Where Deals Still Get Done
While the lower middle market is feeling the effects of the credit crunch, its deal flow has been practically unscathed
March 24, 2008
It's well known that the credit crisis has sidetracked multibillion-dollar M&A transactions, and there is even some erosion going on in the middle market. But in one part of the deal landscape, the lower middle market, acquisitions and divestitures have continued with relatively little interruption.
According to data from Robert W. Baird & Co. and Thomson Financial, 3,076 out of 4,134 US middle-market deals in 2007 were valued below $100 million. Meanwhile, 824 of the transactions were between $100 million and $499 million.
For the first two months of 2008, more than 1,700 deals in the US were announced in total, out of which 383 were less than $100 million. Overall US deal flow was down 16% from the year-prior period, and the middle market saw 27% fewer transactions.
Out of the 1,700 deals, 1,100 had undisclosed values, and the majority of them are likely under $100 million, says Steven Bernard, director of M&A market analysis at Baird. "Transactions below $100 million are the bread-and-butter deals that get done all the time in good and bad markets. These are generally bolt-on transactions getting done for strategic reasons."
Deals at the lower end of the middle market are usually easier to execute because they are not as dependent on the financing markets and do not require high-yield or collateralized-debt-obligation issuances. They also tend to involve smaller, regional banks which have more day-to-day contact with companies in the lower middle market, adds David Platt, a Deutsche Bank managing director who focuses on mid-market M&A.
Platt defines companies in the lower middle market as having enterprise values between $50 million and $200 million. One of Deutsche's most recent mandates in the lower middle market involved advising Cohen's Fashion Optical on its sale to Houchens Industries, which closed on March 3.
David Lonsdale, president and managing director of Allegiance Capital, a Dallas-based boutique servicing the lower middle market, has seen a major uptick in deal flow, so much so that he expects his firm's 2008 fees to be triple the amount it collected in 2007.
Lonsdale assigns lower middle market companies enterprise values between $40 million and $250 million and between $5 million and $25 million in adjusted Ebitda. According to Allegiance research, 30,000 companies worth $1.5 trillion in the US fit those criteria.
Lonsdale has 42 clients worth $1.5 billion under contract, and he says close to one-third of his clients will be sold by the middle of the year. Three deals will close by the end of this month.
The increasing number of baby boomers reaching retirement (and looking to sell their family businesses) has helped spur more lower mid-market M&A. "Baby boomers are selling much earlier in their lives," says Lonsdale. "They've been brought up with a broader appreciation of the world and their self-worth is not as inextricably interwoven with the ownership of their companies."
Chris Zuzick, who co-founded Spire Capital Advisors, a Milwaukee boutique servicing Wisconsin-based companies in the lower middle market, earlier this year, has observed the same trend. "Our deal flow has been steady because most of our clients are baby boomers looking to retire," he says.
Indeed, a family business survey published in November by PricewaterhouseCoopers found that one-quarter of its responding companies are expected to be acquired by other parties over the next five years.
Foreign strategic and financial buyers looking to capitalize on the weaker dollar have also contributed to more deals in the lower middle market. For example, two of Lonsdale's US construction sector clients will be sold to large construction players in Central Europe and Scandinavia.
Less leverage here, too
Although the difficulties prevalent at the other end of the deal spectrum have bled into the lower middle market, the effects haven't been nearly as strong.
"Everyone's feeling that the M&A environment has gotten more difficult, but deals are still getting done in part because participants in the middle market and lower middle market didn't get too ahead of themselves," says Platt. "But, make no mistake, leverage levels have gone down and lending terms are tighter."
Bernard agrees: "The credit markets are tighter, but they're not shut like they are at the higher end."
Lonsdale has observed difficult leverage conditions first-hand. In one of Allegiance's deals due to close this month, the financial buyer wanted the transaction to consist of 30% equity and 70% debt. However, the buyer ended up having to amend the terms to 40% equity and 60% debt.
"There is no doubt that the financial buyer in the US, even in the lower middle market, is having to adjust its posture a little bit," says Lonsdale. Nevertheless, financial buyers continue to regularly transact in the lower middle market, he says.
Takeout multiples in the lower middle market have also taken a hit, but it is a slight one. Lonsdale has noticed multiples have been "off a little bit, but no more than 10% from the peak in the second quarter of 2007."
Zuzick recalls selling a manufacturing company with $14 million in revenue for five times Ebitda last year. If the same company were to sell today, it would likely command four or 4.5 times Ebitda, he says.
Present economic conditions have also affected how due diligence is conducted in the lower middle market. "Due diligence processes are longer and more complicated, regardless of deal size, because the tolerance for risk and error surrounding deals has gone down," says Platt.
The same goes for auctions. "I believe there will be more targeted, quiet approaches by sellers versus broad, public processes," says Platt. "There seems to be an increasing desire from sellers to try and quickly assess who they can transact with and whether it is going to be on mutually acceptable terms."
(c) 2008 Investment Dealers' Digest and SourceMedia, Inc. All Rights Reserved.
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