In November 2016 First West Capital was involved in a panel discussion at ACG Capital Connection in Toronto addressing trends in the mergers and acquisitions (M&A) market, which has seen an increase in activity. Transactions with an M&A component, such as strategic M&As, partner buyouts, management buyouts (MBOs) and leveraged buyouts (LBOs), have become favorable for sellers due to high valuation multiples – thanks to low interest rates and strong availability of capital from lenders and private equity firms. For strategic buyers, low organic growth rates and succession planning are driving increased M&A activity.
The panel represented mid-market sub-debt and private equity (PE) firms, dealing mainly with businesses valued between $15M – $500M. First West Capital typically partners with companies in the lower mid-market – valued between $2.5M – $50M – and therefore was able to offer expertise on this group, which is often lacking significant data.
Based on the data we do have from Pitchbook, PE transactions under $25M in enterprise value made up approximately 25% of the overall market in 2015, and increased to over 30% in 2016. This is pointing to an increased interest in lower middle-market companies.
Some key trends and insights that were discussed:
Increase in M&A activity in Q1 and Q2
At First West Capital 2 out of 18 transactions had an M&A component to it in 2015, and in 2016 this figure increased to 8 out of 20 transactions. Anecdotally, we have heard that the first half of 2016 was active in the M&A market; however, Q3 and Q4 have seen a slowdown. Some of the possible reasons for this slow down include:
- Valuation multiples (particularly for companies with less than $25M in EV) increased in Q1 and Q2 of 2016 to over 6x EBITDA; therefore it is getting harder to find compelling valuations.
- Strong liquidity in both the PE and the debt markets was actively deployed in Q1 and Q2; therefore, the inventory of high quality companies that are for sale has been reduced.
- Buyers have taken a pause in H2 2016 due to a number of uncertainties including potential interest rate hikes and the US election.
Increase in succession-related management buyouts
In speaking with various corporate finance advisory firms, approximately half of transactions in 2016 (and early 2017) have a succession component to it and management teams are becoming viable purchasers for many companies. First West Capital is experiencing a similar trend in transactions that we finance, for a couple reasons:
- Extricating management that is very concentrated, family issues with regards to children remaining in the business, and legacy of employment and the corporate culture, is causing some entrepreneurs to hesitate in selling to a strategic buyer or PE.
- For aging entrepreneurs that don’t have a strong second layer of management, PE investment is not a viable exit option.
As a result, we are seeing a pickup in the MBO market. For many of these companies management are the logical buyers of the business; however, access to capital can be an issue. For this reason, First West Capital has introduced the MBO Financing Package, which looks to invest preferred equity alongside management’s equity, combined with subordinated or mezzanine debt. We hope to facilitate more management buyouts to offer a liquidity option to vendors while sustaining these small to medium sized businesses.
Increase in valuations: bridging the gap
As mentioned before, valuations for companies with less than $25M in EV increased in Q2 2016 to over 6x EBITDA, valuation levels not seen since Q3 2013. It is also nearly a turn higher than Q1 2016, although these valuation levels are typically reserved for highly marketed transactions.
There appears to be an inflection point at approximately $3M of EBITDA where the universe of potential buyers, particularly PE firms, increases significantly – this larger universe of potential buyers can drive up valuations. For companies with less than $3M of EBITDA, reasonable purchases multiples of 4-5x can still be found in the market.
Market participants should consider the following factors when addressing increased valuations:
- The lower mid-market is less competitive from an availability of equity capital; therefore multiples in this market are often driven by an ability to finance calculation.
- We are seeing that senior debt leverage multiples have remained relatively consistent over time at approximately 2-3x EBITDA; the upper end of that range is reserved for companies with strong asset coverage.
- If the company is asset-light, making senior leverage more difficult to raise, subordinated debt can be raised behind an operating line and some term facilities to bridge the ability-to-pay gap.
- Overall, we are seeing total leverage multiples limited to 3-4x EBITDA for lower mid-market companies with subordinated debt typically averaging 1x of EBITDA leverage.
- Vendor financing, or earnouts, is another way to minimize equity contributions to maintain equity returns or to pay premiums valuations. These are often used strategically, as well in lower mid-market deals, to incent the existing owner to transition entrenched customer and supplier relationships.
- We are also seeing a number of vendors who wish to retain a small minority stake in the business, typically “inventor” types who may still want to be involved but they are no longer interested in running the day-to-day business. While this does not necessarily improve returns for the majority shareholder, it can reserve some additional capital (a.k.a. dry powder) for future acquisitions.
2017 is the time to strongly consider your management team as a viable buying group to keep the business under local ownership and to ensure that your legacy of corporate culture is maintained. Reasonable valuations for strong companies can still be found in the lower end of the market for companies with less than $3M of EBITDA. Take advantage of the myriad of financing options available to you, including sub-debt, mezzanine and equity solutions offered by First West Capital, to minimize equity capital outlay.