Mergers and acquisitions professionals tend to rave about how 2015 was a spectacular year for their practices.
By all accounts, 2016 should shape up as another strong year, particularly as banks compete for deals and private equity firms still have plenty of dry powder to deploy. Also bolstering the current market, at least for sellers: Corporate balance sheets remain healthy, and valuations should continue to hold steady at their current elevated levels.
But when asked for their forecast beyond this year, industry professionals MiBiz gathered for a roundtable discussion on M&A say their view is foggy at best. As such, they said the window of opportunity for sellers could start to close in late 2016.
Participating in the roundtable were:
- Erik Daly, partner at Barnes & Thornburg LLP
- Dustin Daniels, partner at Miller, Johnson, Snell & Cummiskey PLC
- Brandon Finnie, managing director at Hungerford Valuations
- John Kerschen, managing director at Charter Capital Partners
- Gary Lewis, managing director at Cascade Partners LLC
- John Porterfield, regional president at Comerica Bank
- Peter Roth, partner at Varnum LLP
Here are some highlights from the conversation.
What’s the lay of the land for M&A from each of your perspectives?
LEWIS: Starting in kind of the late fourth quarter, I would say we started to see a little bit of pullback in the middle market, in pockets — not a broad-based pullback. Valuations still remain, on a relative basis, strong. We still think, at least for the first half of the year, that’s going to continue. As the election comes up and the kind of geopolitical things continue to play themselves out, I think you’re going to see some pullback that is potentially a little more meaningful. … Comparing it back to 2007, I think buyers are still a little cautious. What we’re seeing is very competitive deal dynamics, but buyers are more picky. I will say we’ve had attempts at retrading in valuation, as well as the deal terms — more often than I’ve seen in my entire career.
DANIELS: As a seller, the market is really strong right now. Our advice is, ‘We don’t know how much longer it will last. So if you’re going to do it, do it now. Don’t waste any time.’ That hourglass could be getting pretty short and maybe you are out of time. On the buyer side, I think you should be cautious and have a good thesis and strategic reason to do the acquisition because you’re going to probably have to pay a pretty good value to be competitive with this competition.
FINNIE: That sums it up. The biggest thing we’ve been seeing is an abundance of buyers and not as many sellers. That’s kind of what’s driven multiples recently.
ROTH: I think it’s not a bad time to start thinking about buying. It’s still strong, but we’ve seen some softening. As that softening continues, if you just start (the process of looking for targets) then, you might miss out on that first wave of opportunities.
KERSCHEN: With the amount of capital that’s still out there in the marketplace, even if the economy comes down, it’s still going to be providing a bit of a floor for the valuations. Private equity still has the capital. They still need to get it deployed. They’re still going to be searching for places to give it.
PORTERFIELD: We seem to have noticeably fewer customers thinking of selling right now. Obviously, a lot of them had been in that mindset and a number of them sold the past two or three years, but if they haven’t sold by now, I think they’re starting to maybe think about waiting. There’s a lot of strategic activity going on, people trying to round out their capabilities or their business model. There are some minor recaps going on, minority shareholders getting bought out, that kind of stuff. There are some good multiples, but I’m just not seeing a lot of our customers thinking of selling right now.
DALY: I’ve done a lot of work for a corporate client who does not need to sell. They have plenty of cash, but they have a recognition that this is a great time to sell non-core businesses. They see that it’s a great environment to get a great valuation on a deal, because there’s still capital being invested. They don’t have to sell, but it’s a great time to explore if they’ll get a premium for something that they don’t necessarily view as essential for their long-term strategic vision. For me, that’s provided some sort of sell-side deal work, and private equity is usually on the other side of that.
Will companies continue harvesting cash from assets that they can sell off or will that slow down this year? Is this being driven by any tax fears related to the next election?
DALY: I don’t know that that will be the principal driver. I think the more important driver (for a slowdown) would be that the demand on the buy-side would not be as robust a year from now. This is the right time to set aside the tax consequences because there’s a lot of buyers who see the window closing for this robust deal period.
When you run into a corporation that says, ‘Let’s sell this business unit,’ are they selling it because they can get some cash for it or are they selling it for the strategic aspect that it doesn’t fit into to their mission?
DALY: Some of both. Specifically for one large client I’m thinking of, it’s sort of a corporate-wide mandate that all business units consider because of the deal environment. Are there non-core segments of what we’re doing where we could realize a good multiple in this environment compared to holding them and … continuing that strategic investment long-term?
PORTERFIELD: I’m kind of hearing in your question, ‘Are people looking to increase liquidity, raise cash?’ We’re not seeing that at all, just because of so much cash that has been raised due to strong operations. I don’t see anybody concerned about their liquidity in just selling a piece of business to raise cash in our customer base. I think if they have assets they don’t need and could do something with that cash to invest in other parts of the business, they’re certainly going to do that. But just to raise cash, I don’t think so.
One PE executive told us recently that the firm has started to see a wave of privately held businesses coming on the market right now and that trend usually signals the end of a hot market is nearing. Is that a marker you’re watching to gauge when the elevated activity could be coming to an end?
LEWISL It feels like that’s been kind of going on. The things I’d point to would be more global — things like China, geopolitical issues. The equity market’s been decently volatile. In the second half of the year, the fixed-income market was choppy at best. You’ve had a pullback in the high-yield market that drives large finance, which is really helping for the last five years to drive the M&A activity. I would point to those factors more than the business owners.
DANIELS: Our work at Miller Johnson is busier. We’ve seen more distressed deals. … I think it is poor credit, not being able to refinance. We’re seeing a decent amount of that. Also, banks are being aggressive. There’s some commercial banks being very aggressive. So, you start seeing all these little checkmarks and you start thinking about (the end of the hot market).
KERSCHEN: We’ve got one going on now where they’re a performing business, but senior lenders decided it’s time for them to find the right market. I don’t know if you’d call it distressed necessarily, just time to move to a new source.
Why do you think the banks are passing on certain clients?
KERSCHEN: I think it’s lenders changing their profile of what they’re interested in. They’re less aggressive in this region than they used be. I think it’s bank-driven.
DANIELS: It’s not like we’re having a huge spike. There’s a few more than there has been the prior few years.
LEWIS: I’ve heard from other firms across the region (that the) work-out teams within the law firms and the broader restructuring of firms is starting to pick up pace, which presents interesting buy opportunities as either a private equity investor or maybe a corporate strategic. There’s relatively clean balance sheets and relatively low rates and it provides an interesting buying opportunity. (With) the commercial banks, what’s happened in the credit markets since ’08 is that there’s been an abundance of capital that’s come in to the private credit funds that are not regulated in the traditional FDIC sense. The box that they’re operating in is much different from traditional lenders. That’s provided flexibility and aggressiveness. As a consequence, the traditional lenders are trying to be a little more aggressive and that may be having an impact ultimately on some of the work-out for corporate practices.
If you have clients who wants to sell this year, what are you telling them?
DANIELS: I think it depends on what industry you’re in. Automotive’s interesting as far as the feedback we’ve had in the market. There’s a lot of concern about where we’re at in the automotive cycle from buyers. Health care seems to be stronger. Energy is probably unique.
ROTH: Even in a down industry, if you have a client come and say they’re going to sell, you have to look at their business. You have to get them ready to sell, so there’s a lot of front-end work. People think, ‘Oh, I’m just going to pull the trigger and go out in this hot market and do a sale.’ You’ve got to look at their industry, their business. … It can take some months to really get them in a place where you can take them to market. The front-end work and running a competitive process is something I always talk about.
FINNIE: Talking about that from a valuation standpoint, which is where we play, it’s not likely to get any better. For the most part, it’s about as good as it’s going to get from a valuation standpoint. (Valuations) could stay flat for some period of time.
What does the front-end work look like?
ROTH: It’s making sure the corporate structure is right, especially if it’s one of these non-core assets. I’ve got a deal that we’re just kicking off now and we had to do a spin-off and get those non-core assets in a separate legal entity so we could do stock deals and have a better tax impact. (It’s also) making sure the contracts are what they are. There’s just a lot of things to get cleaned up so you can have a nice package to go out to market with.
LEWIS: The biggest thing we’ve seen is typically around the accounting. It tends to be a large driver of the valuation process for obvious reasons. What we’ve really been guiding people toward is proactively doing a Quality of Earnings analysis upfront — engaging an outside accounting firm that’s not your firm doing your review or your audit. Really dig in and make sure the books are in order and that you’re identifying and anticipating those issues. … What we’re trying to do is proactively anticipate issues. Some of it can be contracts, some of it can be underdisclosed liabilities, but 90 percent of it is typically around accounting issues.
What size companies require this kind of attention? Are we talking middle-market and smaller?
ROTH: Throughout the middle market. It’s surprising how with significant companies, they’re busy running their business day-to-day, not necessarily dotting every ‘I’ and crossing every ‘T.’ If you go into a process, … it takes some time to get those things ready and in the right structure.
DANIELS: I think actually smaller opportunities need it more many times. Even if you have a company of $3 or $4 million, usually the people owning that and selling that — to them, spending a couple hundred thousand getting ready really shouldn’t make that big of a difference if they actually follow through on it. It’s going to be a big event for them, and usually those companies need it the most — the quality of earnings reviews. I always recommend it because I’m a big believer that you’re going to spend those costs either way if you go through with the transaction. … Would you rather be prepared and address the issues or get in the process and get caught with your pants down?
What other issues are you looking for in this pre-sale planning?
DALY: Just to speak on behalf of some of my trust and estate colleagues: For some people, it would’ve been nice to get a phone call 18 months ago because there are things you can do in advance for individual sellers to minimize after-tax impact. … Tax-planning strategies for generational issues, for charitable giving issues, those would be the main things. (It’s a challenge) when we come to our colleagues in the trust and estate planning area 30 days before a deal is going to close and say, ‘Hey, these particular clients are going to realize $60 million for this sale and they don’t have any estate planning documents in place.’ Or if they do, it’s from Legal Zoom or something. [Laughter.]
What type of client runs into those tax-planning issues?
DALY: It’s usually more for a new client who’s not been in this process before. They get into the corporate group because they’re selling a large company they’ve built up. They’ve put their life into building a business — they haven’t put their life into studying the tax code. Thinking about those things ahead of time can have a big payoff.
Given that the hot market is starting to peak and that it takes time to do the legal and tax and accounting reviews, how long should companies expect this to take, particularly if they need to fix something in their business?
KERSCHEN: It could be months, but it could also be years if there’s real structural problems in a company.
ROTH: I had a client a couple years ago, they got into the quality of earnings — which was a smart thing to do — but they found real problems that caused them to not be able to go to market. They’re going to market now, so it’s been two years. But if you get in there and identify some things you can fix, it could be a few months. So it goes back to each individual client.
DANIELS: It seems like if you do everything the right way and don’t have any major delays, six to nine months seems to be what I see, for the whole deal. That seems to be about the right target.
That’s all great insight on the sell-side. Flipping the question around: What are you telling buyers?
ROTH: You have to have a real good thesis for a deal. This is not a market where you can just go in and buy anything. You have to have a reason to deal. You have to be disciplined in your valuation, that you value the business as what it’s worth to you and not get that momentum where someone pulls you into the 15x (deal). Know what you’re willing to pay for it and stick to it and pass on a deal if it’s too expensive, realizing that there will be opportunities coming that are probably going to be cheaper if the first one doesn’t work.
KERSCHEN: There’s still a lot of pockets out there where deals are available, or at least business owners are receptive, but they’re not in a process. That’s really what the private equities are trying to take advantage of today with all the direct marketing that they’re doing. They’re trying to get to it before Gary or I get involved, in order to get in that one-off negotiating situation.
LEWIS: So they can pay 4x rather than 15x. [Laughter.]
KERSCHEN: If you are a strategic buyer, there are opportunities to root out deals that aren’t at the top of the market and you still get the benefit of credit score and the strategic opportunities.
DANIELS: I think another interesting dynamic is that the M&A market is so skewed by mega-deals. It’s not always a true indicator of most of our clients’ dynamic. The one demographic we have in West Michigan is a lot of companies that have aging owners. Even if the market doesn’t cooperate, at some point, they’re going to have to make some decisions. We have other factors that weigh into our market as well.
ROTH: Buyers who know that can get a little bit of an advantage, too. If you approach a family-owned business and you have a pitch about why you’re not a big bad private equity fund that’s going to gut your business, or you’re a local family office that’s going to take care of their business, it’s not going to move the needle on price a ton, but it can move it a little. It can get you that proprietary deal because the owner builds a relationship with you.
LEWIS: From a strategic buyer standpoint, staying disciplined with the valuation but also with the thesis, rather than letting the deal drive your strategy — you’re still being opportunistic but you’re staying close to your knitting. For the closely-held family businesses, there’s multiple options. So it’s not just, ‘Hey, I have to sell to a private equity firm.’
What are some of the other options out there?
LEWIS: Within the mezzanine and leveraged finance market, there’s been interesting recap opportunities to take advantage of that weren’t necessarily available even going back to ’07 in terms of the abundance and depth of capital. I think that creates an interesting opportunity to make it potentially a two-step exit process — as opposed to, ‘Hey, here are the keys.’
One of the main things that we heard at our M&A Deals and Dealmakers Awards last year was the importance of cultural due diligence. Is that something unique to West Michigan or is that across the board?
KERSCHEN: I would say it’s not necessarily unique. It is a characteristic of West Michigan but it’s in other places as well. I would say it’s also not uniform. There are business owners that say, ‘Give me that top dollar. That’s all I care about.’
ROTH: And that’s a question you ask on the front part of the getting ready process, understanding your client. Is that a big driver or do they not care?
DANIELS: I agree exactly with that. You could say it slides heavier towards that in West Michigan, but it’s not unique and it’s not the rule across the board.
LEWIS: Ultimately, this is somebody’s baby. The economics matter but ultimately, it’s the quality of the partner and not everybody wants the partner that shows up in the suit and the tie. … People in the Midwest want kind of a Midwest culture in approach and feel and fit. Valuation always has an impact, don’t get me wrong, but it’s also about (wondering if there are) going to be job cuts. What is the impact on the community? A lot of people live in that same community and whatever happens afterwards impacts their life.
How often do you see somebody walk away from a deal if they don’t have those cultural assurances?
DANIELS: You don’t usually get those assurances. That’s more of a judgment call. Owners, when it’s important, they make the best educated guess they can. Even then, your ability to see out is only a year or two. Who knows what happens three or four years down the road.
DALY: Those assurances: It’s on a handshake basis and understanding that things change.
DANIELS: No buyer’s going to agree to tie themselves up with those types of constraints for the long term at all.
KERSCHEN: I would say cultural issues might be where sellers change their mind. You sign the deal, the dollars look good, the courtship was great, and now you start digging into diligence. Oftentimes the seller’s books, their method of doing business, doesn’t quite meet the standard of the buyer. So the (seller) starts getting nicked and that’s where you start getting the change of minds. It’s not quite as fun to get grilled for 90 days by a bunch of accountants as when they said, ‘Your business is great! I want to pay you X-million dollars!’
LEWIS: The best seller is one that can walk away. It’s an emotional rollercoaster ride. One minute you have the best thing since sliced bread and 24 hours later, your baby is ugly. It’s really difficult to go through that process. … More times than not, if there is a small change in the deal dynamic, it’s the cultural fit or a little bit of seller’s remorse.
ROTH: If we’re all doing our job well, we’re talking to clients about that up front, telling them, ‘Listen, you’re having dinner at The Chop House and everything’s great and he loves you, but … his lawyers are mean.’ [Laughter.] … A lot of clients don’t hear it. All they see is the dollars and that the guy’s really nice to them while they’re having cigars. But walking them through real examples of how bad it can get is important.
KERSCHEN: It’s not unusual that you go through that (letter of intent) and they’re all competing, so they’re putting their best foot forward. I’ve had clients who basically come in and say, ‘You’ve got a great business! We love it! We’re not changing anything.’ That business owner just attaches to (the line), ‘We’re not changing anything … not a single thing, forever.’ And then they start going, ‘Oh, we’re going to change accounting, the name, let this employee go.’
With all the talk about needing to be very disciplined, does it get even more excruciating in periods like this at the peak of the market?
KERSCHEN: I think so. If we’re at the top end of the valuation range, we have to drill deeper as a buyer to make sure that deal pans out because you just don’t have any margin for error. It is more painful to the seller to go through that diligence.
ROTH: I think it swings both ways, though. It’s a competitive process. Some buyers have been light on the diligence. The good ones haven’t, but sometimes they drill down and are really careful and sometimes they’re like, ‘Hey, it’s a competitive process and we really want this deal. I’m going to gloss over some stuff.’
DANIELS: I agree. I think you should stress test the investment as a buyer. I don’t know if it’s more painful. It all depends on the circumstance, but generally, almost all the transactions, when done right, have the same level of diligence and pain.
DALY: One other constituency to think about, if you’re a seller or a buyer, is management. If senior management is going to carry over with a private equity buyer, for example, you need to factor in that they need to negotiate some equity arrangements with the buyer. I’ve had really good experiences with sellers who understood that and wanted to create a good strategic fit between management and the buyer. This gets into culture as well.
Economists are talking about how the window of the economic recovery could be closing in the next year or two. How soon until the flow of capital and credit starts to taper off a little bit?
PORTERFIELD: From a senior credit perspective, I don’t see any material changes in 2016. The one dynamic that will begin to become more apparent with some of the commercial lenders is Fed regulations in regards to high-risk borrowers and us having to allocate more capital to a high-risk borrower type of profile, if you will. … I don’t see it shaking the market, per se, but I think a lot of the banks will be a lot more conscious of that. They need to be.
What about for private capital?
LEWIS: From the private equity side, that money’s been raised and it needs to be deployed, so I think you’ll continue to see that occur. You’ll see a little bit of a more prudent touch to how they’re deploying that capital. But on the private credit side — whether it’s mezzanine, strategic cash flow — I think you’re already seeing a pricing increase transpiring in the market. That’ll have somewhat of an impact. But for 2016, I think that’s still going to be a strong market.
PORTERFIELD: You look at the PE that bought something in ’08 and had to hang on to it for six or seven years, rather than three to five years. They’re selling now. They’re coming back into cash.
If private equity starts to get more prudent, what will that mean for valuations?
DANIELS: I think the question is, ‘What do the credit markets do?’ I think that’s more of the driver than the valuation, being that that burner is softening. To stretch a valuation, they need the debt financing to be there to push the limit. One thing that will be interesting is if things soften, how much subsidizing in the credit markets will go on and what actions will be taken to bolster them.
LEWISL And the pricing effect that the non-traditional lending market is already starting to have, that will have an effect on multiples directly. At the same time, I don’t know that volume goes down 40 percent or something like that. It’s still going to remain, at least for 2016, a relatively robust market.
Is the movement in interest rates any cause for concern?
KERSCHEN: No. They’re still historically low.
DANIELS: If you look back at when the Fed increased rates back in the 2000s … this stuff doesn’t happen overnight. It seems to me that if it is going to happen, it’s going to take some time to work through the system. It seems like 2016 should be strong.
Let’s look at another indicator of the market: Are your M&A practices adding staff right now or are you sticking with the resources you have?
FINNIE: We’re growing right now. Definitely at an intern/analyst level is what we’re looking at right now.
DALY: We would like to add someone who’s got two or three years under their belt already and is ready to step in and work on current deals.
ROTH: We’d like to hire that same person. [Laughter.] For us, we felt like we under-hired when we were in the recession and we pulled back a little too much. As deals have been booming, we’ve been a little bit short-staffed. Now, even if there is a softening, a little more steady hiring at that two- to three-year level is important.
DANIELS: It’s tough in the M&A market for Grand Rapids. When it’s hot like this, there’s a lot of high-paying opportunities in Chicago and New York. I bet you that when the market adjusts, there’s going to be a lot of good people available from those (areas), because those bigger firms will shed more people than Grand Rapids firms. I think it’s going to be tough to hire a good, qualified person right now in this market.
DALY: You had much smaller classes of people who got the right experience and training because there wasn’t so much M&A activity in 2008-2010. They’re highly valued. They’ve put in their years at whatever firm it is in New York, Chicago, wherever else, and they’re more valued by their firms because they’re a small group of people who got very good experience during a time where there wasn’t a huge amount of deal activity. It’s harder to find that right person because there are fewer of them and they’re more valued by firms.
PORTERFIELD: We are hiring a new guy in about two weeks and it’s really because we’ve had very good growth and, not only that, but we see some continued growth this year and new opportunities.
How long does the current pipeline take you?
LEWIS: Twelve months. In general, we’ve been saying that there’s a 12- to 18-month window for the last 12 months. I’m being a bit sarcastic, but it is on a relative basis. We’ve had a fantastic 2015 and we’re optimistic about 2016 as well.
When you look at each of your practices, are you working with more sellers or more buyers in 2016?
LEWIS: We’re kind of seeing a third, a third, a third. So, one-third on the sell-side, one-third financing, and one-third buy-side.
PORTFIELD: I’d say we’re seeing more strategic buyers at this stage.
KERSCHEN: There’s still a lot more buyers in this market. There’s buyers everywhere, but our client base is more skewed toward the seller. That’s who needs the help and needs to create that environment to bring that funnel of buyers down to something they can work with.
FINNIE: We hear about a lot of buyers out there but our clients tend to be the sellers.
ROTH: It’s been an even split.
DALY: By dollar volume, larger on the sell-side. By number of deals, about 50/50.
DANIELS: We had more sellers when I added the numbers last year, but we’re seeing more buyer activity. It’s about evenly split, but I do think that buyer activity is going to be stronger. West Michigan clients are a little disadvantaged in the buyer market to get a deal closed. Our strategic clients are not as aggressive as out-of-market groups and such, so we don’t always get to a close from a buy-side unless it’s a great fit. I think that will change as the market softens.
KERSCHEN: People here tend to be a little more conservative and therefore we don’t go all the way to the edge.
What could kill the deal momentum this year?
KERSCHEN: Something that blows up in the Middle East. I think it would be geopolitical stuff.
LEWIS: I agree. Something on the mega-deal side, some of the stretch deals that could impact the credit markets — something like an Enron. The high-yield market has already kind of had a slow death and that will at some level trickle down, but I think the geopolitical risk is material. China’s economy has a little bit of an overhang and that’s probably an understatement.
What about the presidential election? Is its impact ho-hum at this point?
KERSCHEN: I think it’s actually a positive because you don’t tend to have any major political shifts in an election year, so there’s no new tax policy that’s going to come out this year. Everybody’s going to want a positive message. ‘We’re going to do greater things for your economy.’ They don’t come out with, ‘We’re going to raise your taxes.’
DANIELS: I agree. I think the real question is: Are the circumstances right to where, if we did have an event, would there be a setback? I think the answer is yes, but I think 2016 looks good right now.