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Middle Market Business Insights

At 2013 year-end, middle market M&A had matched expectations, but failed to surpass 2012 levels. According to data provided by S&P Capital IQ, activity fell last quarter for transactions involving companies in the sub $250mm revenue range. Aggregate transaction value (ATV) was halved with over 133 fewer deals, leading to a 12 percent drop in average deal value. Deal volume was picking up in December, having risen in count by 15 deals over November yet fourth-quarter figures were hardly on par with historic performance. ATV and deal volume were down 23 and 12 percent, respectively, from Q3 2013, with activity noticeably lacking during November and December. Figure 1 displays total U.S. middle market deals by quarter over a three year period. Deal count for Q4 2013 was a mere 216 deals closed, extending the decline that began in August. On a year-over-year basis, volume shrunk by 38 percent spread over 14.1 billion in aggregate transaction value.

Amidst a downturn in PEG activity, many companies began strategic integrations in 1H 2013 as a way to foster top-line growth. Ironically, pressure to endow capital from aging funds has forced PEGs to reenter the fray. Excess cash continues to drive demand with over $328bn idly housed in PE funds. Potential sellers, by contrast, are less desperate; having themselves weathered the storm of PEG inactivity. With the cost of debt at record lows, those choosing to accept offers are enjoying unusually high EBITDA multiples. Overall, the market is continuing to take on bullish characteristics. The low price of debt financing has also proven useful for recently integrated companies. This, coupled with sales growth, has helped label these pairings as a success. However, abstinence is becoming less of an attractive option for would-be sellers as the market slowly normalizes.

State of the Economy

In the U.S., a majority of bond categories inched into the positive following the announcement by the Fed to extend quantitative easing at its current level. Late-cycle pressures have rarely been seen as of late. Basic supply and demand analysis suggests the housing expansion is likely to continue. Weak employment and low income growth have capped inflation, though upside risks to oil prices may loom and fiscal policy challenges remain. In the U.S., mid-cycle expansion remains resilient, though maturing with only moderate growth. The Fed’s near-term intentions are less than clear, but monetary policy is likely to remain easy.



As for core spending activity, retail sales were much better than expected, revised to 0.7 percent growth. This was the largest increase in the past ten months, exceeding the forecasted 0.1 percent. On the other hand, job growth was less than stellar, owing primarily to the inclement weather that struck during the holidays.

Inventories also posted positive growth numbers rising 0.6 percent in November and 0.3 percent in October. This will likely lessen the negative effect of inventories on GDP as a measure of economic improvement. Good performance in the stock market may have added to the rush by swelling household wealth.

Gross domestic product (GDP), is forecast to accelerate at a 2.6 percent growth rate in the first three months of 2014, unchanged from previous estimates. U.S. GDP growth during the recovery, underway since the middle of 2009, is among the weakest in recent history, averaging a little over 2% for the past four years, well below the previous long-term trends of 3% to 3.5%. The fact of the matter is, economic activity has been hampered tremendously since the financial crisis by a political gridlock, With the potential shutdown affecting GDP in Q4, the delayed Omnibus legislation put a damper on economic growth, in addition to speculation about the Fed’s quantitative easing and incoming Federal Reserve chair. The outlook appears range-bound amid slow, incremental growth, and high policy uncertainty.

M&A Market Activity

Temporal Trends

Fourth quarter middle market activity experienced a 38% decline in volume year-over-year. This drop off is detailed in Figure 2, which also highlights the disparity between 2011, 2012, and 2013 results.

Aggregate Transaction Value, too, was down in every month this quarter. Figure 3 shows the magnitude of the downturn; the average decline in total deal value over the past three years was 32%.

Average Transactional value for Q4 2013 was up 9% over 2011 in December, but down 17% from 2012. Deal count was trending upward in December. Given historical performance, the outlook for Q1 2014 is good; 2013 deal activity peaked in January with 97 deals closed.

Geographic Distribution

  • Figure 4 shows the distribution of M&A activity by U.S. region across time
  • In terms of deal count, California, New York, Texas, and Florida were the most active states, hosting 136, 79, 73, and 56 transactions respectively.
  • Year over year, deal count fell in New England and the Midwest but rose in the West Coast and South by more than 10%.
  • By state, Iowa, Maryland, Virginia, and New York had the highest average deal values. Maryland and New York also had high average EBITDA multiples for the quarter.

Industry Analysis

  • Particularly high valuations were seen in the internet software and services sector, which yielded an average 11.9x EBITDA multiple for Q4 deals.
  • Average industry EBITDA multiples ranged from 3.4x in healthcare facilities to 15.5x in communications equipment.
  • Already accounting for a modest percentage of activity, the middle market for telecommunications companies has continued to shrink in the wake of recent consolidations.
  • The US output for healthcare, a sector that includes physicians, dentists, hospitals, home healthcare, nursing homes, and daycare services, is forecast to grow at an annual compounded rate of 6 percent between 2013 and 2017, according to First Research. With the effects of the healthcare reforms looming, financial buyers are still reluctant to commit to full-scale acquisitions.
  • Communications equipment space is undergoing moderate expansion, set to grow 4% at an annual compounded rate. Giants like Microsoft are seeking to expand smart phone operations, and the Federal Communication Commission (FCC) made a May 2013 announcement that up to $485 million would be made available for fixed broadband expansion into rural areas.
  • Figure 5 outlines the top fifteen performing sectors in M&A by deal count. With the exception of aerospace and packaged foods, the most active sectors continue to fall into healthcare, information technology, or banking spaces.

Deal Structure and Financing

Private Equity was well represented in Q4 activity; 68.6% of all buyouts and 47% of all acquisitions under $25mm in the middle market were by private equity firms. Availability of debt contributed to the highest EBITDA multiples in a decade but such leverage is increasingly less popular in small transactions. Even so, many funds are set to expire and need to invest inactive capital.

Equity proportions of financing steadily increased from Q2, while non-senior debt continued to shrink. Overall, deal structure has relied less on debt, leading to speculation about resurgence in Private Equity participation. Having attempted to weather the storm of government policy and tax upheaval, many funds remained sidelined in recent periods. Now, PEGs are beginning to compete for attractive deals as the clock winds down on their stockpiles of dry powder. Middle market PEG activity increased over last quarter, adding 3.4% to its proportion of deal volume. For others, turmoil in healthcare and government policy reforms was the force behind a growing interest in outbound activity.

To bring matters into focus, however, it must be noted that strategic buyers (i.e., corporations) accounted for well over 90 percent of deal volume in each of the last three years. Be that as it may, there is growing interest in the sector from private equity funds which will generate greater demand for deals, thus prompting an increase in opportunities in the marketplace.

Fundraising was at multi-year high; the average fund size increased and it only took 9.9 months to close them on average. New funds posted some impressive gains during the year; there were a total of 34 funds sized at $100mm or less that were closed in the first three quarters of 2013. Moving forward, platform type transactions are waning in popularity. Owing to less risk and complexity, add-ons and acquisitions involving a minority stake are rising in prominence among private equity firms. Focus has shifted towards growing revenue and operations, as opposed to relying on arbitrage or financial engineering. The add-on deals are typically small in size and require less effort to kick start the assimilation process. The aggregate effect of these is a contribution towards the prevailing perception of risk reduction.

With funds competing for the most reputable deals, others are also turning to recapitalizations as a way to free up liquidity until the market stabilizes. In accordance with the predilection towards add-ons and minority stake deals, a significant portion of PEGs are utilizing less leverage in deal financing. As a result, lenders are also competing for a smaller client pool. Lower middle market deals are being marked up; closing the gap in valuation spreads. Some IT companies were selling for amounts in excess of 13 times EBITDA.

With regard to debt markets, the resilience of firms issuing senior debt has put the squeeze on mezzanine lenders. Low rates coupled with strong efforts by senior lenders has afforded them precedent over considerations of sub-debt. Side by side, debt financing in the upper middle market was only 4 percent shy of its lower middle market counterpart, which was roughly 3% less than the historic average. Figure 6 shows the average debt to equity breakdown for private equity deals. Although one would expect firms to utilize debt while rates are low, the proportion of equity in financing deals has actually been growing.

Representative Transactions

Industry Analysis

The following transactions were representative of the deal activity that occurred during the fourth quarter of 2013.

  • Curtiss-Wright Controls, Inc. acquired Parvus Corporation from Eurotech SpA for $38 million in cash on October 1, 2013. The consideration of $38 million is debt free. In 2012, Parvus had revenues equal to $20.19 million and EBITDA equal to $4.86 million.
  • The Arlon Group entered into definitive agreement to acquire 50.97% stake in Alico Incfrom Atlantic Blue Group, Inc. for approximately $140 million on October 17, 2013.
  • Innotrac Corp. and Sterling Capital Partners IV, L.P. entered into a definitive merger agreement to acquire Innotrac Corp. (NasdaqCM:INOC) for approximately $110 million in cash on November 14, 2013.
  • 3PD, Inc. acquired the membership interests of Optima Service Solutions LLC from A-1 Home Services, Inc. for $26.6 million in cash on November 13, 2013. The consideration is excluding any working capital adjustments and with no assumption of debt. Optima had revenue of $35.7 million and adjusted EBITDA of $3.7 million, respectively, for year ended October 31, 2013.
  • Miraca Life Sciences, Inc. acquired PLUS Diagnostics, Inc. from Water Street Healthcare Partners for $83.1 million. Miraca Life paid a purchase price of $83.1 million including repayment of debt. PLUS Diagnostics reported revenues of $75.4 million in 2012.

2014 M&A Outlook

Even in light of discouraging year-over-year comparables, the outlook remains positive for the first quarter of 2014. Companies are being valued higher than in previous periods, so all hope is not lost. With interest rates in a favorable spot, the current debt and equity markets are still a hotbed for a surge in middle market activity. But with the Fed beginning to slow its bond repurchases, this type of interest rate environment can only last so long. M&A will continue to stay on the radar for companies looking to grow revenue, and create value in the long-term. The most notable indicator of a coming improvement is the rise in valuations among companies in the sub $100m range. This is a definite sign of PEGs’ deal sourcing and pipelines stabilizing as they move to act on their aging stockpiles of funds.

One critical issue is the partisan gridlock that has plagued Washington and the nation in the recent past. This has been the driving force behind many of the detrimental trends in M&A. Another factor is the fragmented nature of certain key industries. As a case in point, the sector posting the highest EBITDA margins was also one of the least centralized; the 50 largest information technology companies accounted for only 40 percent of all revenue. Key drivers of growth include a heightened focus on data security and the proliferation of wireless devices. US computer and data processing services are forecast to post growth in the range of 4 percent compounded annually. General trends towards Business Process Outsourcing will bring many companies to market as they struggle to compete.

In a survey of 145 C-level executives conducted by KPMG, approximately three-quarters anticipate their company will make an acquisition in 2014, compared to approximately half in 2013. The same study recorded that 77 percent believe that deal activity will take place in the lower middle market ($250m and below). Investment and commercial bankers are proclaiming the strength of the market, but it doesn’t take a wealth of expertise to recognize that there are still arresting forces at work; tax and policy upheaval have placed a damper on activity on both the buy and sell side of M&A. However, anxious PEGs and strategic buyers will likely skew average multiples even higher as they vie for particularly attractive deals. Sales of quality assets are drawing interest from a significant number of private equity firms, especially U.S.-based firms. Private equity firms are doing what it takes to win competitive auctions and gain an advantage in this environment, including by building deep sector-specific expertise in-house. The presence of U.S. financial buyers in Canada will also continue to influence deal financing terms, as acquisition financing takes cues from the United States.

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