KUHN CAPITAL Monday, March 19, 2018
Dispatches from the front

The M&A Thrill Ride


Right now the M&A deal roller coaster is still boring through the rarified, heady atmosphere it entered nearly two years ago. But we’ve been through cycles before and this one feels like it’s getting a bit long in the tooth.

Thomson Financial says that deal volume for the 12 months ending in August was up 7.5% over the same period last year, only a moderate increase compared to recent rates of growth. On the other hand, deal value for the period was $1.1 trillion, up 23%. That looks good, but a lot of it was driven by PE group mega-deals that camouflaged slowing activity in the mid-market

So what lies ahead? To answer that question, we need to describe how we got here.

Why Has the M&A Deal Market Been So Hot?
We think the market is hot now for pretty much the same reasons it’s been hot. Back in 2004 several factors converged to ramp activity up: W’s tax cuts were filling corporate cash tills; banks began lending lots of money on easy terms; and the number and size of private equity groups took off.

Of these three factors, fat corporate treasuries have been the least important: the revival of M&A deal making was mostly due to aggressive PE groups and their accommodative lenders. In fact, for months after 9-11, operating companies froze in the headlights while PE firms kept ratcheting up the sizes and pace of their deals. What fuels these firms’ activity is their ever-growing cash warchests, and their willingness to heap on debt in amounts that scare operating companies.

Yes, it’s true that about 18 months ago, operating companies began loosening their M&A purse strings a bit. But now the PE firms have such huge financing capacity, especially when “clubbing” together, that they can outbid all but the largest operating companies in the world. So PE firms are increasingly dominating M&A deal statistics.

That leaves mid-market transactions. We believe that the hundreds of smaller PE firms now scouring the market for deals have pushed up equity values materially. In other words, it’s an efficient, seller’s market. Across all sizes, deal value/EBITDA ratios are now averaging 10.3x.

PE firms are still buying, of course, but they can only reach their return-on-equity goals by accessing the unusually loose purse strings of the commercial bankers. Even then, some PE firm buyers are now relying on theoretic economies of scale realized through future add-on acquisitions to justify platform company purchase prices.

As for the PE firms’ partner-without-equity, the bank, that’s mostly a tough commodity business. Banks follow lending trends forced on them by competition until their most aggressive peers start falling off cliffs. Then, historically, the survivors rush en masse back from the precipice. Witness the American lender write-offs in South America and Russia a few years back.

What Would Cool It Down Fast
What would send a blast of Artic air through this lending community would a few high-profile bankruptcies at the hands of over-extended PE groups who – since they’d mostly gotten their principal out already through low-tax dividends – would display a remarkable indifference to the plight of their creditors. That indifference would further incite bankers to the exits. Then the big chill would spread to smaller PE fry who suddenly find their loan lifelines drying up.

Of course, we don’t know when all this might come to pass. But the American business experience is pretty clear: investment firm financial engineers have always pushed as much debt onto a balance sheet as their lenders will allow, or until something breaks. They used to be called LBO artists, then MBO artists. Now a growing group of them are “going private” specialists. Whatever they’re called, they’re creating a lot of wobbly balance sheets and we hope that doesn’t bring the M&A parade to an abrupt stop .

Ryan Kuhn

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