M&A Activity Downshifts in Tough Economy
By John Jazwinski, managing director in Deloitte's Corporate Finance Advisory practice and the leader of the Primary Metals Group. In this role, he counsels clients on the purchase and sale of their businesses. Based in toronto, he can be reached at 416-602-1174 or by email at firstname.lastname@example.org.
In each of the last two years, I have written in this column about the level of merger and acquisition activity in the service center industry, the rationale behind transactions and the valuations realized by those selling their companies. The thesis for these articles was that changes within the steel supply chain continue to reward larger companies, and that valuations and the availability of capital made transactions attractive to both buyers and sellers alike.
Much has changed in the last year.
While many service centers still need to grow by way of acquisition, valuations are lower and bank capital in support of transactions remains difficult to access for even well-capitalized companies. In light of these changes, many potential sellers feel the current environment is unfavorable for a transaction and are postponing the sale of their businesses.
While the current market presents challenges for any transaction, the reality is that opportunities to sell remain positive for owners of good businesses.
The value of North American public service centers is much lower than last year. In January 2008, major public service centers were valued at an average of approximately 8.0x earnings (EBITDA). This was at a time when subprime challenges were starting to unfold and the market was unaware of the cascading effects about to take place. In the ensuing months, all industries traded much lower than their historical averages.
The service center industry was no exception. In December 2008, public company enterprise valuations had fallen to an average around 5.5x EBITDA (see chart in print magazine).
While multiples typically are lower for privately held companies, the decline was not as dramatic. This time last year, Deloitte arranged transactions with a range of 5.5x to 6.0x earnings. More recent multiples have been in the range of 4.0x to 5.0x EBITDA, though often applied to record earnings.
The decline in private company multiples has been tempered by the industry’s pre-recession prosperity. Indeed, many closely held service centers are in their strongest financial position in recent history. Those with a long-term customer base, diversification across multiple industries or order sizes and sales into unique markets or applications remain attractive to strategic buyers. Service centers with access to niche steel products, such as electrical steel or certain types of large-gauge seamless pipe, are particularly desirable acquisition candidates. In short, good businesses continue to sell at an attractive price.
Deals take more structure
The credit crisis has motivated active buyers to be more selective in the pursuit of and approach to acquisitions. Active buyers are almost exclusively from the service center industry with only a handful of private equity funds with access to bank capital buying businesses. These buyers and their capital partners are taking more time to scrutinize each deal and are employing transaction structures that share a greater portion of post-transaction risk with sellers.
Buyers today are conducting more financial and operational due diligence and, in some instances, hiring special consultants to study the commercial reasonableness of a company’s business plan. As more diligence requires more time, buyers have more opportunity to observe and monitor business performance and to mitigate any new risks through additional structuring of transaction terms.
The timing of a transaction may also be delayed should capital be required from outside partners such as banks or specialty finance companies. Sourcing affordable capital to fund transactions is difficult in the current market. Our recent experience shows that smaller regional banks and major Canadian banks that have been more insulated from the mortgage crisis are still backing transactions. However, even at these banks, the maximum amount available for a borrower has been reduced to under $25 million. Should a buyer require more than $25 million, it may be necessary to access that capital from multiple lenders. As the number of banks involved increases, so does the time it takes to complete due diligence activities and close the loans.
We counsel our clients to confirm with buyers that any outside capital is committed and verified with written correspondence in the early stages of transaction structuring.
Buyers also are employing additional structuring mechanisms to backstop the lack of available bank capital and to share post-transaction risk with sellers. Such structuring alternatives include:
n Seller notes and rollover of shares: Sellers may be required to hold notes that are unsecured, but that pay a current interest rate more favorable than banks. Sellers may also be asked to roll over a percentage of their equity and participate in the ongoing success of the business. These structures align buyer and seller interests post-transaction and provide a form of mutual insurance for business success.
n Different classes of shares: Some buyers are seeking to prioritize their investment over the sellers through different share classifications. In the event the business is sold or experiences financial challenges at a later date, then a buyer’s equity would be returned first.
n Earn-outs: Earn-outs are a common way to motivate sellers to remain active in a business. In the current market conditions, a larger portion of transaction consideration is often deferred by way of an earn-out, and performance milestones are being elevated.
n Ancillary agreements: While these agreements are company and transaction specific, more ancillary agreements are being requested in the current market to lock up key employees, customers, suppliers and management.
How you can prepare for a sale
If you are the owner of a service center and are contemplating the sale of your business, there are several steps you can take:
n Recognize that the world has changed and reset your value expectations slightly lower.
n Sell. Sell. Sell. Drive sales volume with existing customers and into new products, sizes and applications.
n Use the current headlines as an excuse to speak with your customers and suppliers, ask difficult questions and closely manage working capital.
n Bulletproof your business plan. Take time to write a plan and place emphasis on your growth objectives, customer base, access to supply and working capital management.
n Build a financial model. The model should be both short and long term and reflect your strategic planning within a range of likely operating scenarios. This demonstrates to buyers that you are a smart operator and a forward-thinking business owner.
n Consult with advisors. Share your plan and seek advice on the value potential for your business, how to organize a sale that creates competitive tension, and how to navigate through the legal and financial structuring that congests deals today.
Given the challenges in the capital markets and buyers’ newfound propensity to take longer to close, we will see fewer service center transactions in 2009. While the sale of your business will take longer and may be more complicated, buyers are selective but active and the opportunity to sell at a reasonable value is still available. Take time in 2009 to reflect on your personal and business objectives, and to make better decisions that will optimize the value of your business in this challenging environment.
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