M&A Market Overview (2008-2017)
In 2008 the world's economies experienced the worst financial crisis since the Great Depression of the 1930s. It is therefore appropriate to review the performance of world equity indices (2008-2017) to establish the economic backdrop driving U.S. middle market M&A activity during this period.
Both 2008 and 2009 were cataclysmic years for financial markets worldwide. The U.S. benchmark S&P 500 Index declined 37% in 2008, rivaling the 38.6% drop in 1937 and the record 47.1% drop in 1931. It rebounded somewhat in 2009 but still finished the year 25% lower than the high reached in October, 2007.
Against this background, middle-market M&A activity in the U.S. fell approximately 30% between 2007 and 2008 and a further 16% in 2009 compared with 2008. Financial buyers, in particular, were constrained by paralyzed credit markets. This was most pronounced in the final quarter of 2008 and the first quarter of 2009.
Middle market M&A activity rebounded 31% in 2010 compared to 2009. Activity picked up sharply in the second half of the year as the Federal Reserve Bank signalled that interest rates would remain low "for a considerable period." This accommodative stance, coupled with additional liquidity, created confidence in both the U.S. public stock markets and the private marketplace.
In 2011, M&A deal volume increased approximately 5% over 2010, despite a marked decline in Q4. Strong demand for quality transactions, coupled with more available bank financing, drove multiples back up to 2007 levels. However, a higher equity component was required to ensure that deals closed. Foreign buyers represented approximately 16% of the market for the fifth consecutive year. Compared to the S&P 500 Index, which ended the year virtually unchanged, other world equity markets underperformed in 2011. Emerging market indexes declined an average of 18%. Japan's Nikkei dropped 17%, and the Eurozone equity index shed over 13%.
Middle market M&A activity in the U.S. in 2012 was similar to 2011, both in terms of dollar value and deal volume. Purchase price multiples also remained flat. Activity was skewed towards Q4, driven by impending capital gains tax increases effective January 1, 2013. Compared to the S&P 500 Index, which rose 16%, other world markets were mixed: Germany (DAX) rose 29%, Japan (Nikkei) 23%, the UK (FTSE 100) 5.8%, and China (SSE Composite) 3.2%.
In 2013, spurred on by continuing low interest rates orchestrated by central banks, most Western (and Japanese) stock markets rose substantially. The S&P 500 gained 32.4%, the German DAX 30.5%, the FTSE 100 21.6%, and the Nikkei 31%. This positive performance was not reflected in emerging markets, which barely broke even for the year. Brazil, one of the worst performers, dropped almost 27%. A strong equity market in the U.S. would normally indicate a strong year for M&A. Valuation multiples did indeed rise, but, because dealmakers had rushed to close transactions by the end of 2012 to avoid a higher long term capital gains tax rate effective 1/1/13, middle market M&A volume in 2013 was 5% less than 2012.
In 2014, while the S&P 500 Index rose 13.7%, many world equity markets dropped in dollar terms. Brazil was down 14%, Russia down 46%, Europe down over 5% and Japan down nearly 4%. Notable exceptions were China (up over 8%) and India (up nearly 24%). Almost all major commodities also dropped substantially in 2014, including oil which retreated over 50% from the high reached in June. In spite of a number of mega deals highlighted in the media, M&A middle market volume in the U.S. was flat in 2014. However, transaction multiples (as measured by EV/EBITDA) rose slightly. This upward pricing pressure was caused by increasingly motivated buyers with record amounts of capital chasing a limited number of available companies.
2015 was characterized by continued US strength, buoyed by the Federal Reserve tightening monetary policy for the first time in nearly a decade. The Euro dropped 10% and the Chinese Renminbi dropped 5% against the US$ during the year. Steep slides in many commodity prices exacerbated the pain for many commodity based economies. The Argentine Peso and the Brazilian Real dropped nearly 34% against the US$ and the Russian Rouble lost 17%. A major culprit was crude oil (Brent) which dropped 35% for the year but it was not alone. The Bloomberg Commodity Index which tracks 22 different commodities, including oil, was down 25% in 2015, the steepest decline in five straight years of declines. Global investors sought safety in risk free government bonds driving the 10 year US Treasury yield below 2%. In a number of countries, including Germany, short term yields on government paper turned negative.
Historically low interest rates enabled many markets to continue to move higher. The S&P 500 rose 9.5% in 2016. It then rallied a further 19.4% in 2017 to end the year 72% higher than the high point reached in 2007 prior to the financial crisis and approximately 400% higher than the low reached in March 2009.
The number of middle market transactions in the US dropped by 14% in 2017 compared to 2016.
Transaction multiples (as measured by EV/EBITDA) remained flat.
While private equity buyers pulled back, strategic buyers took up some of the slack. Strategic appetite was driven primarily by the need to buy growth in a slow growth economy.
The current buyout cycle is slowing. US private equity funds investing in the middle market raised $122 billion in 2017 compared to $127 billion in 2016, $125 billion in 2015 and $142 in 2014.
The valuation of companies acquired (expressed in terms of EV/EBITDA) was little changed from 2016.
Over 50% of private equity purchases in 2017 were smaller add-on acquisitions to existing portfolio companies.
Corporate acquisitions of middle market private equity backed companies represented only 45% of exits.
In spite of the dip in the amount raised in 2017 however, an overhang of investment capital raised in prior years, combined with historically low interest rates, will ensure that private equity firms continue to compete strongly with strategic acquirers in 2018.
U.S. Middle Market M&A Prospects for 2018
Even though the US economy is in relatively good shape compared to almost all other economies, both consumer and national US debt levels are rising. The burden of servicing this debt will increase substantially as interest rates move up from their current historically low levels. It is anticipated that the Fed will continue to raise rates in 2018 and beyond.
The problem of higher interest rates is compounded by the fact that the Cape Index, a highly regarded price earnings ratio for the S&P 500 developed by 2013 Nobel Laureate Professor Robert Shiller and based upon average inflation-adjusted earnings from the previous 10 years, was 93% higher at the end of 2017 (at 32.5x) than the average over the past 136 years (16.8x).
As Shiller pointed out in a NYT article published on 1/23/18, the latest available real earnings per share for the S&P index at the end of 2017 was only 6% above the peak reached just before the 2008 financial crisis. However, by the end of 2017, the S&P 500 was not merely 6% higher than the peak of ten years earlier. It had, instead, risen over 70% above the prior peak.
Put another way, as Goldman Sachs indicated to clients in January 2018, the S&P 500 has been cheaper than it is now at least 90% of the time since records began. The current bull market for equities, and, by extension, the perceived value of private companies, is already quite old by historical standards and near the top of the historical valuation range.
All other things being equal, if earnings in the S&P 500 do not rise substantially, the inevitable eventual reversion to the mean dictates that stock prices will fall substantially.
It is impossible to predict when this will occur. Overvalued markets can remain overvalued for prolonged periods. However, the magnitude of the current deviation of the Cape Index from the mean has happened only 3 times before: 1929,1999/2000 and 2007/8. Major corrections in both public and private markets soon followed.
Given current conditions, the smart money will be on the sell side of an M&A transaction in 2018 rather than the buy side.