July 4th, 2011
I am a sailor. I am also an investment banker and mid-market M&A adviser. The two are not so dissimilar.
Progress towards a destination in a sailboat often is not point to point. If the destination is upwind, tacking from side to side will get you there, albeit 'in due time'. Sailboats can make progress to wind 30-50 degrees on either side of the direction that the wind is coming from. If you want to sail North and the wind is out of the North, the best you can do to move North is either Northwest or Northeast. Sailing directly North is not an option. Attempting to sail due North results in a condition known as 'in irons'. That means that the boat stops, the sails flap, there is no water moving over the rudder, eventually the vessel drifts backwards...and it can get ugly from there.
Privately held companies with annual revenue between five and twenty five million seeking recapitalization, exit or financing to support an acquisition are in irons. The conditions that led to a standstill, perhaps even a backwards drift at that end of the market, can be listed in five bullet points:
- Companies with a solid profit profile are not motivated to exit in a market less favorable than three years ago. Like most every other asset (houses, commercial real estate, equity portfolios etc.), small businesses are less valuable than they were three or four years ago. Profits may be trending up, but multiples of earnings are off 20% or more depending on the business, its path through the recession, and its ability to respond to an expanding market - whenever that happens. Private business owners whose businesses were valued at $10M in 2007 and have continued to perform through the recession will likely not command a $10M market price today. That fact is a discouragement for owners to exit when they are willing to continue to operate their companies and collect its profits.
- Banks - regional and national - have a new level of federal government oversight regarding their business lending practices. Bank financing to small businesses is off 15-25% compared to 2007. Small businesses typically do not have the same financial predictability that much larger corporations do. Banks, in the business of managing risk for profit, have imposed much more stringent lending criteria for small business - or did the federal government help them to do that? Companies that have historically managed their credit lines find that they no longer have them...that slows growth...which retards value accumulation...which well, gets back to point one.
- Owners once moving toward an exit have been forced to reengage with their companies to lead them through the recession, or to manage costs, or because they realized that the exit they planned was not going to be as eminent as they had once thought. This action results in companies without a management layer beneath the owner that an acquirer needs to see in place to assure the company's performance through a transition. This creates an unfavorable value adjustment. A company is more valuable if there is both an owner and a management team in place.
- Private acquirers have had their resources reduced through the recession. While the Private Equity Groups have reported a truckload of dry powder waiting to be invested, many of these transaction sizes best fit private and small strategic investors who have a smaller war chest and suffer from the same difficult access to bank lending as other small businesses.
- Impending capital gains tax rate changes. Owner exits before or after an amendment to the capital gains tax rate result in significantly different proceeds to the exiting owner. Part of the argument to this point would be, 'hurry up before the tax rates increase'. The other part is, if the same company is worth 20% less now than three years ago; a typical owner's strategy would be wait until he can get that 20% back before he exits...which may be on the same timing as when Congress allows the capital gains rate to increase. Better, better...well wait a minute...
I have no corner on knowing what the future holds, but here is some thinking that I share with others:
- Owners will need to exit their businesses...sell, merge, gift, or close; and after a three year pause, a buyers market [more quality offerings than quality buyers] will be created. \
- Banks make money by lending it. Their loan portfolios will come back into balance, and business loans; SBA and otherwise, will not operate in such a tight money environment; albeit 'in due time'.
- The tax effect is a toss up and how it is addressed largely depends on unemployment in 2012. If it less than 8%, Obama and company continue; if it's greater than 10% as it is now, there will be a new sheriff in town. Anywhere in between, too close to call. The government certainly has budget concerns to address, I will vote for the guy that has the plan to address the expense vs. the revenue side of the federal government's income statement.
- Business owners are a resourceful lot. In irons with no progress is not an acceptable go forward option. They will adapt their enterprises to best fit the economic environment which will create incremental value. Increasing enterprise value with more access to growth capital will create its own M&A transaction activity which will get the banks back in the financing business.
Or at least, that is what I bet the ranch on.
