conditions are strong, consumer confidence reached a 10-year high in the first quarter, interest rates remain low, private equity firms have a record amount of dry power available for investment and leverage is easy to come by. (See related graphic.)
Most experts predict these terrific dealmaking conditions will last through 2015, but they certainly won't last forever. Now is the time to get the deal done before conditions change.
"It's a tremendous time to be doing M&A. We have had the highest deal volume levels since 2007," says Michael Hogan, a managing director with Harris Williams & Co. "It's a great market, but conditions like this don't last forever."
The number of companies in the middle market has grown tremendously during this period, which is also driving M&A activity. There are more than 3,300 private equity groups today, increased from just over 1,800 in 2004, according to Pitchbook Data.
This growth has fueled private equity deals in the middle market, which increased 162% between 2004 and 2014. Private equity firms are certainly happy about the robust conditions. "We have seen more opportunity in the last 12 months than what we have seen on average in each of the last five years," says Scott Edwards (pictured), a managing director with Sun Capital Partners.
Here are some themes having a positive impact on dealmaking today.
A HEALTHY ECONOMY
Although the economic recovery progressed in fits and starts, the economy has finally stabilized. Gross Domestic Product grew at an annual rate of 3.2 percent in the fourth quarter of 2014, and the final six months of 2014 was the strongest second half since 2003. A big driver of GDP growth was a rise in consumer spending, up 3.3 percent in the first quarter of 2014, the fastest pace in three years. These strong conditions tend to make dealmakers more comfortable in both the private and public markets. In fact, the public stock market hit a record high in April, both for the Nasdaq and the S&P 500 benchmarks
"We've had multiple years of recovery now, so the outlook is optimistic and people on both sides of the table are confident in transacting. Additionally, with better conditions, there is more of an appetite to harvest investments, and buyers and sellers are finding a middle ground on valuations to get deals done," says John Cochran (pictured), a managing director with Lovell Minnick Partners, a private equity firm based in Radnor, Pennsylvania, and El Segundo, California. The firm has been taking advantage of today's strong dealmaking environment. In April, it led an investment of more than $100 million in LSQ Funding Group, an independent financing firm. In March, the firm invested in J.S. Held LLC, a specialty advisory firm that provides outsourced services to the insurance industry.
"For those deal teams looking for a favorable economic environment, now is a great time. Our deal flow quality improved markedly as the economy stabilized," says Cochran.
AVAILABLE DRY POWEDER; MODEST CORPORATE DEBT
Plentiful dry powder and modest levels of corporate debt are also spurring deal activity. North America alone has $535 billion of uninvested private equity capital. Globally, that number was estimated at $1.1 trillion in the beginning of 2014, according to Bain & Company Inc.'s Global Private Equity Report 2015. Even as private equity firms found ways to put that money to work, they refilled their war chests and topped out with $1.2 trillion by the end of 2014. Needless to say, private equity firms are aggressively looking for places to put their capital to work.
From a corporate perspective, debt on the balance sheets is modest, shareholders are looking for growth, there are more companies for sale and corporates are in deal mode. Strategic buyers closed 1,251 middle-market deals valued at $144.4 billion in the first eight months of 2014, up from 1,157 valued at $129.3 billion during the same period in 2013, according to Thomson Reuters.
"Three years ago companies were still grappling to be in a place where they were showing strong growth. Today, the growth is there and strategics are active," says Hogan.
LOW INTEREST RATES; AVAILABLE LEVERAGE
The capital markets remain strong, which is bolstering the deal environment. "While the capital markets are as strong as ever there is more scrutiny on banks doing deals with more than 6x leverage, it's still a very strong financing market. The financing conditions are favorable with limited covenants. This is pushing up purchase price multiples," says Hogan. "The cost of debt remains cheap, so private equity firms are able to get great financing terms. Leverage is the highest it has been since 2007."
According to data analyzed by S&P Capital IQ through the end of 2014, private equity firms paid an average of 9.7 times a target company's trailing 12 months' Ebitda, almost matching the historical highs in 2007. The average multiple was up from 8.8 times Ebitda in 2013. Additionally, average debt levels of deals were the highest they've been since 2007 for both larger and smaller companies: 5.9 times and 5.1 times Ebitda, respectively, through November 2014.
Specialty lenders looking to gain market share -- as traditional banks have pulled back on their leverage lending business -- have been aggressively lending for M&A transactions. Nonbank lenders lent the lion's share of total loans issued to private equity-backed companies in 2014, accounting for $252.8 billion, or 87 percent, of the $291.1 billion in total loans, according to S&P Capital IQ.
"M&A is being driven by the availability of capital and the high supply of leverage," says Cochran, who says this environment has made it a great time to be a seller as well. In March, Lovell Minnick sold Mercer Advisors, an investment adviser company, to San Francisco-based Genstar Capital, after a seven-year hold period.
Dealmakers are also enticed to transact while interest rates remain low. The low interest rate environment is allowing private equity firms to refinance their portfolio companies, take capital off the table and provide some liquidity. There were 77 bond and loan dividend recapitalizations by private equity firms last year valued at a combined $33.4 billion, up from 55 recapitalizations totaling $17.7 billion in 2011, according to Dealogic.
Dealmakers realize that interest rate hikes are on the horizon, which will have an impact on dealmaking. "We believe that if interest rates rise toward the end of 2015, the cost of borrowing will increase and, as a result, lower multiples will be paid on deals," says one respondent to Mergers & Acquisitions Mid-Market Pulse, a barometer of sentiment analyzing the M&A landscape, sponsored by McGladrey.
Hogan agrees that the change in interest rates could be coming. "The Fed has come ever closer to making that shift, but since we have been in a downward interest rate environment for 10 years, which has been a remarkable period of cheap capital so even if they go up 100 basis points it's still an attractive proposition," says Hogan.
BUYERS WANT TO CLOSE DEALS QUICKLY
In addition to the favorable market conditions, the general evolution of the marketplace has created efficiencies that make it easier to complete deals rapidly in today's market. "The shift is driven by technology and the maturity of the marketplace," says Hogan. For example, although virtual data rooms have been in use for at least two decades, how they are used today is very different than how they were used in the past. The quality and breadth of information shared has expanded. This is a result of financial sponsors leaving virtual data rooms intact throughout their investment period.
"This allows the process to begin much quicker," says Hogan. Additionally, sellers are sharing more upfront, often including accounting and industry reports as well as access to management, encouraging buyers to make decisions earlier in the process, which often saves money and time.
These progressions are something Sun Capital's Edwards appreciates. It has always been the Sun Capital position that it's best to move quickly and not get hung up when closing a deal. "In general it's good to move quickly through a transaction. We work through due diligence and negotiations typically within 30 days. We have done it in less than two weeks," says Edwards. One reason is the concern that company management may become distracted by an extended sale process. When management is distracted profitability starts to decrease.
"We don't over-negotiate. Our objective is to acquire a business and we are decisive. We let it be known what we can and can't do, and we maintain a level of flexibility throughout the process," says Edwards, who adds that moving quickly is not only good for the buyers, but also for the sellers who can become weary when a process drags out.
"One trend we have seen is the importance of certainty at close, and the desire of buyers to curtail the duration of their due diligence and loan syndication timing," says David Brackett (pictured), CEO of GE Antares, told Mergers & Acquisitions in an interview.
"Buyers want to close quickly, and that is a differentiator for them in a sale process. Purchase prices are high, and as opposed to having to pay absolute top dollar, some buyers are finding they are able to buy at a slight discount based upon speed and certainty. A long, frothy process involving many different bidders provides an opportunity for the seller to pit one against the other for a long period of time, versus a buyer just locking up the deal and saying, 'I'll take this off your hands, you don't have to worry about financing and I can close in 30 days.'" GE Antares, a unit of GE Capital Sponsor Finance, may benefit itself from the trend. General Electric (NYSE: GE) announced in April it would sell GE Capital, and many sources expect GE Capital Sponsor Finance to be sold separately and quickly.
IT'S NOT 2008, BUT GETTING CLOSE TO THE TOP?
Most dealmakers believe today's environment is healthy--that the industry has learned from its mistakes and will not repeat its 2008 collapse-- but that they could be getting close to the top. "The economy fell so far and so hard during the great financial crisis," Cochran says.
"This recovery has been extended and it hasn't exhibited the characteristics that led to the global financial crisis. There is some over-heating today and some industries will experience more pain than others, but generally we don't see the same broad-based sloppiness that existed then. That said, we are many years into the recovery, and we are certainly sensitive to the risks of being at the top of the cycle."
According to Bain & Company's 2015 PE report and the National Bureau of Economic Research, the longest post-1926 economic expansion in the U.S. lasted 120 months. As of January 2015, the U.S. economy was in its 68th month of expansion. There have only been five expansions longer than 68 months. "We could be nearing the top, and firms need be ready for that too," cautions Edwards.
The fact that the market could be approaching its peak pushes dealmakers to get deals done while these conditions still exist. "We have been doing this through a lot of cycles and we know that these conditions don't last forever, making this a great time to transact. That said, we also don't see anything on the horizon to give us cause for concern. We expect these conditions to last at least until the end of the year," says Hogan.
-Allison Collins contributed to this report.