The Middle Market Deal Comes of Age

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Thomas S. Vaughn Michael P. Fannon

By Thomas S. Vaughn and Michael P. Fannon

Thomas S. Vaughn is a Member at Dykema Gossett PLLC, where he practices as part of the firm’s Business Services Group and serves as Co-Leader for its Mergers and Acquisitions Group. Mr. Vaughn’s practice focuses primarily on mergers and acquisitions, public company securities compliance, private placements of securities involving institutional venture capital and private investors and the drafting and negotiation of a broad array of business agreements. Mr. Vaughn has led Dykema’s Annual M&A Outlook Survey for all thirteen years of its publication.

Michael P. Fannon is an associate at Dykema Gossett, PLLC, where he practices as part of the firm’s Business Services Group. Mr. Fannon focuses his practice on corporate and transaction matters. He has assisted private equity and strategic clients in middle market merger and acquisitions with experience on both the buyer and seller sides including: merger agreements, debt financing, complex due diligence for both national and international clients, and structuring strategy.

The middle market deal has come of age, according to respondents to Dykema’s 13th Annual M & A Outlook Survey. And it has done so during a period of renewed optimism among survey respondents in both the United States economy and the United States mergers and acquisitions market.

In September of 2017, national law firm Dykema Gossett PLLC polled senior executives and merger and acquisition professionals across the United States to measure their experiences and outlook on mergers and acquisitions in 2018. Respondents represented ten sectors, including health care, technology, industrial/manufacturing and financial services, and companies whose annual revenues range from under $1 million to more than $1 billion. The full survey results are available online here.

Almost 80% of respondents said they expect an increase in merger and acquisition activity involving privately owned businesses in the next year, outpacing last year’s response by 10 percentage points. As middle market companies make up the vast majority of privately held companies, this perspective on 2018 deal activity bodes well for owners of middle market companies considering the sale of their businesses.

The Association for Corporate Growth (“ACG”), a global organization focused on driving middle market growth, defines the middle market as companies with $10 million to $1 billion in annual revenue. ACG further breaks the middle market into the following subcategories:

  • Upper Middle Market – Revenues between $100 million and $1 billion
  • Core Middle Market - Revenues between $50 million and $100 million
  • Lower Middle Market – Revenues between $10 million and $50 million.

A majority of survey respondents predict that the volume of merger and acquisition deals under $50 million will increase in the next 12 months, while approximately one-half of respondents believe that the volume of merger and acquisition deals between $50 million and $100 million will increase during that period. Most of the remainder of the respondents believe that the current strong merger and acquisition market for deals under $100 million will see no significant change in the coming year. Similarly, the majority of the respondents believe that the volume of deals between $100 million and $1 billion will see no significant change in the next 12 months, with a quarter of respondents predicting that this segment of the market will see an increase in deal volume next year. These responses reflect an overall optimistic outlook for deal activity in the middle market segment of the mergers and acquisitions market in 2018, considering 2017 year to date deal volumes in the middle market through August 2017 were on pace with 2016 levels (with roughly 2,389 middle market deals in the 12 month period ending in August 2017 compared to 2,399 in the same period the previous year, according to FactSet), and 2016 deal activity was only slightly below the record levels seen in 2015 following the lows recorded during the 2009 recession.

For the fourth consecutive year, availability of capital was seen as the leading driver of current merger and acquisition activity by respondents. This capital comes from three primary sources. First, much of this available capital comes from the private equity industry, which continues on a heady streak. The Wall Street Journal reported that private equity assets have doubled in the last decade to $1.75 trillion, with plenty of room for growth, as that represents an equivalence of less than 3% of publicly traded shares. In 2016, first-time managers raised their highest levels since 2009, with $8.6 billion raised, says Business Insider. In the third quarter of 2017 alone, private equity firms enjoyed their greatest fundraising quarter since 2014, seeing more than $62 billion flow into their funds.

Interestingly, “dry powder”, or cash on hand, is at record levels. An unprecedented $963 billion in uninvested private equity capital is lying in wait of good opportunities, according to a third quarter 2017 report from Bloomberg Businessweek. In the coming years, these funds will be looking to deploy the billions of dollars they have raised. What will spark these powder kegs? Maybe it will be the opportunities in the middle market. With the landscape for quality deals becoming increasingly more competitive, many private equity fund sponsors have shifted their focus to the middle market. Suggesting that 63% of institutional investors are looking to the small market buyout sector, an October 2017 Mergers & Acquisitions publication, “Why the Lower Middle Market is Creating M&A Opportunities for Private Equity,” highlights the volume of opportunities in this market segment, as there are slightly over 375,000 companies within the lower and core middle markets, according to Forbes. This trend bodes well for middle market companies seeking exit opportunities in the next few years.

Second, cash on strategic buyers’ balance sheets remains at record levels since the 2009 recession. According to S&P Global Ratings, corporate cash swelled to a record $1.9 trillion at December 31, 2016, up 10% over the prior year end, creating ample piles of cash for strategic acquisitions and consolidations. With the slow growing United States economy, averaging 2% GDP growth per annum since 2009, and a forecast of growth in the United States GDP of 2.5% in 2018, according to the University of Michigan’s recent economic outlook forecast for 2018-2019, released on November 16, 2017, strategic buyers are likely to use their available capital to accelerate their growth through targeted acquisitions.

Third, debt financing is readily available to both private equity and strategic buyers to finance their acquisition activities. S&P Global Ratings statistics show that the United States leveraged loan volume in the middle market was up 53% year over year for the first nine months of 2017, pacing 2017 to best the record levels seen in 2007.

Aging business owners seeking to sell their businesses was viewed by survey respondents as the leading driver for the expected increase in merger and acquisition activity involving privately held companies, with 44% of respondents expressing this perspective. As the last of the baby boomers near their sixties and the oldest of the baby boomers move through their seventies, these business owners will need to address the succession plans for their businesses and how that impacts their financial futures. Forbes estimates that 4.5 million baby boomer owned firms, with an aggregate value of $10 trillion, will transition over the next 10 to 15 years, with the vast majority of these companies unprepared for the transition.

The availability of quality targets was seen by survey respondents as the greatest obstacle in completing their deals during the past year, followed closely by valuation and buyer competition. Only 5% of respondents cited concerns about declining valuations as a driver of merger and acquisition activity involving privately owned business in the next 12 months, suggesting survey respondents believe current multiples will hold for the next year. These views are consistent with recent reports showing that transaction multiples have increased over the past few years. In fact, the 10-year average purchase price multiple for leveraged buy-outs of businesses valued below $250 million is a record 7.3 times EBITDA, as published by Mergers & Acquisitions. While BusinessInsider reported that core middle market merger and acquisition multiples have hit new heights of 10.7 times EBITDA. These perspectives by respondents suggest a continuation of the current sellers’ market for at least another year.

The prospect of tax reform contributed to the optimistic outlook for the United States merger and acquisition market for 2018. Ninety-two percent of respondents believe that a decrease in corporate taxes would have a positive impact on the United States merger and acquisition market, while 70% of respondents felt that a decrease in personal income tax decreases would positively impact that market. Privately owned middle market companies and their owners would benefit from decreases in both types of taxes. In addition, the tax bill permits the repatriation of foreign earnings at favorable tax rates. This will likely spur the return of billions of dollars in cash held overseas to the United States, further stimulating merger and acquisition activity in the United States.

All of this optimism is occurring during a period in which the survey respondents, as well as many economists, are forecasting continued growth in the United States economy for 2018. Nearly 60% of respondents had a positive outlook for the United States economy over the next 12 months, with only 11% having a negative outlook for that period. Over 50% of respondents believe the United States economy will improve over the next 12 months. United States industrial output continues to climb, hitting a near six-year record after October 2017’s 2.9% rise over last year, according to the Federal Reserve. Likewise, University of Michigan’s recent economic outlook forecast for 2018-2019 reports that business and consumer optimism about the economy remains high. It further reports that the housing sector continues to push economic growth as residential investment expands as home prices rise, all while unemployment continues to decrease to a projected 4.1% by 2019.

The message to owners of middle market companies from the survey respondents is as follows:

  • 1. The current United States mergers and acquisitions market is a sellers’ market, with numerous buyers looking for quality deals in a very competitive arena.
  • 2. Valuations are up and holding in many sectors.
  • 3. Cash available to buyers to complete deals is plentiful.
  • 4. Buyers continue to move downmarket looking for better values, helping to drive middle market deal flow.

So, for middle market business owners who have been contemplating a sale of their privately held businesses, take note – the middle market has come of age. Now is the time to act, the window is open and there appears to be plenty of runway left to get a deal done before the window closes again.

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