Q4 2012 was a heady time for the M&A business and almost every observer of the industry expected 2013 to be the year the deals business broke out of its five-year post financial crisis funk. Best laid plans and all that -- the low level of deal activity that has occurred to date in 2013 has both surprised and disappointed most industry participants. Yet there are signs that this could change.
During H1 2013, deal volume fell off significantly, reflecting a cleared pipeline after the year-end burst. Fortune reported that global M&A announcements for Q2 2013 were the slowest since Q3 of 2009. The U. S. market fared comparatively better, with the dollar value of announced deals up 34% year to year in H1 2013. European activity on the other hand collapsed 43% with the euro crisis and continental recession still in full swing at the time. Even the relatively high level of U. S. activity depended in great part on the announcement of two large deals (Heinz (HNZ) and Dell (DELL)) at the beginning of the year. Without those announcements the U.S. market would have appeared lackluster at best.
The middle market companies we represent depend on both strategic and private equity buyers for business exits. Most M&A industry observers believe that bulging corporate coffers and slow, organic growth will eventually dictate a strong increase in strategic M&A activity. With the exception of a few target sectors, particularly IT related businesses, this corporate gold rush has yet to materialize. As a result, private equity will be a more important source of buyside demand, at least for the near future.
PitchBook publishes the most comprehensive analysis of U. S. private equity activity. Its first-half summary tells the story:
"Dealmakers were optimistic heading into 2013, anticipating one of the most active years for private equity (PE) investment since the financial crisis. All of the pieces seemed to be in place: debt financing was cheap and readily available, PE firms were sitting on mountains of dry powder nearing expiration, there was a large inventory of aging portfolio companies, and investors were primed to get more clarity on regulation and taxation following the elections.
But while public equity markets experienced strong gains throughout the first half of 2013, PE deal-making was at a lackluster pace in 2Q 2013, reaching a new quarterly low since the depths of the financial crisis. PE firms invested $71 billion across 318 deals in the second quarter, down from the 420 investments in 1Q 2013 and far off last year's stellar fourth quarter, in which 671 companies received $141 billion in PE money…
…yet 2Q 2013 may end up being known as one of the least-active quarters for PE investment in recent memory."
GF Data®, which provides valuation information for PE transactions at the lower end of the middle market, was more colorful in their description of the market,
“We were excited by the news earlier this summer that paleontologists found a wooly mammoth preserved in a glacier in Siberia, raising the possibility that the extinct species might be genetically recreated. The glacier surrounding middle market M&A has been less forthcoming.”
Their August 2013 Quarterly Report indicates only 33 deals closed in the first half of 2013 by their panel of 180 participating private equity firms compared with 96 transactions closed by this same group in Q2 2012 alone.
Interestingly, considering this slow market environment, Q2 2013 was the strongest fundraising quarter for private equity firms since Q1 2009.
U.S. PE Fundraising by Quarter
This reflects, in part, a steady rundown in the PE capital overhang since the onset of the recession. While there is still a significant amount of dry powder in the industry, it now appears that investors remain committed to alternative investments such as PE and have proven ready to make new commitments to the asset class.
U.S. PE Capital Overhang
One particularly notable trend has been a move by private equity firms into minority interest investments and growth capital funding. According to Pitchbook, "Growth/expansion transactions represented 28% of all PE deals in the first half of 2013 while buyouts (excluding add-ons) were just 34%. These are the highest and lowest proportions, respectively, that these two deal types have accounted for in the last decade."
Coming off an extremely weak March-May, June closings picked up strongly and we expect the increased activity to continue through the end of this year.
Our unscientific survey of various private equity firms, lenders and investment bankers confirms not only the lull in activity during the H1 2013, but also greater activity since then. This has been consistent with our own experience over the years. The first chart above shows that, with the exception of H2 2008, private equity activity has shown strong seasonality, with second half closings consistently and, sometimes, significantly higher than those in the first half. Since M&A announcements are generally positive to the equity markets, this could provide some support to offset the current macro weakness (SPY).
We've previously shared our view that the current era represents one of the strongest sellers' markets ever. Valuations for high performing middle market businesses are at or near historic highs. Nothing in the year to date data brings that analysis into question. If this cycle holds true to the past, we still have one to two good years before the inevitable cyclical downturn. We have not witnessed the type of late cycle buyers' panic that has characterized previous market tops and we remain cautiously optimistic that the positive environment will continue for some time. There are, however, three new clouds on the horizon, any one of which could significantly affect the outcome: 1) a continued rapid rise in long term interest rates; 2) some discussion of a possible downturn in the equity markets; or 3) expansion of the "Arab Spring" events into a larger crisis in the Middle East. The next few months should be an interesting time for the M&A market and we'll be back to report on the outcome.