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High valuations, strong buyer interest, and availability of transaction funding should bode well for most sellers as we look to the 2015 M&A market.

Preparing for transition

Market for Mergers and Acquisitions Expected to Remain Strong in 2015

  • 1/20/2015

The market for mergers and acquisitions (M&A) in the United States in 2014 can safely be described as “frothy,” when measured by both total transaction value and volume. The frothy transaction environment — characterized by historically high valuations, strong buyer interest, and availability of transaction funding — should bode well for most sellers as we look to 2015.

Ben Axelrod recently joined CLA as managing director, mergers and acquisitions, to lead M&A advisory and investment banking services.

2014 started off strong and M&A deal activity continued to increase through the year. In fact, deal value in the first three quarters of 2014 reached almost $1 trillion. The 5,843-deal total is among the highest on record and represents a 7 percent increase in volume and a 33 percent increase in value from 2013.

The conditions that made 2014 a favorable market for M&A are expected to continue in 2015, including a growing U.S. economy, favorable lending environment, high levels of confidence among CEOs, lots of cash on corporate balance sheets, and significant un-invested capital (aka “dry powder”) within private equity funds. Executives and transaction professionals surveyed in November 2014 concur; 59 percent predicted that deal flow will be greater in 2015 than it was in 2014, and another 37 percent said that it will be at least as good.

Business owners that are contemplating a sale in the next several years should consider current favorable market conditions in their decision-making process. Well-positioned businesses in the middle and lower-middle markets (those with earnings before interest, taxes, depreciation, and amortization of $3 million to $50 million) are expected to get a lot of attention from both strategic and financial buyers. Owners of businesses that are differentiated, competitively strong, and have a solid financial performance track record should fare especially well in the current M&A environment.

Here are some of the factors that contribute to this 2015 outlook.

The pace of economic recovery could accelerate in 2015

Gallup's U.S. Economic Confidence Index tipped into positive territory at the very end of 2014 for the first time since before the Great Recession. The index signaled that Americans are possibly sensing an accelerating economic recovery. Further, the U.S. stock market rebounded in December to end 2014 near record highs.

While many factors have likely contributed to the rise in economic confidence, a more than 30 percent decline in gasoline prices is an economic boon to most Americans. However, the positive effect of lower fuel prices for consumers could be offset to some degree by a negative effect in other sectors of the market. It is likely that falling oil prices caused a number of transactions in the energy sector originally scheduled to close in December to be delayed or put on hold. Some transactions in other sectors may have also been pushed into early 2015 as buyers paused and reassessed market and economic conditions. Still, lower oil prices are expected to bode well for the overall economic recovery since consumer spending accounts for more than 70 percent of the U.S. GDP. Robust economic recovery in turn, is a positive for M&A activity.

The U.S. stock market rose in December to its highest levels in history, while the unemployment rate fell to the lowest level since Gallup began its daily tracking in 2008. With increased clarity around the Affordable Care Act rules, no fiscal cliff, disruptive budget issues, or major tax law events on the immediate horizon, Americans appear to be feeling confident in the economic future. With this backdrop, CEOs and investors should be more comfortable pursuing M&A opportunities.

It is possible that a particularly rapid economic recovery could have an interesting side effect: as companies achieve their target growth rates through organic expansion, growth through acquisitions may slow in some segments. Still, a robust economic expansion would generally be expected to lead to a healthy transaction environment.

Strategic buyers should continue to drive M&A activity and push transaction pricing higher

An important driver of strategic M&A activity is CEO confidence. According to PWC’s recently-published annual CEO survey, twice as many chief executives believe the global economy will improve in the next 12 months, compared to those polled last year. With the strong U.S. dollar, multinational companies that are not fully hedged will likely see earnings pressure, causing some to look for greater domestic diversification. With this backdrop and the pressure to grow, management teams are assessing their position versus competitors. The fear of missing out on key M&A opportunities could also drive some CEOs and management teams toward increased M&A activity.

Many companies entered 2015 with corporate cash reserves at or near record highs, with ample liquidity to pursue acquisitions. According to CapIQ, aggregate transaction value increased significantly more than transaction volume in 2014, primarily caused by a number of large deals. One explanation for this is that strategic buyers are likely more focused on finding opportunities with the right strategic fit. At the same time, while these buyers are being more selective with their targets, they are also willing to pay a premium for opportunities that fit particularly well with their strategic and growth objectives. Companies looking to post above-market growth rates will continue to seek acquisitions to achieve their growth objectives. With quality trumping quantity, sellers of well-positioned, high-quality businesses should expect to see strong interest and attractive valuations from strategic buyers with robust growth targets.

2014 saw a number of transformational deals in several industries, leading some to compare current M&A environment to prerecession activity. However, transaction data indicates that current M&A activity appears to be driven by “strategic” buyers much more so than at the height of the market in 2007. While seven of the 10 largest deals in the United States announced in 2007 involved private equity purchasers, private equity funds were not the purchaser in any of the 10 largest U.S. deals announced in 2014.

Private equity and other financial buyers are expected to remain active and competitive

Private equity groups and other financial buyers were very active in 2014, both buying and selling companies. Nevertheless, many are still working with large sums of “dry powder” to be put to use. According to Preqin, private equity buyout funds had nearly $450 billion in committed capital to deploy at the end of 2014, the highest total since 2009.

Current trends in the private equity arena also appear to bode particularly well for companies in the lower-middle and middle markets. According to data from Cambridge Associates, sector specialists outperformed generalist funds year-over-year between 2001 and 2010. As such, many limited partners (sources of capital for private equity funds) are favoring smaller, niche-focused private equity funds.

Furthermore, private equity firms looking for targets in the lower middle market are increasingly employing new methods to generate deal flow. With an influx of privately-held, family-owned businesses expected to consider a sale in the next few years, more private equity firms are hiring professionals that are dedicated solely to deal sourcing.

Transaction financing remains relatively cheap and broadly available

The transaction lending environment began to recover several years ago and is currently very favorable for M&A transactions. Credit financing remains relatively cheap and widely available, with lenders eager to deploy capital on attractive terms. This, in turn, has continued to buoy valuations, attracting more sellers into the marketplace.

In late October 2014, the Fed announced the final draw-down of its six-year-old bond buying program, known as quantitative easing. Most economists expect the move will increase interest rates. However, the Fed’s announcement in mid-December that it intends to be patient when it comes to increasing interest rates led to a strong rebound in the U.S. stock markets and appeared to alleviate concerns about any rapid increases in interest rates.

In the middle market, one can expect loans to businesses to continue to be funded in large part by non-regulated financial institutions such as business development companies. Traditional banks, which have to follow the Fed’s leveraged lending guidelines, will likely continue to struggle to compete in the middle market arena.

When it comes to earnings, quality matters

Each M&A transaction is impacted by a host of factors unique to the buyer, the seller, and the business itself. However, many external factors — economic conditions, capital markets, regulatory environment — affect nearly all transactions. The current market conditions point to a very active M&A market in 2015. But transaction multiples and market activity do not represent the entire picture. Neither does current EBITDA.

Growth prospects, strength of management team, and quality of earnings (i.e., degree of sustainability, historical accuracy, and the achievability of future projections), can have a greater impact on the valuation of a business than the current market environment. Understanding and actively managing your growth drivers and strategic attributes is a critical step towards a successful sale.

Advanced preparation remains a prudent strategy

Owners of high quality businesses who plan to actively pursue a sale in 2015 can generally expect a relatively high level of interest from the buyer community. Even if they are not actively pursuing a sale, business owners should not be surprised if they are approached about a potential transaction. Finally, for business owners who are unlikely to consider a transaction over the next 18 months, planning for an eventual transition event remains a prudent strategy. Advanced planning can ensure that when the timing is right, the company is ready. This gives the business owner multiple paths to consider and pursue if circumstances change and a sale to a third party becomes of interest.

How we can help

Strategic, private equity, and other types of buyers are all geared up for an active marketplace in 2015. You should be as well. Whether you are approached by a buyer, considering a sale now or down the road, or are thinking about a transition at some point in the future, we can help you with questions about planning for transition events and corporate transactions.