Drinker Biddle and GF Data recently co-hosted a roundtable discussion titled “State of the Middle Market 2017” in Chicago. Dave Rubenstein of Drinker Biddle and Andy Greenberg of GF Data® co-moderated the discussion. Thank you to those who attended and participated.
The roundtable participants included representatives of private equity sponsors, senior lenders, mezzanine lenders, investment banks, accountants and others who operate in the middle market, as well as GF Data’s representatives and Drinker Biddle’s private equity and M&A attorneys.
The discussion focused on the increased activity in the middle market private equity M&A market during the first quarter of 2017. Highlights of the discussion are summarized below.
GF Data Report
Andy Greenberg gave opening remarks and summarized GF Data’s most recent report including: Valuations continue to increase, with EBITDA multiples reaching 6.9 times for 2016. A number of factors contributed to this result, including enormous amounts of capital rating for deployment, increasing competition among PE firms, family offices, independent sponsors and strategic buyers, and a very favorable credit market.
Conditions for Sellers Remain Favorable
Attractive industries continue to be food and food services, building products, and health care (especially specific targeted areas such as opioid treatment facilities). Industries in less favor include retail, with the feeling being that not only are traditional brick and mortar retailers unattractive, but even online retailers that compete with Amazon face significant challenges.
There is also a fault line with respect to size of sellers, generally thought to be roughly $10 million of EBITDA. At that level, sellers start to command a significant premium over smaller companies. Others believe the fault line is somewhat higher i.e., $25 million dollars, but that it depends on the industry—i.e., to the extent a $25 million EBITDA company is an important player in a niche industry, it will command a greater premium than at $25 million EBITDA company that faces significantly larger competitors.
There was discussion as to the psychology and current thought process of private sellers in the market. Some thought that sellers generally don’t currently want to wait to sell and are not basing decisions on forecasted tax rates and other regulatory initiatives. Instead, they see sellers who weathered the last recession and don’t want to wait another seven-to-10 years and risk another market drop. Sellers are increasingly seeking minority capital partners in order to liquidate some of their investment rather than go to market to sell the company. Part of the reason is that, although valuations are higher, there is continuing concern with how to deploy proceeds more advantageously than simply maintaining the status quo in owning the company.
Intense Competition Among Buyers
On the buyer side, there seems to be a continuing willingness to forego dynamic growth as a requirement for premium pricing. Part of this has to do with the intense competition among buyers. Others thought that since companies have cut costs and restructured their operations following the recession, their ability to grow has now been hampered by the inability to find workers. It is thought that buyers continue to believe that they have the ability to grow some of these targets better than the current owners. That is now a common sales marketing argument by some sellers.
Credit and Deal Trends
There is an increasing trend of non-bank lenders stepping into the market. The data seems to indicate that deals are being structured with higher senior debt and less equity or subdebt. Therefore, it seems that much of the senior debt increase is attributable to non-commercial bank lenders. Lenders in the mezzanine market are seeing increasing competition from banks and an increase in unitranche senior debt facilities. Banks continue to be restricted due to regulatory oversight.
Other deal trends include the increasing use of seller-side quality of earnings analyses. Some professionals are telling sellers that they must do a QE analysis before going to market and will be significantly hampered in their process if they have not done so.
The trends for the overall market have also been reflected in the legal market and the sales process. Auctions have become increasingly competitive, with increasing buyer attempts to side-step or avoid them. Purchase Agreements are increasingly less “marked up” by buyers and we are seeing break-up fees and other provisions favorable to sellers that were previously much more common in public deals.
In addition, there is increasing use of M&A rep and warranty insurance in bids, which some believe is just the price to play in this market. This trend seems to be filtering down even to lower middle market transactions, where sellers, buyers and underwriters are all becoming more comfortable assessing and addressing risks in that market. Overall, both sellers and buyers seem to think that the insurance option is a very attractive tool, although there is still concern with using it for certain identified risks.
With respect to the distressed market, there is continued activity, but it has not necessarily been good for the M&A market. Companies looking to buy into that market find themselves competing with liquidators, rather than other bidders.
A significant majority of our participants were optimistic about deal volume for the remainder of 2017. In the longer term, there is greater uncertainty based on economic, political and regulatory concerns.