Before examining the current climate for acquisitions, a brief review of recent deal pricing is necessary to put things in perspective. In 2006 and the first half of 2007, the greatest market bubble in middle market deal pricing in more than 50 years occurred. Any middle market executives that had plans to sell their companies within the next 20 years should have sold then—those pricing levels will probably not be seen again in your lifetime. During the second half of 2007 and first half of 2008, deal pricing reverted to normal levels. However, as the business downturn started in the third quarter of 2008, which led to the Great Recession—the period encompassing the fourth quarter of 2008 through the start of the third quarter of 2009)—deal pricing collapsed. In fact, 2009 was the first year the world economy contracted since the 1930s.
Fortunately, although economic and market conditions were awful, they never deteriorated to the levels realized during the Great Depression. However, middle market deals, defined as transactions with values between $5 million and $250 million, were few. Those that were completed were usually at deeply discounted prices. This pricing level continued until the start of the third quarter of 2010. At that time deal activity and pricing started to improve.
Current Deal Pricing
During the first quarters of 2011, deal pricing is making strides to return to normal levels and middle market deal activity (which is not necessarily comparable to large deal activity) has greatly improved. However, many acquirers still believe they can “steal companies,” primarily due to the depressed earnings most companies realized during the economic downturn. Many sellers are susceptible to accepting these discount prices, as the scars created by the economic downturn have them concerned they won’t be able to sell their companies. However, by the latter part of 2011, middle market deal pricing is expected to increase to above normal levels.
During 2011, as many acquirers use the depressed earnings realized by a seller during the two-year period ended June 30, 2010, as justification for a substandard offer, it is imperative for middle market executives to understand that their companies are long-term assets, and sale priceS should not be impacted by short-term transient considerations.. Furthermore, any serious acquirer does not anticipate earnings returning to 2009 and 2010 levels in the foreseeable future, or they would not be interested in buying companies.
Middle market executives must remember that the true and most significant determinant of a transaction price is a company’s expected future EBITDA/earnings, and the risk in achieving that EBITDA from the business foundation is assumed by an acquirer. This is an acquirer’s major consideration in determining a seller’s value. Any other factors cited are merely used for negotiating leverage and to justify an unwarranted discount price. Consequently, you should not entertain any discussions regarding your earnings during the two-year period ended June 30, 2010, as a factor in establishing a transaction price. Those earnings simply are not a consideration.
Expected Deal Pricing in Late 2011 and 2012
The optimum time to sell a company should be the latter part of 2011 or 2012. This is due to a number of factors:
1. Most companies’ earnings began to show some strength during the second half of 2010. Earnings should continue to grow in 2011 and increase at an even higher rate during 2012. Furthermore, 2013 should be a very good earnings year, supported by a healthy economy. These earnings levels make it possible to realize a premium price.
2. During 2011 and 2012, the capital gains tax will remain at a reduced level of 15% compared to the prior rate of 20%. It is unlikely the 15% rate will be extended beyond December 31, 2012. This 5% tax savings on the realized gain is a significant consideration when determining the timing of a sale.
3. The cheap money, which is a by-product of the excessive credit provided by the U.S. Federal Reserve, should contribute to strong acquisition prices during this period, while still enabling the acquirer to have a solid return on invested capital.
4. As 2011 begins, the majority of banks are loosening the credit spigots. By the latter part of 2011, it is anticipated the availability of credit to be at normal levels.
5. Around the end of 2010, acquirers began to aggressively pursue deals.
These factors combined strongly suggest that those interested in selling their companies within the next seven years should seriously consider selling them during the latter part of 2011 or 2012.
Factors in 2014 and Later
Beginning in 2014, the intermediate and long-term economic outlook gets pretty murky. It is not inconceivable that the economy could stay strong during 2014 and 2015; however, a number of factors give off warning signals that trouble could be on the horizon, which could affect these and/or 2016 and beyond. These factors could negatively impact middle market deal pricing and activity—possibly significantly. Some of these concerns, which could have a major negative impact on the world economy, are:
1. The condition of the credit markets, especially in Europe, could be an intermediate to long-term financial problem.
2. Major issues are impacting the Chinese economy and banking system—including the Chinese Central Bank increasing the “benchmark” lending rate and the reserve requirements for the commercial banks in an attempt to reduce an increasing inflation rate. Potentially, these could have a negative impact on the Chinese economy. And as the Chinese economy is one of the most dynamic and important economies in the world, a negative impact on it will likely have global consequences.
3. The political and economic instability in the world at this time could provide the basis to produce an event that would have wide ranging repercussions.
4. There are many global “hot spots” that could erupt at any time. The impact of any of these events could produce fear and tremendous instability in the financial markets.
I am not saying that intermediate and long-term economic and market conditions will definitely be bad. However, I am strongly advising that a company considering selling should make that sale in the latter half of 2011 or 2012 due to the substantial risk facing the economy and acquisition market in 2014 and subsequent years. The risk factor is, simply, too great to delay a sale until 2014 in light of all the positive reasons why a sale should take place before December 31, 2012.
Although the 18-month period ending June 30, 2007, was the most lucrative time to sell a middle market company in more than 50 years, the latter part of 2011 and 2012 should present a great opportunity to sell at a premium price. This is true for the myriad of economic, tax, financial and market reasons.
George Spilka is president of George Spilka and Associates, a national investment banking firm based in Pittsburgh that specializes in middle market, closely held corporations. Advising since 1978, the company offers a broad-based service that advises clients through the entire acquisition process, and in preparing a company for sale. [email protected]; www.georgespilka.com; 1-412-486-8189