Last week the Wall Street Journal hosted the Middle Market Network to discuss issues relevant to middle market firms in the US. The good news is that middle market companies are getting healthier. With an increase in M&A activity and a boom in the construction industry, middle market businesses are growing and CEO confidence is high.

However, middle market companies still face challenges due to the global economic environment, disruption from technology, and industry and demographic shifts. Below are some of the issues that were discussed along with our commentary:

1. M&A

Middle market activity in 2016 was strong and we can expect robust activity to continue. Debt financing is still relatively inexpensive and the prospect of tax reform is also an incentive for deals. The demographic shift with baby boomers entering retirement and selling their firms also continues to drive activity.

2. Staffing

About half of middle market firms say a lack of talent at all levels impedes growth, according to Thomas Stewart of the National Center for the Middle Market.

Once recruited, middle market companies also struggle to keep employee engaged and satisfied on the job. Stewart suggests on the job training and collaboration with higher education so students learn the skills necessary for joining the workforce.

Another way middle market companies can fill this gap is by acquiring another company for key employees. Also known as an “acqui-hire,” this practice is commonly seen with technology startups, but can be applied to organizations of any size. In fact, identifying “star employees” is an essential part of due diligence.

3. Succession planning

Many middle market businesses have no plan for succession and those that do often fail to execute them.

Succession plans must be developed long before an owner exits in order to ensure the longevity of a company. It takes time to identify and cultivate individuals that can lead the company. Business owners should consider their goals and if anyone is capable and ready to take over. When no succession plan has been put in place, selling can also be option. For strategic acquirers, this is an opportunity to develop a persuasive offer for the company to sell to you. Determine what factors including, price and personal drivers would make selling to you more attractive how it will meet the owner’s goals.

4. Technology

Automation and technology are here to stay and middle market firms need to grasp this reality and act on it. Unlike large corporations who have the money to invest in the latest technology, many middle market companies have not embraced this change either due to lack of resources of fear from works that they will lose their jobs to robots. Marco Annunziata, GE’s Chief Economist, had a few interesting comments, noting “There will always be a human component” to technology. Whether or not this is true, technology has and will continue to dramatically change business.

Cybersecurity is another major concern and only 45% of middle market companies have an up-to-date defense plan. As the world becomes more digital, many companies find they are ill-equipped to deal with data breaches and the threat of hackers. Middle market companies may think cyberattacks only happen to large corporations like Target and Yahoo!, but the reality is no business is too small for hackers to target.

5. Healthcare

Changes in healthcare policy is a major concern for middle market businesses. 74% of firms attending said it would affect their business. With so much uncertainty, navigating the changes and planning for the future has become increasingly difficult.

 

Middle market deal activity reached its lowest level since 2009, according to Mergers & Acquisitions. This may be a result of concerns about the upcoming U.S. presidential election and because banks are shying away from lending to private equity-backed deals.

While middle market M&A activity is down, when compared to 2015 levels, the middle market as a whole is actually leading the U.S. economy in revenue and job creation. According to the Middle Market Indicator, the middle market grew at a rate of 6.3% over the past twelve month while the S&P 500 growth rate was -3.4%. The projected twelve month growth rate is 4.6% for the middle market.

So how should an owner or executive see this paradox? In a word: opportunity. With continued strength in the middle market, but a decline in deals, you have the chance to move more freely than when M&A is hot.

If other companies are paralyzed by uncertainty, you should be emboldened. Seize the opening to pursue transactions while competition is reduced.

M&A can be the best way to own the future, by claiming new market share, adding new technologies, enriching your brand, or expanding your human resources.

But where to begin?

Your first step is to review your current market and identify predictors for future demand. What are your customers buying today? What will they need tomorrow? You probably have an approximate idea but now is the time to conduct thorough research, so you can spot the gaps that your company could fill.

The next step is to consider how strategic acquisition could position you to meet future needs faster than organic growth.

Especially if you have a strong balance sheet, right now is an exceptionally opportune time to accelerate your growth through mergers and acquisitions. So make a plan, and then act.

In light of recent FTC rulings against market domination, Sysco has changed its M&A strategy to focus on smaller, strategic deals rather than large transformative deals. Although Sysco’s change is motivated by regulatory obstacles to larger acquisitions, using strategic, smaller deals is an excellent approach from a strategic perspective. We have long recommended that our clients pursue a series of small transactions to achieve their long-term growth goals. We call this strategy taking “frequent small bites of the apple” because it’s much easier to eat an apple one bite at a time than to cram the whole fruit into your mouth!

Among the advantages of pursuing a series of smaller deals:

1. Focus on One Reason

You may have many needs to meet before you reach your long-term growth goals, for instance improving talent and technological capabilities and expanding geographically. If your vision is growing into a worldwide paint manufacturer and distributor, but you only have manufacturing operations on the East Coast, you will need to expand geographically, build your distribution networks, and perhaps improve on your manufacturing capabilities. Doing all this with only one company may dilute your efforts, or you might acquire a company that really doesn’t fulfill any of your strategic needs.  A better approach: first focus on acquiring a company with an excellent distribution network in the U.S and then another company with quality manufacturing capabilities that match your acquisition criteria. Once you’ve adjusted to this change, you might look at acquisitions outside the U.S.

2. Stay Below the Radar

Large transactions draw attention, especially the mega-deals valued at over $5 billion that have boosted M&A value to record levels. But many transactions are much smaller than these multi-billion dollar deals; in the U.S. from November 1, 2014 to October 31, 2015 there were 12,663 M&A transactions, according to Factset data. 95% of these deals were under $500 million or undisclosed. (Undisclosed deals are typically privately held, smaller transactions that are too small for financial reporting). Smaller strategic transactions allow you to make moves below the radar, out of sight of your competition.

4 reasons why smaller acquisitions are better

3. Adjust to Integration Challenges More Easily

Even the most carefully planned acquisition encounters integration challenges as people and systems adjust to the newly merged company. By acquiring a smaller company, you dramatically limit your integration challenges. Once you’ve had time to work out any kinks and make sure your new company is operating smoothly, you can begin pursuing the next acquisition.

4. Minimize Risk of Acquisition Failure

Although acquisitions are inherently a risky undertaking, smaller strategic transactions are much less risky than large transformative deals. Because integration challenges are minimized, you can remain focused on your strategic objectives, increasing your chances of realizing synergies from the deal. There’s also less financial risk associated with smaller acquisitions; you can minimize capital outlays while rapidly growing your company to reach your long-term goals.

Executing a series of strategic acquisitions is a proven way for middle market companies to grow.

A small deal is also ideal for first-time acquirers who have never pursued growth through mergers and acquisitions. All in all, smaller acquisitions allow you to remain focused, move covertly in the market, and increase your chances of success while still rapidly moving you closer to your vision for the future.

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Instead of investing in growth, companies this year have been holding more than $1.4 trillion in cash – close to a record $1.65 trillion in 2014. Oracle’s $56 billion cash stockpile is 1.5 times its sales and Cisco’s $60 billion in cash is 1.2 times its sales. Eleven companies have cash reserves double their annual revenue.

And it’s not just Fortune 500 companies. According to the Middle Market Center, more middle market firms plan to hold onto cash in 2016. Fewer of them are willing to invest extra money or plan to expand in 2016.

Have U.S. Companies Stopped Investing In Growth?

Companies that stockpile cash don’t invest in stock buybacks and dividends, research and development, other organic growth initiatives or mergers and acquisitions.  A strong balance sheet is important, but the levels of cash held by nonfinancial S&P 500 companies is astounding!  They may be worried about the economy or the upcoming elections. But there’s another possibility: all that money on the sidelines portends robust M&A activity in 2016.

Tax Savings

Publicly traded companies also are stashing profits offshore to avoid paying taxes on them. The U.S. corporate tax rate is one of the highest in the world and tax inversions in particular are being driven by the pursuit of tax savings rather than for strategic reasons. .

The latest example is Pfizer and Allergan’s proposed merger which would relocate the company to Ireland and away from the U.S. corporate tax rate. Other companies that have done this include Chiquita, Perrigo, Medtronic, Endo, and Actavis despite calls for stronger restrictions on tax inversions by Congress and President Obama. Pfizer already has found ways to save on taxes even without the acquisition. The company has designated $74 billion as “indefinitely’ invested abroad.

Invest in Growth Now

As other companies hold onto cash, you have a unique opportunity now to invest in your future. Do this by developing a long-term strategic plan, investing in new products, services or equipment, or growing organically. Or pursue the faster, more powerful vehicle of strategic mergers and acquisitions. Middle market companies can seek privately held, not-for-sale deals that focus on long-term growth rather than on cost savings or short-term quarterly updates with shareholders. This increases the likelihood of a successful transaction and sustainable growth.

Middle market companies cannot afford to dwell on cost savings and sit idle. Make sure you are thinking about long-term growth and how your company will not only survive, but thrive.

Is your company hoarding too much cash? Or are you investing in future growth?

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There’s no denying it that M&A is on fire. Look at any financial newspaper headlines and you’ll see announced deals or merger talks. And keep in mind for all the major transactions involving publicly held companies there are many smaller, privately held transactions occurring unannounced.

We can better understand this current wave of activity and what it means for you if we review historical M&A.  Of two similar spikes in M&A, in 1998-2000 and 2005-2007, the first was primarily driven by Y2K and the dot-com era (or error, depending how you look at it!). This period, though it was marked by a significant burst in activity over a short time, was really an anomaly in the marketplace. It dropped off and certainly wasn’t helped by the events of 9/11.

US M&A activity from 1994 through  Q1 2015

We can better understand today’s robust M&A market by taking a look historical mergers and acquisitions.

M&A activity slowly ramped up until we reached the second peak in 2007 when inexpensive money was readily available. If you think back to 2007, there were a lot of similarities between corporate mortgages, corporate M&A, and the residential mortgage meltdown. The following years were slow for the economy and not surprisingly for acquisitions as well. M&A has a strong correlation to the equity market, although the equity market has done fantastically well since 2009 while M&A remained relatively flat until 2014, when we saw an uptick in activity.

Now there is pent-up demand for acquisitions and we’ll likely continue to see an increase in M&A activity throughout 2015.

Here are some trends to take note of today:

1. Mega deals, transactions over $5 billion, are now back in vogue.

Comparing this year to last, you’ll notice the number of deals has remained relatively flat while the dollar value of deals has increased significantly. In the U.S. for the month of May, the number of deals actually decreased from 939 in 2014 to 903 in 2015. However, the deal value increased to $261.2 million (according to FactSet Data)

2. Banks are more aggressive about lending.

With so much cash in the market, banks are now willing to take on more risk to secure more business. Banks are competing for attention from buyers and are offering attractive loan packages. We are starting to see more covenant-light transactions.

3. Companies still have record amounts of cash on their balance sheets.

Both individual companies and private equity firms now have readily available funds that can be used to pursue acquisitions.

With these ingredients in place, the M&A market remains robust.

What This Means for You

You may think that overall M&A market trends will not impact you, but I can tell you with a high degree of certainty that they will. Every industry will be affected, one way or another, because M&A is both a reflection and a source of business sentiment, and it influences market dynamics in multiple ways. You can be a passive observer or an informed observer. Or you may even choose to be an informed participant. Regardless, I encourage you to take stock of the fact that M&A is causing changes in your industry.  Deal-making may even accelerate in the next few months in industries such as telecommunications, healthcare, and oil and gas. Whether or not you choose to act, of course, is up to you.

With a 70% failure rate for acquisitions, it seems like the odds are against you from the beginning. Before you get scared off, however, let’s take a closer look at what that 70% means.

The 70% failure rate is mainly based on large, publicly traded transactions because large transactions must be reported to the SEC, and information on public companies is generally available. In addition, these large transactions tend to make the news more often since people are fascinated by massive deals involving well-known brands.

Despite this focus on large acquisitions, there are hundreds of smaller, unreported transactions involving middle-market companies and privately held businesses.

We call these types of deals “taking small bites of the apple.” Instead of huge, transformative deals, which tend to be a bit difficult to swallow, smaller, strategic acquisitions achieve a higher rate of success.

Acquisitions are a powerful tool for sparking growth and may be the only way for you to reach your goals. Acquiring smaller companies does not completely eliminate your risk, but conducting multiple, smaller acquisitions, enables you to take manageable steps to executing your growth strategy.

As with any business initiative, you must take some risk to reap the rewards. Following a carefully planned strategy and a proven process will help minimize your risk and optimize the success of your acquisition.

Mergers have hit a seven year high.  While deal value is up 73 percent, the number of deals has decreased 0.4 percent, according to Reuters data. This confirms what we’ve been seeing since last year: larger, fewer transactions. With mega deals on the rise, we will likely see more activity in the middle market as confidence levels improve and executives become more likely to pursue acquisitions and execute deals.

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Midmarket deal flow expanded at the fastest rate in six months, according to a study conducted by Mergers & Acquisitions in April. The survey has positive implications for midmarket growth. As I’ve mentioned previously on my blog, midmarket companies have faced increased competition from larger players and small mom and pops.  Faced with this “squeeze,” it’s likely midmarket companies turned to M&A to spark growth.

Private equity investors and strategic buyers are enthusiastic about 2014. Of the U.S. executives polled recently by EY Americas Transaction Advisory Services, 41 % said they expect to pursue at least one acquisition in 2014, compared with only 23 % polled at the end of 2012.  Uncertainty in regulation remains one of the biggest challenges facing PE firms. Despite this the PE market is growing and private equity activity has begun to make a comeback. Recently released GF data shows valuations acquisitions valued between $25-50m increased to 6.9x EBITDA in 2013.

Family offices will become more accessible for investment opportunities in 2014. Numerous family offices have begun directly investing in or purchasing private companies over the last few years. Family offices have improved capabilities of directly investing, thus allowing them to bypass some of the drawbacks that come from investing via PE funds – such as fees, illiquidity and a lack of control. This trend is expected to continue in 2014, with 2013 seeing a 50% increase in the number of family offices actively pursuing private company investment opportunities.

This post is part of a series addressing current and expected viewpoints on M&A from across a number of professionally relevant sources. Read parts one, two and three of our Midmarket M&A Analysis. 

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This is the third part in a series addressing current and expected viewpoints on M&A from across a number of professionally relevant sources. Read parts one and two of our Midmarket M&A Analysis. 

Industries that showed strong growth in early-stage activity in Q3 2013 included the consumer, life sciences, and telecommunications, media and entertainment (TME) sectors.  Additionally there has been increased activity in the financial services sector.  For Q3 2013 the number of financial services deals reaching due diligence phase was 29% up Q3 vs. Q2 and early stage activity in TME was found to be up 69% up year on year.  Additionally the life sciences and consumer sectors are showing increased activity with the number of life sciences deals reaching due diligence phase 13% up Q on Q and consumer sector early-stage activity up 45% year on year. Furthermore, respondents of a Mergers & Acquisitions survey identified health care, technology, energy and manufacturing as sectors where they expect to see the most growth in for 2014. In support of these sentiments, according to a survey by KPMG, in 2014 the industries expected to have the most M&A activity are technology, media and entertainment (44% of respondents), healthcare/pharmaceuticals/life sciences (41%), financial services (28%), and energy (27 %).

The most attention-grabbing sector for the US has been technology, media and entertainment (TME), alongside a number of megadeals across a range of other sectors. In Q3 2013, announced deals in the TME sector grew year-on-year by 50% in volume and 26 times in value to 25 deals worth US$129.5bn. North American TME companies have been attractive targets of consolidation activities.

The energy industry, and the changing nature of energy supply will be central to global market activity.  Commentators have observed that everything involved in and around fracking will be significant). In addition healthcare — especially as impacts of the Affordable Care Act become clear, is expected to be important through the year and that those involved in healthcare technology and information industries will be the most active.

Telecom M&A is expected to be the focus of much activity in 2014 following signs of gathering strength through 2013 with larger sized deals closing.  Telecoms, by far the most significant sector for the year, accounted for 21% of US M&A activity in 2013 – driven by the $130billion Verizon-Vodafone deal, the second largest deal on record (6).

Consumer M&A activity, particularly in retail, has also seen notably increased activity. In particular luxury retailers that were hit heavily by falling demand during the recession have had some successful rebounding. The retail sector generally is appealing to private equity dealmakers, creating a further driver of consumer M&A activity in the US, with sizeable activity in both buyouts and exits. Industry experts expect the M&A climate to generally trend upward for the US through 2014.

 

This is the second part in a series addressing current and expected viewpoints on M&A from across a number of professionally relevant sources. For part one, read Midmarket M&A Analysis: 2013 to 2014.

2013 saw a number of announced large-cap deals aimed at consolidating market positions and facilitating growth into new regions. Most notable has been Verizon Communications’ announcement of the purchase of the remaining 45% stake in Verizon Wireless from Vodafone. The deal is valued at US$124.1bn and will be the third-largest deal of all time and the biggest in the past decade.

At the same time, completed deals under $1 billion soared in October 2013, as data from Thomson Reuters demonstrates which is leading dealmakers to express continued confidence in middle-market M&A growth.

“Barring a significant macroeconomic shock, 2014 is poised to be a great year for middle-market deal making,” says Mark Brady, global head of M&A at Chicago investment bank William Blair & Co. LLC. Of those who participated in a Mergers & Acquisitions survey conducted in late November and early December, 71 % of respondents said 2014 will be a better year for mid-market M&A than 2013.

In fact, the pendulum seems to be swinging towards the midmarket. According to a KPMG survey there will be very few megadeals in 2014, with middle-market deals dominating M&A. 77% of respondents expect their respective deal activity will be valued under $250 million, followed by 12 % who anticipate their acquisitions will be valued between $250 and $499 million, and only 5% between $500 and $999 million.  

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Following the credit crisis of the last few years and the resulting substantial decline in M&A activity, the subject of a revival in M&A activity has been much anticipated and discussed by industry participants and observers.

This week, we will release a series of blog posts providing a synthesis of M&A sentiment and opinion, incorporating the current and expected viewpoints being expressed across a number of professionally relevant sources. Today we’ll address the outlook for 2013 vs. 2014.

2013 to 2014

Businesses are increasingly turning to M&A to achieve long-term growth and it appears that confidence has returned to the M&A market.

Longer-term economic growth should help bolster US M&A activity and allow it to continue through the upcoming few years.  Supporting this view, the latest World Economic Outlook from the International Monetary Fund forecasts that the US economy will grow by 2.6% in 2014 and 3.4% in 2015.

When compared against S&P 500 firms middle-market businesses show strength and growth opportunities for 2014.  Revenue growth at S&P 500 firms was 2.6 % over the last calendar year whereas middle-market businesses saw revenue growth of 5.5 % over that same period.  Additionally, the NCMM predicts that the next 12 months will see 4.4% revenue growth from middle market firms, as compared to a 1% prediction for S&P 500 firms – more than double the rate of growth.

Following on from Q2 2013, through which there were 7,993 deals valued at a total of $187 billion, making an increase of 0.9% in deal volume and value, 2014 looks set for promising M&A activity.  Largely, fundamentals have remained convincingly strong from the second part of 2013 but the question remains if those conditions can continue through 2014.   Early-stage deal flow in the middle market is accelerating, and dealmakers expect the momentum to continue into 2014 following the substantial upward movement observed from fall 2013, according to polls taken by Mergers & Acquisitions in Q4 2013.

Positive sentiment is indicated in a survey by KPMG LLP, which has found M&A activity is expected to continue the trends of 2013, or grow somewhat, through 2014.  Of more than 1,000 M&A professionals, investors and advisors who participated in their survey, 63% anticipate that their U.S. companies or clients will initiate at least one acquisition in 2014 and 36% of respondents expect that their companies or clients will complete a divestiture in 2014(5). Additionally, among the 145 C-level executives surveyed, almost 75% anticipate their company will make an acquisition in 2014, compared to approximately half in 2013.

Furthermore, the Intralinks Deal Flow Indicator (DFI), an independently verified predictor of future changes in the global volume of announced M&A transactions, has indicated an increase in investor and corporate confidence.  DFI Q3 results have shown strong growth in global early-stage M&A activity, rising 18% year on year.   This indicator points to returning enthusiasm for M&A-led growth over the next six months.

Strong debt and equity markets have the potential to motivate divestitures and exits and this will aid M&A momentum in 2014.  Robert Profusek, global head of M&A at law firm Jones Day, comments: “The deal finance markets have never been better.”

 

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