On the heels of a robust merger & acquisition (M&A) environment for U.S. middle market companies in 2014, measured by both deal volume and transaction value, here are some trends and conditions expected to continue into the new year and drive a continued 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 the last 11 years in the third quarter of 2014, with gross domestic product increasing at an annual rate of 5.0 percent. While a majority of economists forecast a moderate slowdown going into 2015, broad consensus remains for expected growth of 2.5 percent to 3.5 percent in the coming year. The U.S. stock market also continues to perform well, with the S&P 500 remaining at or near record highs, leading to optimism and confidence among corporate executives and investors eager to pursue strategic M&A.
· Consumer – With nearly two thirds of the U.S. economy driven by domestic consumer spending, the state of the consumer is paramount in determining outlook.
o While some market participants point toward an uneven recovery, there is no denying the level of employment in the U.S. continued improving in 2014. The unemployment rate dropped to 5.6 percent after nonfarm payroll employment rose by 252,000 jobs in December, according to the U.S. Bureau of Labor Statistics. Job gains were driven by professional and business services, construction, food services, health care and manufacturing. Manufacturing added an average of 16,000 jobs per month in 2014, compared with an average gain of 7,000 jobs per month in 2013.
o According to the University of Michigan Survey of Consumers, consumer confidence in December 2014 reached its highest level since the last peak in the cycle was reached in January of 2007. According to the report, “Consumers held the most favorable long-term prospects for the national economy in the past decade,” driven by widespread gains in jobs, wages and the recent tailwind of significantly declining energy prices. Overall housing starts and values also have begun to recover, adding to the overall “wealth effect” and positive outlook for the U.S. consumer.
· Manufacturing – According to the Institute for Supply Management, the December 2014 Purchasing Managers’ Index (PMI) stood at 55.5 percent, a decrease of 3.2 percent from November. However, this indicated that economic activity in the sector grew for the 19th consecutive month and further capital spending will contribute to economic growth going into 2015.
o Companies in the manufacturing space continue to garner strong acquisition interest from strategic and financial buyers alike. From a private equity (PE) perspective, valuation multiples for middle market manufacturing businesses have returned to levels not seen since 2007—an average 6.2x Enterprise Value/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.
· Abundance of Capital
o PE investors in the U.S. middle market invested approximately $385 billion in 2014, an all-time record high. 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 timeframe in which to invest this capital, PE firms will continue to be active and competitive buyers in the market.
o Nonfinancial companies, i.e., potential strategic acquirers, now have approximately $1.5 trillion dollars 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.
o Credit Markets – Although the Federal Reserve likely will start gradually raising interest rates in 2015, the credit markets remain wide open with both traditional banks and alternative non-back 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 is allowing buyers to finance acquisitions at valuation multiples higher than what otherwise would be viable.
· M&A Cycle – Historically, there has been a roughly seven-year M&A cycle in the middle market. We are essentially in Year Five of that cycle currently, 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 are not 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 both strategic corporate and private equity firms continue to seek 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.
Tony Giordano, President, BKD Corporate Finance, LLC, firstname.lastname@example.org
Jeff Johnson, Vice President, BKD Corporate Finance, LLC, email@example.com
This article is for general information purposes only and is not to be considered as legal advice. This information was written by qualified, experienced BKD professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult your BKD advisor or legal counsel before acting on any matter covered in this update.