Bankers and investors are looking forward to another bumper crop of mergers and acquisitions in 2005 as the healthy economy and accumulated cash encourage market participants to harvest targets judged most ripe. And while deals that make headlines tend to involve multibillion-dollar companies, such as the match-ups of Sprint and Nextel or Kmart and Sears Roebuck, some data suggest that the companies most alluring to buyers today are those in the middle market.
A study by Brown Gibbons Lang & Co., a boutique investment banking company that specializes in the middle market, shows that in the first nine months of 2004, the average valuation for companies with revenues between $250 million and $500 million rose to a multiple of 9.9 times, up 39.4% from the average valuation of 7.1 times for companies that size in 2003.
Of course, the middle market benefits from its popularity with private equity funds, which currently have about $100 billion to invest. Robert Filek, a partner in transaction services at PricewaterhouseCoopers, describes the middle market as "a sweet spot for private equity" given factors like the amount of leverage such investors are willing to use. And private equity firms are active on both sides of the middle market these days, confirms Patrick Hurley, president-elect of the Association for Corporate Growth (ACG), a group of professionals involved in M&A and corporate development. Those with money want to invest it, since "if they don't spend it, they have to give it back," Hurley says. Other private equity firms are eager to cash in on investments they made three or four years ago, he adds.
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Scott Lang, a principal and senior managing director of Brown Gibbons Lang, argues that middle market valuations improved so dramatically last year because that sector of the M&A market responds most quickly to changes in the economy, like last year's pick-up. "People should keep their eye on the middle market," he says. "A lot of middle market M&A is leveraged and therefore much more sensitive to the economic environment." For example, a deal involving borrowed money could run into trouble more quickly if interest rates rise or growth slows, cutting into the revenues available to make loan payments.
MONEY TO BURN
This year, corporations will be competing with private equity firms in the M&A arena. Corporations also have money to put to work and while they've spent the last few years trying to cut costs, their focus has now shifted to making acquisitions to boost their growth. Filek says that given the economy's lackluster performance in 2003, companies had little trouble in 2004 posting stronger growth each quarter. "In 2005, that is going to be much more difficult," he says. "The bar is higher."
In another plus for M&A, banks are eager to make loans. With 2005 economic forecasts uniformly rosy, there's little that seems likely to slow the deal-making. PwC's Filek says he doesn't expect the implementation of Section 404 of Sarbanes-Oxley to impede acquisitions, although he thinks it will affect the timing of deals and increase the amount of due diligence that acquirers perform. The ACG's Hurley argues that Section 404′s requirements could even give M&A a boost if it discourages owners from cashing in on the value of their companies by doing an initial public offering and instead causes more of them to exit by finding an acquirer.
How long does the party last? "It's likely that we've got another year or year and a half before some of these aggressive lending conditions start to result in problem companies, which would put a damper on the availability of debt," says the ACG's Hurley. Scott Lang of Brown Gibbons Lang notes that middle market companies are no longer cheap. "We're getting to the point where valuations are pretty maxed out again," Lang says, but adds that "as long as the economy is moving up, a rising tide lifts all boats."
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