One of my favorite explanatory images is “the dog that didn’t bark” — Sherlock Holmes’s key to solving a mystery by paying attention to what didn’t happen as well as what did. As readers of GF Data’s most recent report may appreciate, the dog that didn’t bark is an apt metaphor for middle-market deal activity in the year to date.
For the fourth quarter of 2012, the 183 private equity firms that are active contributors to GF Data reported 92 completed transactions in the $10 million to $250 million Total Enterprise value (TEV) range. This groundswell of activity — clearly driven by individual business owners anticipating increases in federal tax rates — did not carry over into the early months of 2013. For the first quarter of 2013, the same universe reported 14 deals.
Financial buyers and other deal professionals seem to agree that M&A activity is picking up, but that the traditional markers — economic growth, key sector strength, corporate performance, public stock prices, capital available to buyers — still suggest a market more vigorous than the one we are actually experiencing.
Why is deal volume continuing to lag? I’d submit that the dogs not barking — the deals not getting done — are a big part of the answer. These deals have been subject to two influences, the first easier to measure than the second:
1. The transient effect of tax-minded sellers not able to close by year-end pulling their businesses from the market once the anticipated benefit of a pre-year end closing was lost; and
2. The ongoing effect of more business sellers walking away from transactions where initial indications of value satisfactory to them were reduced by prospective buyers following due diligence
Let’s measure the first then talk about the second.
Since the middle of last year, we’ve been asking private-equity buyers to identify the nature of the selling entity as individual/family, PE/financial or corporate. As one would expect, the preponderance of individual/family sellers jumped in the fourth quarter, presumably reflecting concerns about expected increases in federal tax rates.
Prior to the fourth quarter, these non-institutional sellers accounted for about 59 percent of deal volume. For the fourth quarter, it was 78 percent. At the same time, overall multiples fell from the mid-to high sixes earlier in 2012 to 6.0x trailing twelve months (TTM) adjusted EBITDA in the fourth quarter.
In our report, we described this as “buyers’ tribute” — concessions extracted from sellers unwilling to jeopardize closing before year end. We believed — and continue to believe – that aggregate valuations have not declined, and that the market for desirable properties remains quite strong. This is confirmed by valuation data for the first quarter. Valuations on businesses sold by individuals and families continued to slide to an average mark of 4.9x, while the average for companies with corporate or private equity sellers improved to 7.1x.
So — confronted with the external consideration of expected tax changes, it looks like non-institutional business sellers fell into one of three groups:
1. Sellers who got deals done by year end and accepted modestly lower pricing overall as an offset to the tax benefit;
2. Sellers with weaker business prospects (in aggregate) who did not get their deals done by year-end, but closed in the first quarter and accepted markedly lower pricing; and
3. Sellers with stronger business prospects (in aggregate) who didn’t close by year-end, pulled away from the market, went back to building business value, and are not reflected in our data.
In the absence of a countervailing incentive like avoiding tax increases, individual business sellers are much less likely to reduce their valuation expectations.
This brings us to the second group of non-barking dogs — sellers whose deals are getting priced up in the early stages and then falling apart when the business owners refuse to accept post-letter of intent adjustments in purchase price.
As we all know, individual or family business owners are better armed at the front end of the sale process than they were five or ten years ago. They are more likely to be represented by intermediaries and have more access to information that — on point or not — frames their thoughts on value.
So, the result of a competently managed process is often a sweetened initial valuation, but also a sharper incentive for financial buyers to make sure that the business is as advertised once they are in later stage due diligence.
Many of us have seen this film before. The buyer has completed its quality of earnings analysis or other due diligence, identifies reductions in EBITDA or other concerns, and is prepared to proceed, but only at a lower valuation. The ensuing discussion between investment banker and client is never a good one. Emotionally, the client wants to tell the buyer to go pound sand, or words to that effect. If the short-term situation for the company and the owners can support it, they often will.
The standard of practice in the advisory end of our industry needs to change, and it is. Steve Brady, Grant Thornton’s partner in charge of transactions services says, “Over the past year or two, we’ve seen an explosion in more sell-side due diligence being undertaken earlier. It’s now individually owned businesses as well as the PE-backed companies.”
Better M&A practitioners are bringing preemptive due diligence and valuation defense onto an equal footing with front-end marketing and stimulation of initial indications of interest. We will see whether completed deal volume picks up, with the narrowing of this disconnect as a contributing factor.
Andy Greenberg is CEO of GF Data and Managing Director of Fairmount Partners, an M&A firm. Both are based in West Conshohocken, PA.
(c) 2013 PEPD * Private Equity’s Leading News Magazine * 6-10-13