Expect Activity to Accelerate in 2018

SUMMARY & OUTLOOK

Expect Activity to Accelerate in 2018

Heading into 2018, the state of the mergers and acquisitions market looks strong. U.S. target middle market announced deal volume climbed 19.6% to 9,630 YTD 3Q17. Value grew 15.4% to $183.0 billion during the same period. And, purchase price multiples hit 7.5x EBITDA in 3Q17, raising the last twelve month average to 7.0x.

Debt and equity capital continue to be plentiful. M&A leveraged loan volume amounted to $249 billion through 3Q17, up 12% year over year. Dry powder available to private equity groups and cash held by corporations remain at or near record levels.

Overall, the economic variables that drive M&A continue to be sustaining.

  • The Conference Board Leading Economic Index® (LEI) for the U.S. increased 1.2% in October to 130.4 (2010 = 100), following a 0.1% pickup in September, and a 0.4% increase in August. The expansion of the LEI suggests that the U.S. economy will continue to grow through 4Q17 and into 2018.
  • According to the “second” estimate by the BEA, real GDP increased at an annual rate of 3.3% in 3Q17, following a 3.1% bump in 2Q17. Positive contributions from inventory investment, nonresidential fixed investment, and exports were partly offset by negative contributions from residential fixed investment and imports.
  • Total nonfarm payroll employment increased by 261,000 in October as the unemployment rate crept down to 4.1%, the U.S. Bureau of Labor Statistics reported.
  • The Consumer Price Index for All Urban Consumers increased 0.1% in October and 2.0% during the last twelve months. The Producer Price Index for final demand advanced 0.4% in October and 2.8% during the last twelve months, the sharpest increase since a rise of 2.8% during the last twelve months ended February 2012.
  • The Conference Board Consumer Confidence Index® stood at 125.9 (1985 = 100) at the end of October, its highest level in almost 17 years. Consumers’ more buoyant assessment of present-day conditions, the job market and business conditions were thought to be the primary drivers of the boost in confidence.

Taken together, our outlook for M&A activity in 2018 is positive. Retirement, concerns about the window closing, and shifts in strategy continue to bring sellers to the table. Aside from geopolitical risks, the lack of available, high quality targets is probably the greatest threat to another robust year.

For more information or to discuss how BlueWater Partners can help you evaluate your financial and strategic alternatives, please contact us.

 

M&A ACTIVITY

Deal Volume

Source: Thomson Reuters

According to Thomson Reuters, U.S. target middle market announced deal volume increased 19.6% to 9,630 from 8,049 through the first three quarters of 2017 and 2016, respectively, and pushed last twelve months (LTM) September 30, 2017 volume to 12,270. This marks a continuation of the upward trend that began at least five years ago.

 

Source: FactSet

Technology Services was the most active sector during the last three months (L3M) ending September 30, 2017, according to FactSet. The next four most active sectors include Commercial Services, Finance, Consumer Services and Health Services. The top four have essentially remained the same during the last year or so.

Deal Value

U.S. target middle market announced deal value rose 15.4% to $183.0 billion from $158.7 billion during the first three quarters of 2017 and 2016, respectively, according to Thomson Reuters. At the same time, average deal value dropped 3.6% to $19.0 million from $19.7 million.

Source: GF Data

Purchase price multiples, which had dipped slightly in the first quarter of 2017, surged in the second and third quarters. According to GF Data, the average multiple for transactions with $10-250 million Total Enterprise Value (TEV) catapulted to 7.5x LTM adjusted EBITDA during 3Q17, the highest mark in the 15-year history of the database. The “size premium,” which is the spread between the lower middle market ($10-25 million TEV) and upper middle market ($100-250 million TEV), averaged 2.4x during 3Q17, down somewhat from the average of 2.8x during 2014-2016. During 3Q17, lower and upper middle market companies traded at 6.9x and 9.3x, respectively.

Debt and Equity

Source: GF Data

Middle market transactions were funded with 4.6x total debt/EBITDA on average during 3Q17, up from 4.0x in 2016. This reflected an increase in senior debt combined with a decrease in subordinated debt. Senior debt in 3Q17 rose to 3.8x from 3.0x in 2016. Subordinated debt decreased slightly to 0.8x during 3Q17 from 1.0x in 2016.

According to Thomson Reuters, leveraged loan volume expanded to $1.07 trillion YTD October 2017, 53% higher compared to the previous year. More specifically, M&A leveraged loan volume increased by 12% to $249 billion. After tightening for most of last year into this year, middle market yields tightened again in 3Q17 to 5.94%.

 

 

Source: GF Data

Equity contributions, which averaged nearly 50% in 2013, continued their retrenchment to 42.3% through YTD 3Q17. This trend has been aided by steady valuations and surging debt. As interest rates rise, either buyer or seller expectations will need to adjust.

The amount of cash held by corporations remains at or near a 10-year high, and the amount of dry powder available to private equity groups reached another all-time high. According to FactSet, S&P 500 aggregate cash positions (ex-Financials) have remained at about $1.5 trillion during the past few years. Similarly, Preqin reports global callable capital reserves (“dry powder”) of buyout funds rose to $608 billion in September 2017.

 

SELECT ENGAGEMENTS

Knapp Energy, Inc. (“Knapp”), a leading distributor of fuel, lubricants and propane to commercial and residential customers, has been acquired by Crystal Flash, an employee-owned energy distribution company. The acquisition enabled Crystal Flash to expand its capabilities, footprint and talent. All employees of Knapp were retained.

BlueWater Partners acted as the exclusive financial advisor and Lewis Reed & Allen acted as the legal counsel to Knapp for this transaction.

 

 

Deals aplenty: Survey results point to stronger M&A market in 2018 (MiBiz)

“In terms of confidence and growth and leading economic indicators, and the amount of capital, it’s all very supportive of transaction activity.”

Building Value Through Culture

Ray Beerhorst, Director
BlueWater Partners, LLC

Business owners and leaders are continually striving to maximize their financial performance while staying competitive in an ever changing, global environment. They continually lean-out operations, reduce fixed overhead, reduce inventories, and add automation. But why are some much more successful than others? How do some companies ignite growth like a nuclear chain reaction and achieve critical mass? What are they doing to make it appear easy?

The common denominator is culture.

Successful companies have embedded synergistic, rapid learning in their work teams and middle management as a result of leadership, vision, and culture. Rather than being distracted by climate, leaders have focused on building a culture that creates the climate for innovation, change, and competitive advantage.

There is a distinct difference between the culture and the climate of an organization. The climate of an organization consists of “the way things are.” In other words, what is sensed or perceived while working with (or in) an organization. Leaders use terms that describe outcomes such as employee engagement, teamwork, and quality products or services. Culture, on the other hand, consists of “the way things are expected to be done.” In other words, culture is the shared interpretations, beliefs, and values that drive behavior in the organization.

One way to understand the relationship between climate and culture is to visualize a tree: Climate is the trunk, branches, leaves, and fruit; culture is everything below the ground—the root system that supports the tree. To improve the health of the tree (climate), there must be intentional focus on building a healthy root system (culture). By working on shared interpretations/beliefs and values, the team strengthens the organization’s root system and lays the foundation for sustainable growth and longevity.

Most companies today only look at the root cause of quality or production issues. Great companies dig deeper to address culture and build value before performance, innovation, competiveness, or morale decline.

At Bluewater Partners, our goal is to help good companies become great. We’ve been helping clients create, manage, and realize business value since 2001. Our expertise includes facilitating acquisitions and divestitures and advising destressed companies. In our experience, culture matters.

If you’re interested in discussing our approach to assessing your organization’s culture and identifying levers to drive specific outcomes and increase value, click here.

M&A Expected to Pick Up in 2014 (MiBiz)

“At BlueWater Partners LLC in Grand Rapids, Managing Director Matt Miller expects moderate growth in 2014 in M&A deal volume following a “good year” in 2013. Among the primary drivers: the retiring baby-boomer generation.”

Anatomy of a Letter of Intent

A letter of intent (LOI) is a documented handshake between a potential buyer and a potential seller that sets forth the principal points of the agreement. In this way, an LOI mitigates the risk that prolonged negotiations may not result in a closing. In addition, with transactions requiring financing, the buyer’s lender may require a signed LOI before issuing a commitment to finance the acquisition. An LOI may even enable accelerated compliance with regulatory requirements such as those under the Hart-Scott-Rodino Antitrust Improvements Act.

But to be most effective, it’s critical that an LOI clearly delineate the binding provisions from the nonbinding ones. Briefly: The binding provisions regulate the negotiation process; the nonbinding provisions outline the transaction and its structure. Note that even though they’re nonbinding, there is a “moral commitment” by both sides to abide by the nonbinding provisions.

Binding Provisions

Binding provisions may include buyer access to the target company’s facilities, books and records, and require the target’s cooperation in the due diligence process. They may also contain a “no-shop” or “exclusive-dealing” provision that prohibits the acquisition candidate from directly or indirectly soliciting or entertaining offers from, or negotiating with, third parties in a transaction similar to the one the LOI outlines. Another common binding provision is that the seller must operate the company in the ordinary course of business. A mutual, comprehensive confidentiality provision protecting both parties and encouraging forthright dealings is also customary.

Each party typically bears its own costs and expenses and helps the other prepare and file for any necessary consents or approvals from lenders, landlords or third parties. It’s advisable to include a statement that the binding provisions constitute the entire agreement between the parties, superseding all prior oral or written agreements, and that the LOI may be modified only in writing, signed by both parties.

The binding provisions may also specify jurisdiction and venue for any disputes involving the LOI. It may be wise to include a provision relating to the LOI’s termination, perhaps incorporating a breakup fee. But note that the breakup fee normally isn’t the only remedy in the event of a breach by the seller

Nonbinding Provisions

The nonbinding provisions may be broadly scoped, including a description of the transaction type, a good-faith estimate of the closing date and a summary of the target executives’ employment agreements. They may also incorporate an adjustment to the purchase price based on changes in the consolidated stockholder’s equity following a specified date. In addition, they would address the preparation and approval of definitive documentation that would contain customary and comprehensive representations, warranties, indemnities, terms and conditions. Last, they could set forth escrow provisions for holding back a portion of the purchase price for specified contingencies.

One caveat: The LOI drafter must ensure that the nonbinding provisions cannot morph into binding provisions. The most powerful weapon against this danger is clear and concise draftsmanship. However, the courts have given significant weight to communications and other actions between the parties. For example, a statement such as “We have a deal,” followed by handshakes all around, may persuade a court that the parties intended to be bound.

Safety’s Sake

Nothing guarantees that a deal will close successfully – or at all. But a carefully crafted LOI certainly paves the way to a smoother transaction. In essence, they’re written agreements with the target made before the purchaser incurs full-blown negotiation and due diligence costs. Please call us for assistance with LOIs or any other aspects of an acquisition or merger.

Chart the Best Course

Deciding To Keep or Sell a Family Business

After 20 years at the helm of the family business, Maite is considering selling the company next year. After all, her company has satisfactorily matured, and she believes the time may be right to put it on the market. But questions plague her. How can she be sure it’s the right thing to do – for her, for family members active and inactive in the business, and for loyal non-family employees?

The answer, of course, depends on numerous factors, including the company’s value and current market conditions. Maite has wisely chosen to take her time before divesting. That way, our fictional business owner can properly plan and – in conjunction with M&A experts – assess the most expeditious approach to her goal.

Keeping It in the Family

First she considers keeping the business in the family. Her experienced team of M&A professionals analyzes her company’s financial situation and market position, among other factors. Here are a few highlights:

Valuation. First, Maite obtains a business valuation. The value may well determine Maite’s final decision and certainly drives the plan if she intends to keep the business. Then she must determine whether to transfer the business during her lifetime, on her death or on her husband’s death. Of course, the company’s value and Maite’s plans interest numerous parties, including tax authorities and her family.

Let’s say Maite decides to will the company helm to her spouse. No estate tax will be due then because of the marital deduction, but it will be due on her husband’s death. But Maite and her spouse might want the value minimized for the future estate tax payment on his death. Federal estate tax begins at an effective rate of 41% (on assets greater than the estate tax exemption of $1 million) and moves quickly to 49% (on a taxable estate greater than $2.5 million). Conversely, as you might imagine, the IRS is vigilant in looking for businesses that may have been undervalued in an effort to minimize taxes. This is particularly true for businesses whose fair market value is disputable.

Active and inactive heirs also may have different views of the business’s proper value, especially if they don’t hold interests in the business or if their inheritance is to be “equalized” from other assets (that is, compensated for their share of the business through assets other than the business itself). So make sure your valuator clearly understands the valuation’s purpose.

Transition. Maite will turn 64 next year. Therefore, retirement is another option she must consider. If she chooses to keep the company, she must decide whether everyone now involved in the business should stay involved. That means assessing personnel’s aptitude, ability and temperament. Then she must determine if only those children who are active in the business retain current, or have future, ownership of it. Finally, she must decide what inactive heirs should receive.

Without considering these issues, Maite would be less inclined to make an ownership transition during her lifetime. And that might not be in her (or her family’s) best interests.

Decision-making authority. Presume at this point that Maite has decided to leave the business to her heirs. She must then determine who will take the helm when she leaves. If she’s not done so already, she should empower those running daily operations to make important decisions. She should consider whether the decision-makers should report to a formal or informal board of directors, or an institutional executor or trustee. With her M&A team of experts, Maite should examine whether her company can meet its capital and borrowing needs and how it can maximize its intellectual capital. If a solid management team already exists, it should have an incentive to stay on when the next generation of Maite’s family assumes ownership and control.

Full benefits. Many business owners don’t take into account the value and extent to which they are receiving benefits from the company in addition to salary. In our example, Maite must recognize medical benefits, perquisites, pensions and employment opportunities for herself, family members and others before deciding to retain or divest the business.

Estate plan. Contrary to popular belief, having the correct legal documents doesn’t constitute a business continuity plan, nor should that plan remain static. Changing tax law and values require a periodic estate plan review, as do changing children’s (and grandchildren’s) ages, maturity and marital status. Health concerns also affect planning. If Maite wants to keep the business in the family, an estate plan is a key component.

Letting It Go
Let’s say Maite decides to sell the business to outsiders. Here’s a look at the salient issues from the seller’s side.

Value. A buyer bases a business’s value on strategic benefit and fit with other businesses, earnings and cash flow, and the management team. For the seller (Maite in our example), the gross value most often determines whether to sell. Note that consideration paid can take several forms and should be carefully structured and negotiated.

Getting at net value. The extent, timing and payment of taxes (be they capital gains tax, income tax or estate tax) on the proceeds can and should be planned. Total purchase price should not be as important as the net value to the seller and his or her family. The buyer can be convinced to deliver more to the seller if it is more tax efficient for him or her.

Presale planning. A great deal of planning should take place before any sale transaction. The more time that elapses between the implementation of a strategy and the sale transaction, the better the potential to preserve wealth and structure a deal that is beneficial to all parties.

Transaction strategy. Before a business goes on the market, have your expert examine its financial status and state it in the best possible light. In other words, balance sheets and income statements may need to be re-evaluated. Fortunately, Maite’s M&A experts helped her identify an appropriate buyer (from a field of strategic, financial, institutional and management candidates) and communicated with that company’s representatives throughout the process.

Implementation and positioning. Before negotiations began, Maite and her M&A team defined her role and others. By doing so, the sale process moved smoothly and she was on track to the best possible results. Experienced advisors helped her determine the most effective offer process.

Post-sale planning. Coordinating a change in the assets’ makeup (for example, from stock in a closely held business to liquid assets) requires an income and security analysis and a review of any existing estate plan.

Smooth Sailing

Chances are, you wouldn’t drive to an unfamiliar destination without a map. Neither should an owner even contemplate selling a business without a plan. That plan will reveal the best course of action and chart how to get you there. Please call us to help you navigate your way to the successful sale of your business or with any other M&A issues you may have.

Sidebar: Pertinent Considerations

There’s no one-size-fits-all answer to a businessperson’s keep-or-sell conundrum. Fortunately, there are several constants. The decision to retain or sell a company includes considerations such as:

  • The owner’s desire to work or retire,
  • Family dynamics,
  • Financial security for working family members and shareholders,
  • The current business environment as it relates to the business’s market value,
  • What will and should happen to loyal executive and employee groups,
  • The extent of the owner’s assets, and
  • The tax impact.

These are a just a few of the many items to review before making a decision. Call us for more detailed information.

Company Acquisitions: Why They Can Be Important

According to PricewaterhouseCoopers’ 10th Annual Global CEO Survey, more than 70 percent of CEOs expect to acquire all or part of another company in the United States within the next 2 years.  So, why are so many companies buying other companies? And should you be one of them?

Barriers To Organic Growth

In many cases, acquisitions are a way to overcome barriers to organic growth, or growth from your existing assets. In other words, if your existing business isn’t growing, buying another business is a common strategy to grow and benefit through increased cash flow, higher business value, greater ability to attract capital and talented management, and business sustainability.

The following barriers can keep a company from growing:

  • Changes in knowledge, belief and behavior that affect purchasing decisions
  • Changes in interest rates, inflation and unemployment that affect economic growth
  • Technological changes that make your machinery and equipment less competitive or obsolete
  • New products or services that make yours less competitive or obsolete
  • Low barriers to market entry that make it easier for new competitors at home and abroad to take away your market share
  • Many small companies selling to a few large companies, putting the bargaining power in the hands of the buyers.
  • Many small companies buying from a few suppliers, giving the supplier more leverage
  • Slow industry growth and overcapacity shrinking the pie and increasing rivalry among competing firms.

Strength From Within

If you find yourself faced with these barriers, an acquisition is one alternative that may help you overcome them. In addition to addressing these external forces, acquisitions enable your company to bolster its competitive advantage by acquiring resources like strong management or skilled labor, complementary or proprietary products or services, and production capacity or new technology to meet demand.

In other cases, acquisition can be a way to expand your company geographically or manage your business risk through market or customer diversification. These are ways to avoid relying on one large customer or a single market for the majority of your sales. If you lose that customer, or the economy in your region slows down, having exposure to other markets and customer diversification can help you buffer the blow while you work to replace lost business.

Companies Searching For Acquisitions

Here are a few examples of why companies pursue acquisitions.

Earnings and sales growth. A large precision machined products manufacturer decided to boost its organic growth with acquisitions. In addition, the management team wanted to fill existing capacity, acquire new products in new markets and establish operations in new locations close to certain customers. The company is owned by two private equity groups and, therefore, has the experience and capital to purchase businesses. However, it doesn’t have the human resources to manage the entire process. As a result, they outsourced part of the process and engaged a financial advisor to identify, contact and negotiate with acquisition targets.

Business model change. Another company interested in making acquisitions wanted to transform its business. The company’s management team acquired a troubled company in an out-of-favor industry a few years ago and completed a dramatic turnaround. In the meantime, the company grew quickly and accumulated significant cash on its balance sheet. Through its strategic planning process, the company decided to change its business model and enter a related industry with better long-term prospects. To do so, they engaged a firm to advise them through the entire acquisition process—from strategy development to closing transactions.

Vertical integration. Another reason for acquisition is to become more vertically integrated. What is the benefit? In this case, the management and the board of directors of this consumer health care products manufacturer decided that vertical integration would help them gain more control over the supply of certain raw materials. They considered building these capabilities themselves. However, they concluded it would be faster and more cost effective to acquire these capabilities instead and worked with a firm to identify, contact and negotiate with acquisition targets.

How To Get Started

You might have decided to explore an acquisition and know some likely targets, which is a good start.

What’s next? You can begin contact on your own, or if you don’t have this type of business experience, you can engage the services of an investment-banking firm. The biggest benefit to outside help is that you can tap into their expertise in making acquisitions while you focus on your expertise: running your business. The right advisor will help in other ways as well:

  • Creating or refining your acquisition strategy and criteria
  • Determining whether or not you have the capital, human and other resources to make an acquisition
  • Providing advice on current market valuations and valuation methods
  • Identifying and weeding out acquisition targets
  • Analyzing and valuing interested targets
  • Developing transaction structure alternatives, draft term sheets or letters of intent, and presenting them to interested targets
  • Arranging the financing to complete transactions
  • Helping you and your legal advisor and CPA conduct due diligence and close transactions.

Looking Forward

Many of the variables that affect the way deals are priced and structured are currently favorable to buyers. Interest rates are likely to remain steady or go down, and commercial bankers are aggressively pursuing good business deals. After increasing for several years, purchase price multiples decreased at the end of 2007, suggesting that multiples may have stabilized or may continue to decrease. In the meantime, debt to EBITDA multiples have remained steady.

What does that mean to you? It’s a good time to buy if your cash position is strong and your strategic plan calls for customer or market diversification, or you want to eliminate your competitors by buying them out. Talk to your investment banking firm to see what your options are and the most appropriate way to begin the process.