Uncertainties about valuations are holding back transactions
M&A transactions involving small and medium-sized manufacturers arguably have been more severely affected by the lingering crisis than any other industry segment. Even though credit has shown signs of easing and economists predict a return to steady – albeit slow - growth, transactions in this sector remain limited in number. This article examines the reasons underlying the dearth of deals and tries to find answers to the questions as to whether and - if so when - the industry will pick up its “normal” pace again. Even more important is the question what companies can do to unfreeze the increasingly pent-up demand for strategic transactions.
A healthy deal-flow is important to an expanding industrial sector. Feeling the growing pressure at the hands of their global competitors, forward looking companies have come to depend on acquisitions to fill product/technology gaps or to provide access to new markets. As they, typically, do not have the time nor the resources to pursue all of their projects in-house in a timely fashion, they need to go outside and beat time and competition by acquiring companies that have the desired skills, products or market access.
The valuation madness
Transactions of this nature have been few and far between since the financial crisis erupted – a backlog of needed transactions has been building to the detriment of the competitiveness of many companies and the industrial sector at large. While there is a growing willingness and even eagerness on the part of many buyers, sellers seem to be rather skeptical as to whether selling their company makes sense at this time. In their perception prices right now are too low. There is also a pervasive feeling that in the medium-term valuations might reach the pre-crisis levels again, so they are prepared to wait one, two or even three years before making the decision to sell. This line of reasoning may be flawed, though.
Of course, valuations indeed are lower than they were two or three years ago. The reason is that the underlying profitability patterns and the multiples, two key determinants in any valuation model, have undergone startling disruptions.
For many companies and industries the underlying profitability has changed in two ways: sales have dropped (bringing down profits) and in addition the profit ratios (percentage of profit in terms of sales) have fallen (indicating that some of the overhead and fixed costs could not yet be adapted to lower sales volumes).
Looking into the near or medium-term future there is no doubt that well-managed companies will be able to bring their profit ratios in line again. But, the other part of the equation, the question as to whether and when revenues will climb back to pre-crisis levels and if there is going to be a sufficient and sustainable growth rate in revenues will largely remain unanswerable as the fate of industries and companies continues to be intertwined with the overall development of the national and world economies. Will the economies of the industrialized world resume growth in the next five years? Will there be stagnation? Or will there be a second dip into an even worse recession? Nobody knows, but given the indebtedness of the Western economies a growth spurt of the industrialized world seems to be the least likely scenario in the foreseeable future. Betting on the future remains a big risk!
The multiples, the second key determinant in valuation models, have dropped, too, from admittedly overheated levels. Historically, strategic investors were the “drivers” as it relates to the multiples. If a seller’s company, its brands, products, markets and technologies were of particular interest to a group of strategic buyers its multiples sometimes were literally driven up in a heated auction-like atmosphere. Nevertheless, corporations operate under certain rules; one of them being that any acquisition has to pay for itself after a certain number of years. So, there was and is a “natural” price ceiling, a limit beyond which strategic buyers would not and could not bid. Enter private equity investors.
Buoyed by ballooning liquidity, financial investors started to pile into these quality companies from the early part of the last decade. They had to abide by rules, too, but those were different rules. They were predicated on the belief that the endless supply and growth of liquidity would perpetuate and that prices of investments (by that time financial investors’ prices already were completely decoupled from the companies’ intrinsic values) would continue to rise. And it worked! Private Equity firm A bought a property at a multiple of 7 and sold it again a few years later to Private Equity firm B for a multiple of 8. Company B then sold the same property to another financial investor C for a multiple of 9: a classic bubble that was driven by an oversupply of very cheap money. Many strategic investors – while aggressive - were no longer able to compete amid this madness.
After the bubble burst financial investors disappeared or they were forced to lower – in some cases to halve - their valuations. Now, the situation is reversed again: after lingering on the side-lines as passive observers of the post-Lehman market for a few months strategic investors have jumped headlong into the fray again. In terms of multiples strategic buyers are paying almost the same multiples for good companies again as they were willing to offer in 2007.
Will the good times come back rolling again – and, if so, when?
An attempt to answer these questions can be made by an analysis of the key valuation determinants – the multiples and profits. As mentioned above the “strategics” have come back to the market relatively quickly again and have pushed multiples up to almost historic highs (by their standards). Financial investors also are coming back to the market, but they are offering multiples that are considerably lower than the ones offered by strategic buyers let alone the ones they (the financial investors) offered before the demise of Lehman.
A third category - opportunistic buyers - typically buy at somewhat lower levels than strategic buyers. They are laggards rather than leaders as far as the multiples go – they have not exerted any upward pressure on the multiples nor will they do so in the future. Looking out into the future it is not likely that strategic buyers will go much higher in terms of multiples than what they are offering now; financial buyers will continue to come back, but with a subdued attitude towards multiples for many years to come. And opportunistic buyers have not and will not play a role as far as the multiples are concerned.
In a nutshell: it is rather unlikely that the multiples will go up in the foreseeable future as strategic buyers are willing to pay high multiples anyhow, in particular if synergies can be realized. There are risks, however, that they will go down:
- The ominous clouds gathering over Greece’s and other countries’ indebtedness could be harbingers of a retightening of credit.
- It already may be happening – we only don’t know if or how serious it is going to be.
- If we were to experience inflation in the future the cost of financing would go up and higher costs of financing would depress the multiples
Will profits rise again?
On the premise that long-term profits are a reflection of sales and that sales in turn depend – at least to a degree - on the growth of the economy this question can be rephrased as “When will the economy start growing again?”
Nobody really has a good answer as to what to expect in the next three or four years. With private and public households in debt up to their eyeballs across the industrialized world the locomotives that have been pulling us through the crisis were lavish shots of more debt (stimulus programs) and the relative vibrancy of some BRIC countries, in particular China.
As the effects of the stimulus programs are coming to an end the question arises if the Western economies have gained enough momentum to gather speed on their own or if they need a new dose of stimulus programs to keep going? Another uncertainty relates to China: “Will the Chinese locomotive chug along or overheat and stutter?” These are questions potential sellers should ask themselves before making a decision. Different decision-makers at different companies and circumstances will arrive at different conclusions. However, there probably would be agreement that banking on a recovery of the OECD economies (Western industrialized countries) in the short or medium-term is a high risk gamble.
Against this background it may be safe to conclude that the current times may not be all that bad for sellers. Of course, valuations are no longer what they used to be a few years ago, but they may not reach those levels again in a very long time anyhow –they were inflated as they did not reflect the intrinsic values of companies; they reflected the empty value of speculative financial instruments.
What should potential sellers do?
Just as there is a need on the part of strategic buyers to continue to buy even in times of tightening credit, there is also a need for sellers to sell their companies. Many scenarios come to mind that may make it necessary or desirable to sell or find a strategic partner: owners or managers reach retirement age; the particular industry is under consolidation pressure; the company may have excellent products and a strong balance sheet, but it may feel ill equipped and too small to compete on a global basis etc.
All of these scenarios have a built-in time factor, meaning that one can push out a decision only for so long before the window of opportunity closes. For example, if a company misses the consolidation boat, its owners may wake up one day running a small company surrounded by giants, who no longer will need to buy their company at a premium, but they might buy it as an opportunistic play (if and when it becomes available at a low price) or they might not be interested in buying the company any longer. Similarly, if the managers/owners’ age approaches retirement age they have to ask themselves how many more years they are prepared to wait to get the sales process going? Are they taking into consideration that the sales process can take a year or longer and that sometimes the buyer wants them to oversee the transition and stay for another two, three, four years?
This article does not pretend it has an answer as to what the optimal timing for the sale of a company or a divestiture is (this by itself could be the topic of a doctoral thesis) nor does it want to give recommendations as to when a company should be sold as each case is different. However, what should be pointed out is that built-in time factors for many companies are of immense importance and that they should be periodically reviewed in a systematic fashion by the shareholders even if a sale of the company is not on their mind.
And yet, there is another time factor that often falls by the way-side: the time value of money. The latter is of particular importance in times of economic turbulence like the ones we are experiencing right now. Are we going to have inflation in a year or two? Or maybe even hyperinflation as some economists suggest? The latter group asserts that there will be inflation as it seems to be the only way for governments to get rid of their debts.
If after due consideration of all relevant factors, the owners of a company come to the conclusion that it may be better to sell now rather than wait they have the option to sell it in a direct process or to use one of the (creative) deal-structure models that have come to be very popular. Some of the more interesting models that are being used today include:
- A direct sale: the sellers would hire an M&A firm/consultants such as GGI that help them organize a process. One of the key elements of this process consists in adequately bringing out the company’s unique advantages (provided it has any) and match them with the needs of potential buyers. The objective must be to identify a large enough group of excited and motivated potential buyers so that the bidding process will lead to an auction.
- Earn-outs: if sellers continue to be confident about their future growth and profitability, while buyers are “not sold on forecasts”. These different perspectives on the future often can lead to widely diverging valuations. One way to bridge the gap would be the use of earn-outs. Nobody likes earn-outs, everybody considers them to be too “messy” and yet from what we see the years 2009 and 2010 could be dubbed “the years of the return of the earn-out”
- Share-deals: some public companies might offer to use shares rather than cash for an acquisition. Most public companies’ share price is down 25% or 30% from their peak levels. If sellers are optimistic about the economy then it stands to reason that the share price of that particular buyer will surge along with the economy. Of course, there is risk involved, so GGI would never recommend a straight share deal. In similar scenarios the conservative position is to use a mix of cash and shares. Traditionally, large strategic buyers have been reluctant to use shares for acquisitions as their shareholders did not want to dilute their holdings, but given the shape the economy is in and the threat of a recrudescence of the credit-crunch some corporations are rethinking their position.
- Merger: another rather appealing model is to merge two closely held companies. The advantages can be multi-layered:
-- if the companies’ “home base” is in different countries/markets they can get immediate access to each other’s customer base
-- if they have complementary products they could offer a more complete product range, leapfrogging their competitors
-- merging might give them the size to act globally
-- as a bigger entity they might become very attractive targets to multinational players
-- they might be big enough to consider taking the company public
-- if one of the partners has a young, dynamic management the succession question might get resolved, while the “older” owners of the other partner remain on the board of the combined company.
Finding the right merger partner is very difficult as the partner’s profile has to meet many criteria. It will be critical that the company does a very analytical and systematic approach. Again, it is advisable to use specialist firms such as GGI that have knowledge of the market, experience and are following a disciplined methodology.
The above “approaches” only address some situations. Each company is different in the framework of the circumstances it operates in. There is no one-size-fits all solution. Depending on the circumstances the above models might have to be tweaked and adjusted or an altogether different model might have to be considered.
GGI’s role in a successful transaction
GGI is one of the very few specialists in the industry that focuses only on narrowly defined industry segments. Beyond those industries GGI does not accept any new business. In its focus industries GGI knows the key players on the entire globe. Depending on the type of transaction GGI’s role may differ. However, the distinguishing and unique contributions that GGI brings to the process are related to its knowledge of the industry:
- GGI knows who the potential players are
- GGI knows key decision-makers at many companies.
- GGI knows or can find out with a few phone calls how potential buyers feel about certain products, markets, technologies etc., how they feel about certain advantages and features.
- GGI helps to “bring out the advantages”
- GGI knows the buyers and can work with them and the sellers to shape new creative deal-structures should there be a gap between sellers’ expectations and the buyers’ willingness to pay.
These distinguishing characteristics have been very helpful in getting deals successfully completed. GGI is very confident that its unique approach will continue to help sellers get optimal valuations even in difficult times.