By: Anthony A. Latini, Jr. of Curtis Financial Group and Paul G. Mattaini, Esq.
Regional mergers and acquisitions, defined as activity in Central and Eastern Pennsylvania, Delaware, and Southern New Jersey, has not necessarily correlated with M&A activity on a national level. Regionally, there has been a decline in deals starting in the third quarter of 2006, almost forecasting what would eventually reach the national level. Although not a perfect forecast, deals picked up again regionally in the second quarter of 2007 as the national M&A frenzy peaked. The increase from the third to the fourth quarter of 2007 shows a promising trend leading into 2008.
Since 2002, private equity groups have played an increasing role in the M&A market, representing almost 30% of all buyers in U.S. transactions and approximately 15% of the regional buyers.
For many in the regional market, private equity is a name they hear but do not truly understand. Simply put, private equity firms attempt to buy stakes in private or public companies that they believe could achieve significantly greater growth and profitability with the right infusion of talent and capital, in the hope of selling them at a higher price later. Private equity groups range from huge national and internationally known names like KKR®, who purchased Toys “?” Us® and RJR Nabisco®, and The Carlyle Group®, who purchased Hertz® and Manor Care®, to regional and local names like Susquehanna Capital and Eureka Growth Capital. Because private equity groups represent approximately 15% of purchases in the region, business owners need to understand how private equity can affect the process of selling their business and its ultimate value.
Although private equity groups have existed in one form or another since the 1970s, they came of age in the 1980s, fueling the $25 billion acquisition of RJR Nabisco and others. Since then, the industry has grown at a rapid pace. In 2006, KPMG estimated that the private equity industry had over $750 billion in capital, which would have been enough to fund the acquisition of every company on the London Stock Exchange and the NASDAQ. Through another lens, that war chest was larger than the GDPs of Sweden, Australia, and the Netherlands.
Discussions about private equity transactions often involve complex verbiage and terminology, but the underlying transaction is actually quite simple. The purchase price is typically a combination of debt and equity. The private equity group relies on the acquired company’s cash flow to pay off the debt, meanwhile increasing earnings so that the company is worth more. With the leverage created by the debt, private equity groups can realize large compounded returns. According to the Private Equity Council, the top quartile of private equity firms returned 39% per annum to their investors from 1980 through 2005, as opposed to the S&P 500 Index returns of 12% during the same time period.
Benefits of Private Equity to Business Owners
Private equity can play an important role for business owners. Given that their business purpose is to invest capital, private equity groups can be a source of stability during turbulent times. Along the same lines, private equity groups function to buy companies and are willing to buy when a strategic buyer may be on the sidelines undertaking internal issues. Private equity groups also have more flexibility in structuring deals, and attractive deals with leverage possibilities may yield a healthy price. Private equity groups also provide confidentiality, as opposed to making a sale public to potential competitors who may also be interested in the acquisition. Simply having private equity firms involved in a transaction process can be extremely valuable. It enhances the competitive process while increasing the potential of receiving multiple acquisition proposals and resulting higher prices.
According to Jack Bovender, Jr., the CEO of HCA Inc., which was acquired by a private equity firm in 2006, being a private company allows the chance to focus on a much longer-term basis without worrying about quarter-to-quarter blips in earnings because decisions have been made for the long term. This could mean a more attractive alternative for a selling management team, as compared to selling to a public company.
As beneficial as private equity groups may be to business owners, there are naturally risks involved. Since a private equity group exists to sell companies for a higher price than originally paid, there is a shorter term horizon than that of an owner who may have built the company over several decades. Private equity groups may also require management to stay in place, rather than cash out, or may require a continued investment in the company to align management interests with the private equity firm. While transaction structures can be flexible, there may be earn-outs that are paid over a number of years depending on the company’s performance. Additionally, closing private equity transactions is often contingent on certain factors. The first is typically ensuring that financing for the debt needed to close the transaction will be in place, which has recently become more difficult. Private equity groups may also have a longer due diligence process, as they may require more education about the underlying business.
With some of the M&A market tensing up, as well as the falling dollar, there will be an increased likelihood that international buyers will become involved in transactions in the region. In 2007, foreign buyers accounted for some of the largest U.S. transactions. Locally, Campbell Soup announced the sale of their Godiva unit to a Turkish buyer.
As a percentage of total transaction volume, foreign buying of U.S. companies reached an all-time high in 2007.
Foreign buyers are winning deals because the appreciation of their currency against the U.S. dollar enables them to pay the highest prices. The opportunity to sell a company to a foreign buyer at a high price may be one of the bright spots in the regional M&A picture for 2008.
The second half of 2007 saw a dramatic tightening in the debt markets, as the chart below shows. Debt multiples, after reaching a high in the second quarter of 2007, have started to return to historical levels. As the debt markets continue to change with increased pricing and more stringent underwriting, private equity groups may have to change transaction structures by increasing the amount of equity in the deal, or there may be strategy changes in store for private equity groups as both acquisitions and investment exits become more difficult.
Despite the recent changes, data indicates a continued robust M&A market for regional companies and given the macro–environment of low capital gains rates (which may change), low interest rates, and continued availability of capital in the mid market, it remains a great time to sell.
Anthony A. Latini, Jr. is a managing director at Curtis Financial and has provided corporate finance and investment banking services to middle market and large corporate clients for the past 20 years. He focuses on merger and acquisition advisory services and capital raising for clients in a wide variety of industries including manufacturing, distribution, and financial services. He can be reached at 215.972.2353; firstname.lastname@example.org