By: Robert Rough, Partner-in-Charge, Business & Transaction Advisory
2015 Transaction Climate – Off to a Slow Lousy Start
While the initial observations may be somewhat acid-inducing, overall I feel good about the future outlook.
The number of transactions consummated in Q1 of 2015 dropped dramatically compared to almost any recent three month period according to Pitchbook[1]. Down 26% from Q4 2014, down 30% from Q1 2014. To find a worse quarter one has to travel back to the just-after-the-recession days of Q3 2011. The result is even stranger since in a Firmex/Mergermarket survey[2] 88% of respondents expected the level of U.S. M&A activity to “significantly” or “somewhat” increase during 2015.
How could this happen? Everyone knows that private equity funds are flush with capital to invest, banks are open for business and baby boomers are ready to sell their companies and retire. Where are the transactions?
There are a number of reasons for the drop. Let’s take an analytical look, because while some will impact only selected industries and sellers, several will impact all potential transactions. Here are the reasons, in no particular order:
- Oil prices – While a benefit for many, the free fall in oil prices that started in June of 2014 was a death knell for many potential transactions in the market. Keep in mind that transactions take months to go from inception to close. With oil still in the $90 a barrel range in September and $80 as late as October, sellers were still initiating transactions which would have closed in the first quarter. By the time oil was selling in the $40 a barrel range in January, many of those transactions were pulled from the market (or didn’t even get to market).
- West Coast dock slowdown – This did not get much national attention until the docks actually shut down in 2015, but work was slowing down as far back as mid-2014. Smaller U.S. companies relying on imports from Asia started feeling the pinch during the fall. Higher value items could switch to expensive air freight but low value or high cube to value items waited their turn on boats or in Asian warehouses. Air freight and other workarounds (East coast ports) pinched margins while stockouts dampened sales. Either way, financial results suffered and some potential sellers decided to wait it out.
- Supply and demand – This is not easy to quantify but our private equity contacts complain about a lack of quality companies available at realistic prices. Caveat – PE principals have been saying this for at least twenty years. I know; I was one of them, back in the day. What they mean, I believe, is that sellers and their advisors are bringing companies to market that are not prepared to go through the sales process. The books are a mess, legal documents are not in order – the company isn’t “clean,” because they haven’t done the work to make the company attractive to buyers. Most private equity firms are willing to pay a fair price but they want to know what they are getting without having to sort through shoe boxes of receipts or guess at the company’s market strategy.
- New restrictions on bank lending – This topic is complex enough to warrant a book rather than a mention in a blog post, but to summarize, banks have been hit with two rules that reduce their appetite for the high leverage that private equity funds use in transactions. The first is the High Risk Borrower or HRB rule and the second is the Liquidity Coverage Ratio. Details are beyond the scope here but the result is to make banks less willing to make those high leverage loans for private equity transactions. As pointed out in a previous post (Sell – Now or Later? 12.05.14), the multiple of EBITDA paid for a company is very dependent on the availability of debt to finance the transaction. For more proof of this idea, Pitchbook reports that the median EBITDA multiple for the transactions in its report went from 10.7X in Q4 2014 to 7.7X in Q1 2015 with 83% of the drop being explained by a reduction in debt.
So what will the rest of 2015 bring and what does it mean? While I am not willing to call the date, I am willing to say that transaction activity will pick up during the year. Here’s the Rough Report on what I see happening for Q2, Q3 and Q4.
I know nothing about oil prices but I do know that many of the transactions done in the oil field services area will not be able to service their debt at $50 a barrel. If the price stays low, there will be an uptick in transactions in oil & gas as companies come together to survive, likely with a restructuring of their debt.
The dock strike is over and ports are getting caught up. For many companies, those sales are lost rather than postponed but at least they can get back to selling product rather than chasing it.
Private equity funds exited (sold) a record number of companies in 2014, fundraising was strong and they still have a lot of capital to invest. Competition for transactions is high since not investing is tantamount to going out of business for funds. If sellers and their advisors bring quality product to the market, they will buy.
Banks will continue to lend, although less aggressively than before. Non-bank lending entities will likely pick up the slack although the debt is usually more expensive due to their funding sources. Look for more creative debt structures and possibly more requests for seller financing to make transactions work.
Baby boomers will continue to get older and want to sell, and the first step they need to take is to get their companies and themselves ready for a transaction. Even when transactions pick up, quality will still be in demand.
[1] U.S. PE Breakdown 2Q 2015
[2] Mid-Market: The Crux of North American M&A
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