We are now two years into a strong bullish cycle fueled by pent-up demand for deals, accommodative senior lenders, and a return to normalized earnings levels. Given the following factors, our outlook for 2012 remains favorable:
- Taxes: The looming expiration in the 15% maximum tax rate on capital gains combined with the upcoming November presidential election continues to create uncertainty among business owners thinking of selling their businesses. These individuals must weigh potential increases in multiples and earnings against a backdrop of significantly adverse tax treatment for proceeds on sale.
- Demographics: Time, the ever-marching soldier, continues to favor the need for liquidity events among many business owners as aging baby boomers aren’t getting any younger.
- Accommodative credit markets: We see no reason to believe that senior credit markets, which by some measures are back to 2007 levels, will significantly tighten any time soon.
However, the same risks faced by the broader economy also effect the deal market, namely continued disturbances within the European Union’s fiscal agendas, elevated unemployment levels, and the dismal housing and residential construction industries. In our view, though, the positives outweigh the negatives, and we look forward to a sustained wind in the sails for 2012.
M&A Market Activity
2011 proved to be another strong year for U.S. M&A activity. The year saw a modest 2% increase in total number of deals closed in 2011 vs. 2010 to nearly 13,000 completed transactions, and a more robust 6% increase to $828 billion in reported transaction value.
Based on Figure 1, one may infer that the momentum appears to have peaked. Second half 2011 volume and reported value represented a 2% and 15% decline, respectively, over the first six months of the year, and similar declines over the same period one year ago. However, we do not believe that the M&A markets will cool in 2012. It is likely that first half 2011 activity was fueled, in part, by expectations for domestic GDP growth heading into second half of 2011 and early 2012. However, the second half of 2011 brought continued anemic unemployment data, U.S. debt-ceiling negotiations in Washington, European debt crisis, Japanese supply chain disruptions, and dramatic commodity price swings. These events impacted expectations for near-term growth and caused the economic picture to become a bit murkier. As a result, a cautious, “wait-and-see” attitude developed among buyers and caused a slowdown in processes. We believe these cautionary stances are already easing, and that 2012 will be another strong year for mergers and acquisitions.
How did the size of deals completed in 2011 compare to 2010 (Figure 2)? While data on lower middle market transactions is often difficult to come by, the year-over-year comparison does suggest two conclusions. First, smaller deals falling within the lower middle market (in this context defined as transactions less than $250 million in total value) continue to dominate deal flow, accounting for nearly 96% of total M&A activity in 2011. Second, there remains a healthy appetite among buyers for companies valued between $25 million and $100 million, a common target size range among middle market private equity groups, with overall volume and value in this size range each increasing 10% over the prior year.
Which sectors were “hot” in 2011 (Figure 3)? Not surprisingly, given the continued regulatory pressures and capital threshold requirements placed upon depository institutions and the resulting need for further consolidation, Financial Services remained the single most active sector as measured by number of deals completed during the year. However, Consumer, Industrial & Basic Materials and Healthcare all exhibited healthy activity in 2010 and carried that momentum into 2011.
The continued resurgence in deal volume from the depth of the recession was facilitated in large part by the renewed relevance of the strategic buyer. For much of 2005 through 2007, many strategic buyers found themselves scratching their heads over the valuations paid by private equity groups for transactions, valuations achieved purely as the result of financial engineering (read: leverage) available and not due to potential synergies available as part of a deal. Figure 4 shows the increase, by sector, in total number of deals completed in 2011 vs. 2009, and how many of those deals were financial buyers vs. strategic buyers. As can be seen, with the exception of Financial Services, which experienced an equal mix of interest, the overall return of deal activity can be attributed in large part to the return of strategic acquirers.
The stimulus for strategic-led deals is a combination of lower organic growth prospects absent acquisitions, more reasonable valuations, aforementioned accommodative senior debt markets, and as shown in Figure 5 a record $2 billion in cash and other liquid assets held by nonfinancial companies, which as a percentage of total assets represents a 10-year high water mark (though it should be noted that a portion of this cash is overseas with structural barriers against tax-advantaged repatriation).
It’s important, however, not to dismiss the role of private equity in deal flow over the next few years. Favorable credit markets and an estimated $425 billion capital overhang ($100 billion of which is nearing the end of its investment horizon), will continue to provide impetus for investors to remain competitive in transactions. Furthermore, it should be kept in mind that the $425 billion capital overhang actually translates into $1 trillion or more in purchasing power, given leverage available in today’s marketplace. See Figure 6.
Beyond the next 24-36 months, leveraged buyout activity will be fueled by the additional $93 billion of private equity capital raised by funds in 2011, a remarkable 80% of which (by fund count) was raised by lower middle market-focused funds.
The continued strengthening of M&A activity has, not surprisingly, coincided with a rebound in valuations. As further evidence of the “return” of the strategic buyer, the data in Figure 7 shows that strategic buyers are, once again, outbidding financial buyers on an aggregate basis contrary to the dynamic seen at the height of the bubble.
In summary, our expectations for 2012 based on our experience in 2011 is that the window for continued M&A appears to remain wide open. While we cannot guarantee how long this will be the case, we do believe the short- and long-term fundamentals driving today’s mergers activity are both solid and sustainable.
Senior Financing Trends
2011 proved to be a very good year for middle market senior lenders, with overall issuance up 22% to $182 billion from 2010 levels. However, this annual increase masks the softness that occurred in the fourth quarter, which saw a decrease of 4% quarter-over-quarter and a decrease of 21% year-over-year. See Figure 8.
The lower middle market, defined in Figure 9 as total deal size less than $100 million, exhibited a trend similar to larger middle market deals with overall 2011 issuance of $43.2 billion increasing 15% over 2010. The softness seen in the fourth quarter for lower middle market deals was not nearly as pronounced as that seen in the larger transactions.
Of all middle market issuances, refinancings represented a majority of the middle market lending in 2011, which continued a trend that began in 2009. See Figure 10.
It is interesting to note in Figure 11 that of all non-sponsored senior debt deals completed during the year, refinancings comprised 76% of total activity in 2011; new money issuance of $28 billion remains at low levels. For sponsor-backed companies, refinancings only comprised 34% of activity.
Overall, both non-sponsored as well as sponsor-backed loan issuance has rebounded to pre-crisis levels, with the most dramatic improvement (as a percentage of recessionary levels) obviously being seen in the sponsor-backed loan arena, spurred by recapitalizations, refinancing, and to a lesser extent the relative return of middle market buyout activity. See Figure 12.
Spreads have tightened considerably since second quarter 2009 (Figure 13), though it remains to be seen whether the slight uptick in second half 2011 in non- sponsor-backed (and more pronounced widening in sponsor-backed) issuances are an aberration, or the beginning of a sustained trend. The S&P downgrade of U.S. debt in August and the continued debt crisis in Europe contributed to the pullback in rates. Widening late last year was further exasperated by the announcement by the Federal Reserve in July that short-term interest rates would remain low into 2013, an announcement which ran contrary to investor expectations and which resulted in a net outflow of $2 billion, or 14%, of capital from prime funds in August and September. With several of these issues either in the past or already fully priced into current market conditions, we do not expect any significant changes in available liquidity or in pricing.
The debtor-favorable senior debt markets have helped fuel leveraged buyout activity as of late. This is evident in both the senior debt leverage available to fund acquisitions as well as in the declining equity contribution required of sponsors at close. However, it should be noted that the absence of aggressive subordinated debt (primarily in the continued anemic second lien issuance market, which remains at depressed levels despite relative improvement in 2011) has restrained total leverage and required equity from approaching pre-crisis levels. See Figure 14.
Mezzanine capital is either equity with a current pay coupon, or debt with an equity “kicker”, depending upon your view. In good times mezzanine capital can offer borrowers much-needed growth capital with less dilution than pure equity, and during recessions mezzanine offers patient capital with flexibility around cash interest payments and can provide a much-needed liquidity cushion until profitability returns.
For large-cap issuers, filling the hole between senior debt and equity is not a problem: issue high-yield notes. For smaller companies, second-lien loans were (pre-recession) a viable alternative. Today, for companies below $10 million in EBITDA, cash-flow based loans with capital structures approaching 4.0x debt to EBITDA are only possible with 1.0x-1.5x of mezzanine debt (although unitranche and “one-stop” lenders continue to gain market share).
Mezzanine investors are still looking for all-in returns of approximately 18% to 22%, though how each fund achieves this return varies. For most funds, the borrower is required to pay a 12% cash coupon, plus a paid-in-kind (“PIK”) portion that accrues non-cash interest until maturity. The PIK portion of the loan varies from 1% to 4%, depending on the individual lender and the credit profile of the borrower. The remainder of the return hurdle is often achieved using a combination of some type of equity instrument, whether via actual co-investment of equity or via warrants (penny or with an otherwise very low strike price). It is also common to see other debt-like features contained in the loan agreement, including some type of call protection (e.g., one year non-call period followed by 103 and 102 in years two and three, respectively).
Similar to private equity, mezzanine funds raised record funding from limited partners during the 2005 to early 2008 timeframe (Figure 15). This fundraising was punctuated by a $22 billion fund raised by the mezzanine arm of Goldman Sachs in 2006 and 2007. For funds focused on the traditional middle market (those with fund levels below $1 billion), fundraising was down in 2011 relative to 2010; though eleven funds still raised a respectable $4 billion in total commitments. This continued allocation of capital to this particular asset class by limited partners, and the current $30 billion in capital overhang it represents, is the reason that mezzanine lenders are actively seeking investment opportunities and will stretch on total leverage even for “storied” credits.
Conclusions and Outlook for 2012
The current environment remains highly favorable for companies wishing to pursue capital markets activities, regardless of type or purpose. Whether refinance, growth capital, partial liquidity, or full liquidity, such transactions are both possible and in many cases ideal in today’s market. We are now two years into a strong bullish cycle fueled by pent-up demand for deals, accommodative senior lenders, and a return to normalized earnings levels. Our outlook for 2012 remains favorable given the looming changes in capital gains tax treatment, aggressive senior lenders, and ever-marching demographics in favor of continued need for liquidity events. Significant risks to this view remain the same as the risks to the broader economy and those squarely faced by the capital markets in the second half of 2012, namely continued disturbances within the European Union’s fiscal agendas, elevated unemployment levels, and the dismal housing and residential construction industries. However, in our view, the positives outweigh the negatives, and we look forward to a positive 2012.