Pent-up Demand for Deals

There are many reasons why the mergers & acquisitions markets should be heating up.  Let’s recount just a few of them in this post as we wait for what should be happening to begin to happen.

• According to PitchBook, there is a $425 billion “overhang” of private equity just waiting to be invested. Much of this equity was raised two or three years ago or more, and there is growing pressure for the private equity firms to invest the capital. For a chart illustrating this overhang, see here.
• However, there is another overhang in the private equity markets. PE firms have invested in more than 6,000 companies in the United States. Of these, some 4,000 are maturing investments in companies where the PE firms are under increasing pressure to sell in order to generate returns for their investors.
• Corporate coffers are over-flowing with cash, with more than $2.2 trillion in cash sitting on US companies’ balance sheets.
• Commercial and Industrial lending is on the upswing, primarily in banks with more than $1 billion in assets.  Smaller banks are seeing upward trends in lending, but primarily on the real estate side.  More bankers everywhere are beginning to think in terms of commercial lending.  If they got creative, perhaps they could facilitate some dividend recapitalizations and partial buyouts in successful closely held businesses that don’t want to sell in the entirety?

The Age of Aquarius?

The population of Baby Boomer business owners continues to age. I don’t have to cite a statistic for this. All I have to do is calculate the average age of business owners I meet and look at myself.  Many business owners are perhaps waiting for that elusive perfect time.

The absolute perfect time to sell a business is when the stock market is hot, when the economy is good, when industry conditions are favorable, when financing is readily available and cheap, when conditions at a company are on the upswing or perking along with good margins and growth,  when management is ready and has plans for what follows and ….  It reminds me of a song by the 5th Dimension, Age of Aquarius, which states, in part:

When the moon is in the Seventh House
And Jupiter aligns with Mars
Then peace will guide the planets
And love will steer the stars

This is the dawning of the Age of Aquarius
Age of Aquarius
Aquarius! Aquarius!

I’m not sure if the Age of Aquarius, or the perfect time to sell a business, will ever come. I wrote about this in February 2011.

A Perspective on the Baby Boomers

To touch on the Baby Boomers once again, many baby boomer business owners missed the surge in mergers & acquisitions activity that preceded the crash in 2008.  There was pent-up demand for selling businesses in 2008. Now that we are on the short side of 2012, that pent-up demand is causing unknown pressures for business owners, their families, and their employees, who are uncertain about the necessary transitions that await.  One M&A adviser tells the story this way:

What happened between 2008-2011?

The answer, from a business transition viewpoint, is very little. Businesses generally suffered a decline in revenue, profitability and cash flow, making them less valuable to buyers. It became very difficult to finance the purchase of a business as credit became tight and de-leveraging began to occur. Transactions were difficult to close. Sellers sought a return to the prices that were paid in 2005-7 which was not realistic given the reductions in value. Companies that performed well during the downturn achieved greater multiples of value as there was a shortage of supply of quality sellers.

Baby Boomer Transition Bubble just got kicked down the road?

In essence, the bubble is still there – it just got kicked down the road. Now, the backlog of sellers is bigger and the situation may become more urgent.  It is true that most business owners have adjusted their retirement expectations and it has been estimated that retirement ages have been pushed out about 3 years on average. Since very few businesses sold during the 2008-2011 timeframe, there is an enormous backlog of business owners who would sell given the right circumstances. Our best estimates are that between 1.2 million and 1.5 million business owners are in that backlog.

So What Should Business Owners be Doing?

Pent-up demand for business transactions is a fact of life.  We know from history that transactions tend to come in waves.  When will the long-awaited wave of transactions involving Baby Boomer business owners arrive?  I don’t know, but it almost has to come soon.  In terms of age, the leading edge of the Baby Boomers turns 67 this year.  The lagging edge turns 47.

Many of the Baby Boomer businesses are small firms with limited potential in the M&A markets.  However, much of successful, private corporate America is owned by and led by Boomers.  We won’t live forever.

I spoke with a business owner the other day.  He is 75 years old and still working.  His business needs to be transitioned to the next generation of owners (not his family).  And yet he waits.  The longer he waits, the less ability he will have to negotiate a favorable transition.  The situation is even more dire if he becomes disabled or dies and his family is left to handle the transition. This is, perhaps, an extreme situation, but it is not uncommon.

Owners should, as always, be running their businesses as if they were in the market to sell. I have said many times that a business that is ready for sale is, well, ready for sale.  It is also a whole lot more fun to work in than one that is not!

So business owners should be preparing themselves and their businesses for the next transactional wave.  Business advisers should be encouraging their clients to get ready, as well.

The tsunami is coming.  We may not see the Age of Aquarius, but we will see more deals in the foreseeable future.  Will you be ready?  Will your clients be ready?

If you need help with valuation or transaction issues, give me a call.

Customer concentrations are a risk for any business having them. Public companies must disclose any customer relationships which account for more than 10% of their revenues.  Public investors are interested in them and in being able to assess the degree of those risks.  Two recent announcements by sizable public entities highlight the importance of customer concentrations.

FedEx and the U.S. Postal Service

FedEx Corp. announced on July 17th that its contract with the U.S. Postal Service expires in September 2012. According to a Reuters article:

•  FedEx is the Postal Service’s largest contractor
• The Fedex contract, which has been in force since 2000 with extensions, is set to expire in September and will be up for rebid
• The contract accounts for $1.5 billion, or over 4%, of FedEx’s $43 billion in sales
• United Parcel Service (UPS) is the logical competitive bidder
• FedEx will definitely attempt to retain the contract, but likely on less favorable terms if it succeeds, which some think is likely
• The contract renewal will cast an overhang on FedEx shares until the issue is resolved

FedEx shares fell 1% during the day of announcement.  With a market capitalization of some $29 billion, this represented a decline of $290 million in market value.

SAIC and Lockheed Martin

SAIC, Inc. recently announced that it lost its largest government contract to Lockheed Martin Corp.  In a Bloomberg release and from SAIC we learn:

• Revenues for SAIC are about $11 billion
• The contract was estimated to provide “base revenue” of $1.9 billion over three years, so on an annual basis, it provided about 6% of revenues
• One investment bank lowered its 2014 EPS estimate for SAIC from $1.38 per share to $1.26 per share
• SAIC plans to protest the contract loss and there is some chance that it could be regained

SAIC shares fell as much as 5.2% during the day of announcement and closed down 3.1% for the day. With a market capitalization of some $4 billion, the closing price represented a decline of $120 million in market value.

Business Valuation Implications

The fact that a company has customer concentrations is important.  That’s why business appraisers always ask for an analysis of revenues (and profitability in many instances) by customer.  Customer concentrations definitely create risk and must be considered in business valuations.

Many years ago, Mercer Capital valued a distribution company on an annual basis.  The company was profitable and growing.  Management was always a bit dissatisfied with the relatively low multiple we placed on their earnings. Remember the basic valuation equation:

We considered the risk of the customer relationship in the discount rate, r, which was utilized in the appraisal.  Obviously, if r is increased, (1 / (r – g)) decreases, and value is decreased as a result.  With FedEx and SAIC and their recent announcements, the fact of the potential losses caused a laser focus by the markets, if only for a short while, and value was affected.

More background on this client company from years ago:

• The company’s largest customer accounted for about 60% of sales
• Growth at the business was fueled by rapid geographic expansion of the largest customer
• The relationships between company management and the management of the largest customer were excellent
• Obviously, we asked about this relationship every year at appraisal time
• According to management, there was “no chance” that they would lose this customer relationship

But something changed.  One Friday afternoon, the largest customer was acquired.  On Monday, the contract between our client company and the largest customer, which was only verbal after many years, was terminated.  Within two weeks, all business had been diverted to the favorite suppliers of the acquiring company.

Our client company did survive.  Fortunately, they had retained some earnings, responded quickly to the loss, and hunkered down.  It took a number of years for them to return to reasonable levels of profitability, but they did.  Their next annual appraisal reflected a sharp decline in value, but not nearly so much as would have been the case had we not made specific consideration of the concentration risk.

Lesson Learned

The lesson I learned there and elsewhere is this:

Every customer relationship has a beginning, a duration, and an end.

What the markets are saying in the examples of FedEx and SAIC is that the loss of a customer is a time to reevaluate not only that relationship, but other customer relationships as well.

Business appraisers must focus on the risk of customer concentration, as well as other forms of concentrations (suppliers, products, geography, etc.).

Q:  Isn’t a valuation process agreement just a fixed price buy-sell agreement that is updated every year?

Answer:

The question is a good one.  And the answer is “no” and “yes.”

“No.”  A buy-sell valuation process agreement specifies just that – a valuation process to determine value.  The price is determined by appraisal. It is the appraisal process that establishes value on a regular basis or at trigger events, and not agreement of the parties in the context of setting price. So a valuation process agreement is not just a fixed-price agreement that is updated each year.

“Yes.”  A valuation process agreement does set a price which, for a time, is fixed.  In that context, it is a “fixed-price” agreement.  However, unlike with an actual fixed-price agreement, which calls upon the parties to reset the price each year (and they seldom, if ever, do), the valuation process agreement specifies a process for “fixing” the price that is, once underway, outside the hands of any party.

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For more information on this topic and other topics related to buy-sell agreements, check out Buy-Sell Agreements for Closely Held and Family Business Owners.

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This series, “Ask Chris Mercer,” is derived from the Q&A session of the May 16, 2012 webinar, “Buy-Sell Agreements” sponsored by WealthCounsel and attended by over 600.  

If you have a question for Chris, feel free to email him directly here.