By John Hammett, Managing Director
Minneapolis Office, Corporate Finance Associates
The lost years of 2008, 2009 and 2010: As most private company owners know directly, or have heard from their customers, suppliers, bankers, advisors and friends, the opportunity to sell private companies has been challenging since the ’08 financial market meltdown. Over the last two years, the business climate was marked by declining sales and earnings, evaporating bank credit and poor visibility into future business conditions. Company owners had little confidence in projecting demand, capital availability, government regulation and taxes.
Because trailing earnings is the largest determinant of current sale value for private companies, savvy owners stayed away from actively looking for buyers until the future became more positive and more predictable. Many advisors to owners recommended waiting to sell companies until earnings had begun to recover and the outlook became more stable. The result is that deals for companies valued below $50 million slid from more than 1,000 transactions in 2006 and 2007 to a rate of less than 500 deals expected in 2010.
The accompanying chart divides deals by the type of buyer. Financial buyers buy private companies as investments and help them grow to be re-sold later to industry buyers or large financial buyers. Strategic or industry buyers acquire private companies to expand their business into new products, markets, technologies or geographies. The black line shows the percentage of deals that are made by strategic buyers. While overall deal activity has declined in the last three years, strategic buyers have maintained a higher level of activity while financial buyers have pulled back more. The reason is that industry buyers find value in the strategic fit and they understand the industry better. Financial buyers are more dependent on historical earnings and less comfortable taking industry risks.
Deal Overhang: Before the economy softened, deals in the under $50 million range averaged close to 1,000 transactions per year. This was a consistent level supported by the natural flow of companies sold so owners can retire, or sold because they were worth more to an industry buyer than to the individual owner. Compared to the average deal volume in the four years prior to 2008, this decline left some 1,200 fewer deals done.
These deals that need to be done represent owners who would otherwise have been actively in the market to sell between 2008 and today. In fact, as more baby-boomers approach retirement age, even more deals will need to be done in the next decade. The overhang left over from the last three years will add an extra boost to the deals that will be closed by financial buyers and strategic buyers. These 1,200 unsold companies represent an overhang of more than two years of deals completed at the rate that was averaged over the last three years. This means that there will be an increasing supply of sellers coming to the market. The next question is whether there will be buyers for those owners who want to sell as the economy begins to stabilize.
Capital Overhang: If the supply of sellers is building, what does the supply of buyers look like going into 2011? The answer is that the demand may be even more significant than the supply of sellers coming into the market. There is a capital overhang that far exceeds the supply of companies that will be taken to market in 2011. This capital has three components:
- Over the last three years, financial buyers have accumulated uninvested capital of $500 billion. This represents two and a half years of fundraising for these investment firms.
- Non-financial companies have been hoarding cash too, and are ending 2010 with more than $1.8 trillion in total cash on their balance sheets.
- Over the last two years, banks have accumulated nearly $1.2 trillion of cash on their balance sheets. This is $900 billion more than was available to lend to buyers at the end of 2008.
The combination of these three large pools of capital indicates a huge amount of money waiting to fund the next wave of company buyouts. Private equity buyers will team up with bank lenders to complete private company acquisitions. Corporations will tap their cash reserves to acquire companies that add value to their strategic objectives.
Likely Scenario for 2011: During stable market conditions, most private company deals are valued between four and six times trailing earnings. However, the overall supply of companies for sale and demand for acquisitions from financial and strategic buyers plays into the valuation of transactions. Clearly, the $3.2 trillion (yes, trillion) capital from investors, lenders and corporations will drive demand.
This is good news for company owners who are slowly re-entering the market to sell their companies. With capital overhang that exceeds two years of historical investment, multiple buyers with substantial resources will be bidding for companies to acquire.
The extra good news is that this kind of supply – demand imbalance creates a seller’s market where, at least in the early stages, more money will be competing for the few sellers that come into the market early in 2011. The historical data of the most recent seven years shows that deal multiples rise as deal flow increases. It has been falling over the last three years. When the capital overhang comes into play, it is likely to drive up valuations for the private companies that are being acquired by those with the capital. The implications are that private company valuations will recover from an average of five times trailing earnings by 10% to 20% to reach multiples in the high 5.0x range. Of course, there is a wide range in these valuation averages. Individual companies’ valuations are always ultimately dependent on the buyer so some valuations can reach up into the 7.0x and 8.0x ranges.
NOT ON OUR DISTRIBUTION LIST?
If someone forwarded this newsletter to you and you would like to
continue to receive future issues, please
sign up now.