The persistent fog of economic and political uncertainty that has stymied investment is lifting, giving way to improved visibility for lenders, borrowers and private equity sponsors alike. Increased economic confidence, more certainty with respect to Fed tapering, and fewer concerns about future government budget stalemates are paving the way for greater willingness to buy, sell and invest in middle-market companies.
If in recent quarters companies were primarily focused on cost savings, they are shifting their attention to strategic growth opportunities. There is an abundance of capital – in the hands of both debt and equity investors – waiting on the sidelines, which will help buoy M&A activity.
“Private equity is still sitting on a lot of capital to put to work. Companies squeezed a lot of growth out of cost-cutting measures and efficiencies. But what do you do when you can’t grow further organically … you typically make acquisitions.” said Joseph Lynch, co-portfolio manager of the Neuberger Berman Floating-Rate Income Fund.
Demand for floating-rate credit assets is at unprecedented levels, and appetite for the higher yielding, middle-market segment is strong. Investors including specialty finance companies, institutional accounts, business development companies and traditional bank lenders still have ample capital to put to work.
Equally, private equity firms not only have significant dry powder to invest in new acquisitions, but are also coming under pressure to sell existing portfolio companies in order to return money to limited partners.
The confluence of these factors is expected to contribute to more new-money dealflow in a disciplined, rather than frenzied, M&A market expansion.
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 pick-up over the very lean $10.8 billion inked in 2013, a Thomson Reuters LPC quarterly survey of lenders found. Still, that remains below the nearly $20 billion booked in 2012.
For much of the past two years, market participants have lamented the disconnect between buyers and sellers, saying the M&A market stagnated because the two sides simply could not come together to agree on price. Now, lenders anticipate a narrowing of the bid-ask spread.
Sellers were wary of pulling the trigger. Amid improving financials, many wanted instead to hold a business for another quarter with the hope of fetching a better price at auction.
The limited supply of businesses for sale led to a highly competitive auction market, and combined with soaring equity valuations, purchase price multiples began climbing. But buyers hesitated. They were often unwilling to pay a premium without feeling more confident about growth prospects.
At the same time, many private equity sponsors have faced increased competition from strategics. The loss of deals to corporate bidders stemmed some buyout activity. In the third quarter of 2013, purchase price multiples rose to an average of 11 times EBITDA from 8 times in 4Q11, according to one banker. This year, market participants expect some rebalancing with respect to purchase prices. Historically, as interest rates rise, purchase price multiples come down, said one lender to lower middle-market companies. Interest rates are expected to gradually notch up due to tapering of the Fed’s bond buying program.
As investors become more confident about growth prospects, some buyers may also be willing to come up on price where they were unwilling previously.
Also, private equity funds raised between 2005 and 2008 are facing the pressure of forced exits as they reach the end of their investment terms. Portfolio companies being put on the auction block will also contribute some traction.
In a market flush with capital, which has unleashed record volumes of refinancings, repricings and dividend recapitalizations, terms and conditions look to remain borrower friendly, affording sponsors and corporates alike a variety of strategic growth and investment choices.
“There is such optionality driving all strategy today,” said Bob Rubino, executive vice president and head of corporate finance and capital markets for RBS Citizens Financial Group.
Gone are the days of exit solely by way of a sale or initial public offering. Private equity trades are more common, while other sponsors opt to return money to investors through a recap instead of pursuing a sale, Rubino noted.
Add-on acquisitions to grow and expand existing portfolio companies are also widespread, while corporates are eyeing divestitures.
But the pursuit of strategic growth opportunities, whether through the acquisition of a competitor, picking up a business unit spun-off by a corporate or buying platforms that expands product offerings and market share, will remain targeted and disciplined, market participants agree.
“Corporates seeing organic growth are investing in the business. They don’t want to distract their employees from delivering for their clients now that demand is improving,” said Rubino. “If you are going to disrupt the business, it must be very strategic and performance focused – for example, buying a new technology or expanding into a new geography.”
In the middle market, competition among lenders to win lead mandates is expected to remain high as the investor landscape continues to evolve with increasingly varied sources of debt capital moving into the middle market.
A constant theme in 2014, according to investors and arrangers alike, will be figuring out how to address the evolving marketplace and changing investor base. The extent to which banks do or don’t pull back, and the ability of alternative sources of institutional debt capital to meet borrower needs will shape the middle-market landscape going forward.
Leela Parker is a senior reporter for Thomson Reuters LPC in New York