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Capital Ideas for Middle Market Businesses

Middle Market Business Insights

This year has been very active in all aspects of the financial universe and M&A has benefitted from climbing valuations coupled with surprisingly cheap borrowing costs. One year further out from the great recession and things are slowly looking up. The S&P has reached new heights and investors can’t find a reason to quit buying. Deal activity is firing from the lower middle market all the way up to the mega deals which have dominated headlines. So far 2014 has provided solid returns in almost every asset class and private equity firms have taken advantage of buyers’ appetites, pushing to exit investments they’ve held onto since before the height of the financial crisis.

M&A activity has been on the rise for the first half of 2014, with the $1,571bn total aggregate transaction value representing an increase of 56% from the same period in 2013. There were 76 deals with transaction values between US $2-10bn, the greatest number of large bracket deals since the second quarter of 2007, according to a trend report by Merger Market. Also, Merger Market mentions the number of mega-deals during the Q2 of 2014 increased to ten deals worth approximately $311bn, the most since Q4 of 2008. Compared to the same time last year, total aggregate deal value has increased 98% in the United States and 56% worldwide. Highlighting global M&A activity, Cross-border deals increased 107% against the 1st half of 2013.

State of the Economy

The first half of 2014 has been quite exciting for the economy and financial markets alike. Equity markets have reached all-time highs and while the threat of an end to the easy money policies of recent times seems eminent, markets don’t seem fazed. The unemployment rate in the United States dropped to 6.1% in June, the lowest since 2008. Unemployment has continued to track down and according to data reported by the investment firm CBRE Global Investments, "employment is projected to increase 1.5% per year over the next five years." Even with employment rebounding and the GDP growth rate for the United States projecting at almost 3%, inflation remains around 1% and is projected to stay in the 1-3% range for the next few years.

The Federal Reserve has wound down their bond buying to $35bn per month and it is widely expected that they will end their five year bond buying spree following their meeting in October. Although this historic increase in the size of the Fed’s balance sheet seems to be coming to a close, the Fed will need to determine whether the US economy is healthy enough to go it alone, which is still unconfirmed. While the Fed is set to end QE quite soon, bond markets which seemed poised to raise yields in anticipation of the Fed’s actions have kept yields low and 10 year treasuries have actually shown substantial gains since the start of the year. In January, when the yield on 10 year treasury bonds was around 3%, it was a consensus between many leading economists that the yield would increase to well over 3% by years end. But much to the contrary, yields on 10 year T-Bonds have declined to under 2.5% for the entire month of August and reached 2.35% on August 29th. Unexpectedly, 30 Year US treasuries have returned 17% so far in 2014 while some treasury indexes are up 25% or more from the start of the year.

Although the end of the Fed’s QE program is still expected to push borrowing costs up sooner rather than later, markets seem poised to not let that get in the way of the party. With yields unexpectedly low at this stage, credit markets are providing the ammunition to keep deal flow active and should keep M&A activity strong throughout the remainder of 2014. Yields could still jump later into the quarter, but that has yet to be seen.

Representative Transactions

Middle Market Deals

  • On June 27, 2014, the engineering and construction company MasTec, Inc. acquired Pacer Construction Holdings Corporation for approximately $210 million in cash. The deal is said to be paid with $126 million in cash and it is assumed $87 million in debt, coupled with a five year earn out.
  • Holiday Inn and Suites Milwaukee Airport Hotel was purchased from Magna Hospitality Group, L.C. by Waramaug Hospitality LLC for $7.7 million in cash on June 25th. The hotel is expected to remain under the Holiday Inn brand.
  • WEK Industries, Inc. was acquired by Toledo Molding & Die, Inc. from Myers Industries Inc. The transaction was completed on June 24, 2014 for $19.5 million.
  • On June 22, Virdia Inc. was purchased by Stora Enso Oyj from Khosla Ventures and other minority shareholders for $62 million. The deal consists of $33 million in cash and $29 million that is subject certain milestones paid upon completion by 2017.
  • Valeant Pharmaceuticals acquired ECR Pharmaceuticals from Akorn, Inc. on June 20th for $41 million in cash certain liability assumptions. ECR was acquired through the acquisition of Hi-Tech Pharmacol and is expected to be a synergistic fit with Valeant.
  • MHS Capital and Crosscut Ventures Management, LLC and others sold Pulpo Media, Inc. to Entravision Communications Corporation, a Spanish-language media company, for $18 million on June 19, 2014. The offer includes a $15 million initial cash payment and up to approximately $3 million in contingent earn out payments based on specific performance criteria.

Highlighted Mega Deals

  • Comcast Corporation acquired the renowned cable company Time Warner Cable Inc. for $68.5 billion USD on February 13. The takeover of TWC by Comcast highlights the upsurge in deal activity occurring in the telecommunications sector so far this year. The offer price was listed at $158.82/per share USD, which is approximately a 17.4% premium of its closing price of $135.31 on February 12, according to a report by Merger Market Group.
  • AT&T Inc. acquired DIRECTV for $65.5 billion USD on the 18th of May. Another mega deal in the telecommunications sector which accounted for $230 billion USD in total aggregate deal value.
  • The cross border takeover of the Irish healthcare company Covidien by the giant medical device maker Medtronic Inc. for approximately $43 billion spearheads the surge in M&A activity for the healthcare sector. The acquisition lends Medtronic more fire power to compete with Johnson & Johnson for the lead spot in the medical device industry.
  • The Canadian based company Valeant Pharmaceuticals International Inc., acquired a 90% stake in Allergen Inc., a US company. This $45.9 billion USD mega deal, which occurred on June 18, is representative of the up-tick in cross-border deal activity which was prominent through the first half of the year.
  • Facebook Inc., who has been very active in the deal market this year with a number of large scale acquisition topped off their buying spree by acquiring WhatsApp Inc. on February 19th for a total deal value of approximately $16bn. According to a report by the Merger Market Group, Facebook’s average deal size so far in 2014 is $3.6bn USD, while 2013 it was $34m and in 2012 its average deal was approximately $226m.

M&A Market Activity

Private Equity Activity

With global market conditions ripe for private equity firms to cash in on their investments, exits continue at an exasperating pace on all fronts. Contrary to the usual climate, IPO’s, sales to strategic buyers and other PE firms are all hitting at the same time, which is just another example of how ripe this market seems to be. According to a report by the research firm PitchBook, exits for 2014 are on pace to easily reach an all-time high, eclipsing the $307 billion worth of exits in 2012. The ratio of PE exits to new acquisitions is just over 2x and represents the lowest number for that figure in almost a decade.

Compared to Q4 of 2013, deal volume totals in the United States declined a bit in the first quarter of 2014 from $151 billion from 633 deals down to $108 billion from 589 transactions, according to the US Private Equity Breakdown provided by PitchBook. An increase in valuations has been seen through the start of the year that is thought to be the result of more add acquisitions, as platform opportunities have somewhat diminished. PitchBook cites that number of add-on acquisitions executed comprised 42% in Q1 this year, compared with 35% two years earlier. On the other end, platform transactions were down to 29% in Q1, a record low and a large decline compared the 38% recorded during the same period in 2012.

In the second quarter of 2014, PE deal flow declined 32% from Q1, which although is substantial, it did exceed expectations. EBITDA multiples in 2014 have averaged an impressive 11.5x, exceeding the 10.4x of 2013. According to a trend analysis constructed by the research firm PitchBook, PE activity continues to be driven by low borrowing costs and firms have recently increased leverage in their buyouts, while substituting cheaper senior debt for non-senior debt in executing transactions. EBITDA multiples for the overall PE purchasing rose from 6.6x in Q4 of 2013, to 7.2x in Q1 of 2014. Compared to the 4th quarter of 2013, middle market transaction multiples have increased slightly in Q1 of 2014 for deals between $25-250 million USD, but have declined for deals under $25 million from approximately 5x to 4x. PE firms have shown a renewed interest in high growth companies to since starting the year, with "80% of recent acquisitions were of companies experiencing revenue growth prior to investment", according to PitchBook’s report. While PE firms have been more attracted to high growth companies as of late, they are still haven’t been afraid to close transactions on struggling companies -- with 8% of companies acquired in Q1 having declining revenues. Although the number of companies purchased with declining revenues is down from 20% in Q4 of 2013, firms are still finding room in their portfolios for struggling firms. Private Equity groups have been closing transaction in a shorter time frame than previous periods, with transactions closing in less than five weeks eclipsing the 10% mark in the first quarter of 2014, which was almost unheard of two years prior.

Private Equity Fund Raising Highlights

  • Hellman & Friedman LLC have raised approximately $9bn for the Hellman & Friedman Partners VIII Fund -- Open date of April 17, 2014
  • Riverstone Investment Group LLC has raised $7.5bn for their Riverstone Global Energy & Power Fund VI LP -- Open date of May 27, 2014
  • Lone Star US Acquisitions LLC has raised $7.25bn for their Lone Star Fund IX -- Open date of January 8, 2014
  • Centerbridge Partners LP has raised $5.75bn for their Centerbridge Capital Partners III LP -- Open date of June 13, 2014
  • Natural Gas Partners LLC has raised $4.825bn for their NGP Natural Resources XI LP -- Open date of May 2, 2014
  • Blackstone Corporate Private Equity has raised $4bn for their Blackstone Energy Partners II Fund -- Open date of May 7, 2014
  • Lindsay Goldberg & Co. LLC has raised $4bn for their Lindsay Goldberg IV Fund -- Open date of April 2, 2014
  • Vista Equity Partners LLC raised $3.8bn for their Vista Equity Partners Fund V -- Open date of February 2, 2014
  • Thoma Bravo LLC raised $3.65bn for their Thoma Bravo Fund XI -- Open date of January 15, 2014
  • Welsh, Carson, Anderson & Stowe raised $3.5bn for their Welsh, Carson, Anderson & Stowe XII LP -- Open date of January 31 2014

Note: All Private Equity fund raising data is provided by FactSet

Industry Analysis

  • M&A activity has jumped considerably in H1 of 2014 compared to a year prior, seeing dramatic increases in all sectors except financial services.
  • Life sciences and healthcare have benefitted from the current conditions, seeing aggregate deal values increase almost 400% year over year, according to a report by Deloitte.
  • The technology, media & telecoms sector has been active throughout the year, competing with life sciences & healthcare for top benefactor.

Leading the M&A surge so far in 2014, TMT along with life sciences and healthcare have met expectations while the financial services sector logged unexpectedly low consolidation activity. Driven by converging technologies, cloud computing and data analytics, the TMT sector saw 18% year over year growth for deal volume. Some of the consolidation in the healthcare sector can be attributed to the leverage game being played out between big pharma buyers and producers. We are seeing insurance companies and hospitals teaming up to increase their leverage when making purchases and in response we have seen big pharma companies joining forces to level the playing field. The Industrials & Chemicals sector saw a large amount of activity to start the year with 200+ deals closed in North America during Q1 before declining slightly in Q2. Baring setbacks in the economy for the remainder of 2014, deal activity in the industrials and chemical sector should exceed 2013—driven by strategic acquisitions looking to increase economies of scale and improve efficiencies. Driving forces for M&A in consumer markets will most likely be attributed to consolidation of core businesses/competition, the search for customer growth, expanding into new geographic regions and the desire to implement new products and services inorganically.

Outlook for the Remainder of 2014

After a bustling first half of 2014, the third and fourth quarters portend to continue the active M&A climate. With leverage still considered cheap, large cash reserves itching to be deployed and the economy seemingly pushing forward, private equity and strategic buyers remain hungry for solid middle market companies with strong balance sheets and excellent fundamentals. Conversely strategic buyers look to use those inflated balance sheets to buy market share and expand capabilities.

According to a poll conducted by international consulting firm Deloitte, 40 percent of business executives surveyed identify North America as the top market to consider for mergers and acquisitions activity for the remainder of 2014. Reasons for the optimistic outlook included rising consumer incomes, job market expansion and improvements in consumer cash flow bolstering spending. As more middle market companies see continued top-line growth as a result of a rebounding economy, many owners that had been on the sidelines since 2008 are starting to test the valuation waters.

Since 2008, the bulk of North American middle market private equity groups have focused more on value creation within portfolio companies than building their platforms with add-on investments or ventures into new platforms. According to a report from financial news source Thomson Reuters, middle market leveraged buyout volume, referring to the private equity-backed segment of M&A, is projected to reach $15 billion in 2014, a significant uptick over $10.8 billion in 2013. A report from research firm Pitchbook, shows that add-on transactions as a percentage of total global buyout deals is up significantly over the past 24 months. This is reflective of private equity taking multiple small steps back into acquisition mode while at the same time staying true to the ideal of building up their platforms and boosting values for their limited partners.

Strong valuations could also be a trigger for private equity exits in the coming months. With nearly 18,000 companies owned by private equity groups – according data published by the Private Equity Growth Capital Council – now may be as good a time as any to provide their limited partners with a liquidity event.

Strategic acquirers, especially public companies exuding confidence as a result of soaring stock prices, have been heavily entrenched in deal activity with few reasons other than a major correction to slow them down. Nonpublic companies that may be mired in slow organic growth have also turned to M&A as a way to increase top and bottom line results.

One thing that could dampen the cautiously optimistic M&A environment would be the federal government increasing interest rates making heavily leveraged transactions a bit more difficult to get across the goal line. In June Federal Reserve Chairwoman Janet Yellen announced that rates will remain unchanged in the short term but could begin to inch up in 2015 and 2016. This, of course, could be another spark to ignite deal activity before the end of the year. Many buyers – especially on the private equity front – want to take as much advantage of the low of cost of money for as long as it lasts.

Another aspect that could slow M&A momentum is large political instability in the Middle East, which could lure the U.S. and Canada into extenuating circumstances. The historically fickle stock market balks at just about any international hiccup leading to far reaching economic ramifications. That coupled with economic uncertainty driven by issues such as the debt ceiling and capital gains tax fluctuations is enough reason to maintain a healthy dose of caution.

That said, there is plenty of reason to believe the second half of 2014 will provide a hotbed of middle market M&A activity based on the following factors:

  • The pervasive availability and low cost of debt to support healthy valuations.
  • Private equity looking to build up platform investments and deliver liquidity to limited partners thirsty for a nice return.
  • Owners who had seen their value expectations dashed as a result of the "Great Recession" finally seeing some light at the end of the once-dreary exit tunnel.

One sector expected to lead the way as we close out the year is technology (software, infrastructure, connectivity, services) according to data published by Mergerstat, a financial data company. The ever advancing "Internet of Things" promises to advance through M&A in the weeks and months ahead. Still, old fashioned manufacturers and distributors with steady and healthy margins remain alluring targets for the majority of active buyers.


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