By Maurie Cashman
This week I want to complete the summary of the Iowa M&A Conference that I attended a couple of weeks ago. Letâ€™s continue the discussion of trends in the M&A market with a discussion of the financing and credit markets.
As you can see from the charts below, the overall rate environment has stabilized at rates slightly below where they were two years ago. High yield spreads have increased significantly however as investors continue to take on risk in an attempt to capture higher yields. One indicator of capital supply is the requirement of sellers to provide financing. Speakers commented that for businesses with EBITDA under $2M some seller financing was still often required, while above that level it usually was not. Returns on seller notes generally range from 5-6%.
A second comment was made that I found interesting: One panelist comments that an increase in interest rates would have no impact on valuations. There is simply too much buyer supply and money is being locked up at extremely cheap rates.
I do not agree with that assessment for a number of reasons. First, valuations nearly always come down when rates go up. It is a simple matter of increased cash being pulled from the system by lenders and buyers having more attractive places to park money. Secondly, the number of buyers may not remain stable; they may decrease as rates increase. While investors and lenders may be throwing money at buyers now they wonâ€™t be as likely to at higher interest rates and some buyers will opt for safer investments in bonds. Many financial buyers have a limited time in which to invest money and need to put it to work now, while rates are stable and low.
As the Fed continues to wind down its purchases of bonds this is going to have some impact on the bond market, whether or not you believe the Fed is able to control interest rates in the first place.
Finally, will the pool of sellers increase as boomers age and are forced to sell? Supply nearly always balances demand over the long term and I see no reason that they markets will not correct to equilibrium over time. The question is not if, it is when.
As you can see from the chart below, interest rates remain remarkably low and will likely remain so for some time. There is simply not enough inflationary pressure in the market right now to drive them much higher. And with a stock market at record highs, there is little pressure to create falling bond prices.
According to speakers, buyers are having to stretch to get deals done. Some deal values are being justified utilizing increased synergies, which may be a sign of a bubble forming in this market as this justification is pushed to the limit. Buyers have investors and boards that they must report to with expectations of high returns on capital.
As we have discussed, debt is cheap right now. As a result, we have seen median values of deals of $10M-250M climb to record levels. It should be noted that smaller transactions carry a very significant discount to these large deals and also that the following information may be skewed by a few very large transactions. However, it is instructive to look at them for overall market guidance.
A couple of things should be noted. First the level of equity employed in general has returned to pre-recession levels. This is to be expected with low interest financing available. However, the level of debt is exactly the same on a debt/EBITDA basis as it was in 2007, after falling significantly during the recession and the level of senior debt continues to be tighter than pre-recession. So on one hand there is more leverage being applied as a percent of transaction value but less being applied as a percent of cash flow. This leads one to conclude that, while lenders like to tout that they are hungry to lend based on cash flow, they are requiring more collateral than in the past (not necessarily bad).
Some projects are being transacted without financing contingencies in the Letter of Intent. This is obviously favorable for the seller. However, sellers should be aware that buyers are requiring enhanced representations and warranties and performing significant due diligence on the quality of earnings in order to drive these bids. Your financial statements need to be in very good condition if you hope to secure a cash offer.
There is a lot of data that I have shared in the last two weeks and it is inadequate to draw a solid conclusion on the state of the market. It does provide some reasonable guidance however. Interest rates are not going to remain at these levels forever. However, one must remember that there is a reason that interest rates are at this level for a reason, and that reason is uncertainty.
Much has been written about timing the sale of your business to the business cycle. There is of course some truth to that, presuming we know what that cycle is and when it will change. Much like timing the stock market, I believe you should not try to time the sale of your business. Establish goals, both for your business and personally, and when the opportunity comes along to act on them, be prepared.
Those with a plan are almost certainly going to fare better than those that rely on luck.