M&A activity should remain strong in 2018 and perhaps get a push from federal tax reform.
As well, rising interest rates should not pose a barrier to deal flow, although most companies — whether on the buy-side or sell-side — face a key challenge with finding skilled talent.
That’s according to a group of M&A advisers that MiBiz gathered for a roundtable discussion on the state of the deal-making market in West Michigan.
Participants in the roundtable were:
- Mike Brown, partner with Charter Capital Partners, a Grand Rapids-based investment banking firm
- Jason Byrd, co-founder and managing partner at Concurrence Capital Holdings LLC, a Grand Rapids-based private equity firm
- Jeff Helminski, managing partner at Grand Rapids-based Auxo Investment Partners, a private equity firm
- Rajesh Kothari, managing partner at Cascade Partners LLC, an investment banking and private investment firm based in Southfield
- Remos Lenio, partner at Grand Rapids-based Tillerman & Co., an investment banking and merchant banking firm
- Matthew Miller, managing partner at BlueWater Partners LLC, a Grand Rapids-based investment banking and consulting firm
- John Pollock, managing director of LV2 Equity Partners LLC, a Grand Rapids-based private equity firm
- Peter Roth, partner at Grand Rapids-based Varnum LLP, which sponsored the discussion
Here are some highlights from the discussion.
How was dealmaking in 2017 and what do you see ahead in 2018?
Helminski: For Auxo, it’s been a great year. (Auxo made) two platform investments with three operating companies under it (and there are) just a couple slots left in the fund before that’s closed. (We) got the office done, got the team coming together with a few hires. We’re ahead of schedule on the year in terms of where we expected we’d be. (There’s) a lot of momentum going into 2018 and we’re feeling really good about where we’re at as a firm.
Lenio: 2017 was strong for us. We’ve seen a lot of opportunities out there and we continue to see a lot of opportunities. I guess we’re a little worried what’s going to happen to interest rates. Is that going to impact pricing? Is that going to impact our ability to finance deals? We just kind of want to see what’s going on, but there are a lot of people chasing a lot fewer deals. There are a lot of people chasing the really good deals and sometimes I wish I was a seller.
Kothari: There was a little bit of hesitancy in the market, I think, as people are trying to figure out what’s happening with the new administration. Are they going to be as aggressive? Are they going to be as revolutionary (with) policy? So I think we saw a lot of folks dragging out their process and their decision making. I think the biggest element is, you look at all the data, deal volumes were all down, but values were all up. So really, you’ve got a bifurcation of the market. If you had a really nice asset, everybody and their uncle is after it. And if it was in the middle of the road, you’d trade it but it wasn’t quite as crazy. We’ve seen that across the board in our client base. But as you look at the momentum that we see coming behind the second half of 2017, I think 2018 is going to blow away 2017.
You’re seeing still good growth. The only segment of the market you saw growth in was the middle market, which is where we all mostly play. Deal volume’s up, deal values were up, valuations are up. I’ve done this 20 years, I’ve never seen valuations like this.
Roth: The other thing I would lay on that is the approach to deals. I think people were more aggressive in the back half of the year. I think at this roundtable last year, I said I saw more people focusing on diligence, being a little more careful, a few busted deals, and people were still paying but they were being cautious (and) maybe a little nervous about where we were in the cycle. In the back half of the year, I saw that flip. People are being pretty aggressive.
You’ve got a lot of people out there doing deals who maybe haven’t done them as much in the past, so it’s almost a little sloppy. People are willing to differentiate themselves by cutting the diligence short, signing up for rep and warranty insurance and not requiring some backstop on the indemnity. So I think in addition to being aggressive on price, I would say (they’re being) aggressive on legal terms, aggressive on diligence.
Byrd: In terms of the year, we started in May and were able to get a deal closed in September, so we feel really fortunate about how 2017 is turning out. Momentum for us is turning pretty nicely. Getting that first deal done lends more credibility to the fact that we’re going to be here for a while.
Miller: Volume and valuations are up at all-time highs, at least post-recession. For our firm, it’s been a good year, a little bit better than last year. We’re really expecting more of the same barring material changes in interest rates (or) maybe a return of uncertainty.
Pollock: I feel the exact same way I felt this time last year and probably the year prior, and it’s only escalating. So valuations are really high, money is really cheap and easy. It’s hard to find good deals that we can justify the price that they’re wanting, which is why we’ve really focused on add-ons because we can make that make a little more sense and pay a little bit more for that if there’s some economies and so forth. Our constraints, without question, is people. … Being in mostly manufacturing platforms, it’s skilled labor. Operators, welders, those types of things. We’re feeling it. The pressure on wages is going up and we’re just searching for people.
Brown: It’s a great time to be selling your business. I think one thing we’ve seen this year is because we can get more aggressive on some of the legal terms … and with rep and warranty insurance kind of coming down market, it’s a little easier to close deals now than it was a handful of years ago. I even got a little higher hit rate on deals that were signed up now than three or four years ago. But like these guys said, we struggle for people — good, educated people with deal experience.
Was there any rush at the end of 2017 to get deals done?
Brown: We had the opposite. We have at least two deals right now closing in the first week of January.
Kothari: Everybody’s pushing. Everything’s going to stretch now because it’s going to turn to their favor, so everybody’s pushing deals out after the first of the year.
Why are sellers pushing deals into 2018?
Lenio: Lower tax rates.
Kothari: In general, the seller’s got a propensity to want to close it after the first of the year anyway because then they’re not paying taxes until 16 months later, but when we were going into it, it was, ‘Well, taxes are going to go down, how exactly are they going to go down, and how it’s going to play out no one knows, so were going to defer.’ Now that it’s coming out, it looks like it’s still going to be — in every way, shape and form — advantageous to stretch it out into January.
Pollock: We had a deal last December. It was under LOI in December 2016. We were moving forward with it and the seller completely took it off the table. December ’16 was right after the election, and his logic for it was, ‘Well, tax rates are going to go way down. So buyers should be able to pay a bit more for this business.’ It’s back now. It’s back on the market.
How could tax reform affect the M&A market?
Byrd: It probably depends on what part of the market you’re playing in. Anything sub $30 (million) in revenues, I don’t think there’s going to be significant changes, at least from an interest deductibility perspective. So the way we do our valuations, it’s probably not going to change all that much. The way we’re going to do depreciation is similar.
Lenio: Sellers are going to get a nice increase in their value. And you’re buying a stronger cash flow stream because not so much goes to Uncle Sam.
Kothari: I don’t think it’s going to change in terms of profitability of companies. It’s going to change because there’s going to be more certainty in the marketplace. There’s going to be stronger economic growth, because people are going to have more dollars, in theory, to spend. You’re just going to have this spin-up. The question is, does that actually push people to say, ‘OK, now it’s time for me to sell?’ Because the problem today is there is plenty of money. There are not enough quality deals out there, because people are surprisingly not bringing their businesses to market — despite crazy, crazy valuations. Now (with) a lowering tax environment, it’ll be interesting to see do people actually come out and say, ‘OK, now it’s time for me to retire.’
Roth: And they’ve been in a boom M&A market for five, seven years. So I don’t see people making that life-changing decision because of things any of us are talking about.
Lenio: The last four or five transactions I’ve seen, they were all 70-plus sellers, age-wise. They were all being sold for health reasons.
Brown: The reason why they were successful business owners is because they liked working. It’s hard to convince those people who like working to stop working.
What are you seeing with clients in the marketplace?
Kothari: We’ve done really steady, modest growth, and no one is getting over their skis. Folks go from 5 percent (to) 10 percent growth to 10 percent (to) 15 percent growth. That allows you to change your valuation expectations if you think that growth is sustainable. Whether you think it’s sustainable or not is a whole other court. People are already having some pretty nice growth because we are seeing an increasing number of folks coming to us saying, ‘I hear valuations are really high, I think it’s time to look at it.’ They’re in their 40s and 50s, they’re not planning on going anywhere. But they’re hearing more and more of this talk and they’re starting to explore and they’re starting to open the dialog.
Helminski: We see a lot of opportunistic sellers, the 48-year-old guy who suddenly had a bump up in profitability and said, ‘Oh, the timing is right.’ What we tend to see is a lot of companies that I think are not terrific companies where owners are saying, ‘Wow, if the market looks like this and I just got this little (bump), I never imagined I could get this much for my business. I’m cashing out now.’
Miller: Everybody’s talked about talent. We all know for years, all of our clients and portfolio companies are struggling to find people. On a recent client transaction, the buyer is a fabricator of different plastic and metal products, and they acquired a tool and die shop because they want to control the supply. They do some of that themselves, but they need to expand the capacity, and specifically their human capacity. So it’s not necessarily bricks and mortars, but the skills. The skilled trades seem to be struggling to find people to enter those (careers).
Is the talent shortage more apt to make somebody buy?
Brown: It’s about what they’re looking to buy. Why we’re seeing an uptick in technology and capabilities, whether it’s automation or other technology, is because they’re not going to get the growth if they’re trying to drive the same amount of man/machine ratio that they’ve had historically. Is it more apt to make a seller come to market saying, ‘I don’t want to deal with this constant recruiting.’ Maybe they sell to somebody who’s better at that.
Kothari: We’re doing a deal exactly because that’s the reason, right now.
Brown: That owner is saying, ‘I’m great at building this widget, but I’m not great at hiring 15 people every year and I’ve got constant turnover. So I’d rather bring in somebody who can help me do that and let me focus on whatever I am good at.’
Helminski: What we see specifically at Bernal, our company in Rochester Hills that’s a machine and tool maker, is the key piece of the labor force there, guys are starting out at 24 bucks an hour: You don’t just go to the market today and find those people and hire them. You’ve got to train those people internally and that’s not a six-month training process. It’s a big commitment if you’re going to say, ‘I’ve got that kind of a business and I’m going to grow it.’ You’ve got to be thinking about the long term. If somebody says, ‘I can’t go find (the talent needed) in the market anymore,’ now you’re talking about two or three years before you can ramp up (and train people), maybe (they) just call it a day.
Is the talent situation affecting deal flow?
Kothari: I would tell you it’s a peripheral factor, it’s one of the elements when the operator gets to the point and says, ‘I’m done.’ (It’s not a factor when someone sees) an interesting market opportunity and (says), ‘I want to go see what I can fetch.’ For the guy that says ‘I’m done’ — it’s a contributing factor, but it’s never the (only) factor. This isn’t a new problem. … It’s been happening year after year after year, and it gets harder and harder. It’s frustrating, but it isn’t the one that’s putting them over the edge.
Miller: I think on my side it is driving deals in a couple ways. The search to acquire talent is, in addition to technology and customers and products, sort of rising in terms of reasons cited for acquisitions. But it’s also automation. We’re seeing a lot of activity in automation. In part that’s driven by a lack of skilled labor, on one hand. On the other hand, I think it’s driven by innovation and automation and the opportunity to automate a plant and increase productivity and take people out, to either eliminate cost or not have to hire them.
What is the rising interest rate environment going to do to the market?
Pollock: I feel the same way I felt two years ago. Whether your federal funds rate is zero or three (percent), it’s immaterial. It’s got to get a lot higher before I feel it does anything of substance to deals or financing. I think we’ve got a good way to go before we feel the effects of that.
Byrd: At the end of the day, probably the more relevant data on the debt financing is the flexibility, less about the rate. As long as I’ve got availability and time to pay it off, you don’t care as much about the rate. You want flexibility.
Helminski: We make that trade off in just about every deal we do. I’ll trade rate — at least in today’s environment — for amortization, for flexibility, for availability.
Kothari: But the low rates are creating part of that flexibility. We have the catalyst for that rate level that could be problematic two and three and four years out. You have far stronger economic growth in Europe than you did a year ago driving economic growth. When you layer it on with the tax cuts, I think … two to three years out, we’re going to be in a place where that interest rate is going to matter, and some of that flexibility that we’re getting today is going to disappear. At 7, 8, 9 percent, some of these alternative lenders aren’t going to make sense anymore.
Pollock: I think it hits the peripheral companies first. Those are that are over-(leveraged) and distressed as it is now, they’ll feel the effect first and you’ll see fallout from that before it hits the deal market in a big way.
The push into the lower middle market by private equity buyers has been discussed here and reiterated by national surveys over the last year. What’s driving that activity?
Pollock: That’s where the opportunity lies.
Kothari: It’s a numbers game. There are way more deals.
Brown: These guys that are professional owners and buyers, there’s things that they can do to a lower-middle market business that an entrepreneur has never done. ERP systems and things like that have never been implemented into a lot of these businesses. When you’ve got a $300 million business that’s already been owned by an institutional owner once or twice, those things are already done.
The general feeling is for a continued strong market in 2018. What could happen that would throw a wrench in things?
Helminski: Some shock to the system that has nothing to do with the fundamentals of the economy.
Brown: It’s something political or a bad actor in another government that would really throw us for a loop.
Kothari: I think the end of ’18 and starting into ’19 and ’20, there might be more (issues with) market fundamentals.
Roth: I think it’s hard or impossible to figure out what will turn this around. A lot of the things that we’ve talked about today — high valuations, lack of diligence — all of these things set up (and) somebody gets left holding the bag. When it cycles around and there’s a lot of fundamentals that are out of whack, then it’s going to be ugly.
Lenio: There is kind of a scary underlying feature out there: There’s no experienced bankers left in the market. I mean who knows what that’s going to do to the banks and how far do they pull their horns in.
Kothari: Most of the lending, the capital raising we’re doing: Banks aren’t who we’re going to because they’re stuck in their three-by-four box. They can’t be flexible and creative, which is what these guys are looking for. The non-traditional lenders, they’re coming down and they’re being incredibly flexible, incredibly creative. The last bunch of deals we’ve done have all been with non-traditional lenders.
Brown: We just had lender presentations on a deal and four of the lenders I’ve never heard of. They’re specialty lenders.
Pollock: There’s a lot more non-traditional players in the market now then there were in ’06, too.
Kothari: But how fast do they dry out? When rates go up, they’ll dry out.
Brown: But they provide flexibility. A lot of them are industry-specific. They really can get into a specific deal with a private equity group that invests in an industry over and over again. They have relationships with these specialty lenders.
Other than sellers wanting more money, what are you seeing creeping into the demands they’re making?
Roth: Speed, certainly. Lack of diligence, lack of skin in the game after the deal. So I mean guys I’m talking to that are selling, they want to close quickly, they want light diligence, they don’t want to hang around and pay indemnity.
Kothari: Rep and warranty insurance has gotten so much cheaper that you can actually use it. Both demand and the ability for the buyers to satisfy the demand is kind of a nice convergence.
Is there ever an earnout in any of these equations anymore?
Roth: Only in small deals, from my experience.
Helminski: In the deal we closed before Thanksgiving, there’s a two-piece earnout that’s 10 percent of the total valuation. The owners are totally out and it’s performance-based.
Miller: We’re seeing fewer seller notes and earnouts, which we’ve never liked to begin with. There are more alternatives in terms of buyers, financial buyers and institutional investors. I think there’s greater flexibility, whether management stays or not. A lot of our clients are interested if it’s a financial buy, one that’s not going to flip it in just a few years. So with family offices and other types of institutional investors coming into the market, it’s given them a lot more alternatives. So I think there’s just a lot more flexibility, which is being driven by the competitive nature of the M&A marketplace and a need to differentiate.
Byrd: In my mind, I think it really just comes down to maybe the size of the transaction. In the lower, very-low end of the middle market, I think earnouts are probably still pretty routinely seen. There are just fewer and fewer options for some of these other non-commercial bank lenders, so the only way to bridge some of these differences in valuation are really to work into some of the seller financing. This isn’t every case, but I think they still are happening in that under-$30 million range.
Are more family offices coming into the market?
Lenio: They’re quiet, and they’re hidden.
Kothari: We see them all over the map, but they’re doing it while looking more like a traditional (private equity) fund, more organized and more professionally done than historically.
Miller: My sense is that they may not be reaching as far as equity groups. They’re still getting their feet wet and they’re probably a little more conservative. They’re private, they like to keep things quiet, but they’re probably not getting as much done.
Brown: Family offices are traditionally more regionally focused. A couple hundred miles from wherever they’re located, that’s where they want to buy businesses. A private equity group will go anywhere in the world.
Kothari: I think the private equity guys have a need to deploy. The high-net worth guys and family offices are like, ‘We’ll buy smart. We’re in the market.’ … And they’re selling a very different story that has some appeal to some sellers.
Brown: When you find a family office that made their money in an industry and you have an asset for sale in that industry, they’ll pay just as much as a private equity group. They know it better than anybody else.
Are they any more flexible in terms and in how they put a deal together?
Brown: No, I think they’re willing to take less risk usually.
Helminski: I see a lot of interest and a lot of talk about it. I don’t see a lot of execution from the family offices. I’ve talked to some people that are the sort of CIOs for family offices and they’re having trouble pulling the trigger. Some of it’s valuation. I think it’s a function of valuations in general are up and that gives them pause, but I think you see a lot of family offices that are looking for a deal. That’s hard to build a business if your investment thesis is ‘I’m looking for a deal.’ In today’s environment, that’s almost impossible.
Pollock: But then they don’t have the same pressure to deploy money.
Kothari: The challenge is the market is getting more efficient the farther you go down. It’s far more efficient in the lower middle market than it was 10 years ago. As a result, those guys are getting tossed out of the process much faster. It’s pretty rare that we’re even having a conversation with a fundless sponsor and letting them in because you don’t need to.
Give us a prediction for 2018: What’s going to surprise us?
Brown: I think one industry where we could see some issues is automotive. I’m not sure that’s turning in the right direction right now. But it’s not going to fall off a cliff.
Kothari: I think the economy will be much stronger than people expect next year. I think we’re going to be surprised with the upside.
Helminski: I would say if you want to pick something more micro or more industry-specific for a surprise for most people, I would say keep an eye on health care. I don’t know if it’s the next 12 months, but certainly in the next 24, and maybe it goes as long as 36 months, we’ll see some financial stress in health systems. I don’t think a lot of people sort of understand the behind-the-scenes there. There’s some buyers that are going to be buying into companies that service that health care space that are going to be surprised when they see hospital consolidation and hospital closures.
Kothari: But I think the activity is not happening in the hospital sector in the health care world. Where the market was down overall, health care deals were flat this past year, and I don’t think that trend is going to change. The big bets are being made in technology and health care. I don’t think that’s going to change next year.