Hangover Effect for the Dealmakers
Middle market dealmaking hit a bit of a frenzy point in the final weeks of 2012.
Looming 2013 capital gains tax increases meant that many business owners wanted to be out the door before the ball dropped in Times Square, which in turn created a target-rich environment for private equity funds and strategic buyers.
While Thomson Reuters reports that the total value of all 2012 middle market M&A transactions wasn't much changed from 2011 ($199.4 billion vs. $194.8 billion) , the value of 2012 4th quarter closings spiked more than 20% over the same period in 2011.
So what does all that mean for middle market deals in 2013?
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My current assessment is that middle market M&A activity levels should again hold steady this year -- no mean feat given the ardor of those 4th quarter sellers last year. The reasons that are emerging are interesting and somewhat unexpected.
The middle market deal world has three main groups of participants:
- Individual entrepreneurs and families, generally active in the market as sellers, who often build businesses from startup to significance (in the middle market, that usually means $25 million to $500 million in enterprise value) and then for a variety of reasons seek an exit.
- Middle market private equity firms playing both the buy and sell side whose business objective is to acquire, improve, and grow businesses for three to seven year holding periods before seeking an exit.
- Corporate strategic buyers who seek acquisitions (and occasionally make divestitures) that help them focus on their key competencies and business lines.
The entrepreneurs and families are generally straight-up individual taxpayers, and are therefore very sensitive to changes in capital gains tax rates or laws. The private equity firms, however, are much less so: They raise their funds from large investors, generally in chunks of $5 million or more at a time, so many of their backers are non-taxpaying entities like pension funds and charitable endowments. Corporate acquirers are, more often than not, intent on buying and running businesses for the long term, and therefore are also less sensitive to capital gains taxes.
What we saw play out last year was many tax-sensitive sellers come to the table seeking exits before an anticipated capital gains tax rate increase. (We had several clients who said, in effect "Get this deal done by December 31st or we're not selling.") That was a double-edged sword in negotiations, with some buyers trying to take advantage of the date sensitivities of the sellers through overly aggressive due diligence and price adjustment demands. Some sellers dished it right back, however, essentially saying to buyers, "Quit messing around – we close by year-end or we don't close at all."
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Given that many private equity firms also had 2007 and 2008 vintage funds (both were record fundraising years for the PE industry) whose investment periods were drawing to a close, the markets got hot and deals got done.
What I'm seeing take shape for the year ahead is the drivers and laggards in the market switching places, more or less: Private equity funds that gorged themselves on the tax-driven buffet last year are feeling a bit bloated and examining their own swollen portfolios for divestiture candidates. And entrepreneurs and family sellers are now frequently expressing a "there's no particular hurry here – we'll wait it out" mindset.
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Other factors play in to the equation too, of course:
- The lending environment remains bifurcated, with intense competition to lend to very strong companies and sponsor groups and minimal interest for making loans to weaker companies and questionable turnaround situations.
- Corporate buyers remain cash-rich and organic growth-constrained in an economy that still seems to be woozy from recession and deleveraging.
- Private equity fund teams who were frantically busy in the last half of last year now have some time and energy to focus on new transactions after taking a much-needed breather in January.
- The overall market was so crowded with deals late last year that seasoned PE players wanting to sell companies in most cases simply held back, thinking that any assets brought to the auction block in 2013 would enjoy the higher visibility that a slower, more orderly market might bring.
- The fact that federal deficits remain untamed and the tax code seems still to be "in play" keeps a lingering pall of uncertainty over the deal market that prevents it from returning to a fully dynamic state.
All in all, middle market investment bankers and private equity funds' phones are ringing and deal flow pipelines are being refilled. Look for closing activity to be relatively weak in the first half of this year, moving to relative strength again in the third and fourth quarters as players shake off the effects of the 2012 year-end deal party.
Mike McGill is Co-Founder & Managing Director at MHT Partners, a Dallas-based national middle market investment banking firm and a CNBC-YPO Chief Executive Network Member.
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