Has it Been Three Years Already?

In my last post I noted that now is a good time to pursue a divestiture or private equity transaction based on: (i) coming out of the recession in 2009 and seeing a general return to growth and profitability, (ii) historically low interest rates, and (iii), a tremendous amount of investible capital at private equity funds and on corporate balance sheets.  So how good is it?

The following is a chart of the S&P500 over the last three years. Since March of 2009, after reaching a low in the 675 area, the S&P500 is now 100% higher and flirting with recent highs.

The 10 year US Treasury yield index is below 20 (at a three year low resulting in a yield of 1.87%).

The facts are as follows: we are near a three year high in the S&P500; S&P500 earnings have improved every quarter since Q1 of 2010, interest rates are at three year lows and a recent study by the Wall Street Journal highlighted that "cash accounted for 7.1% of all company assets, the highest level since 1963."  In short a strong foundation for a healthy M&A market.

BUT, people are worried.  Worried about the European debt crises, US budget deficits, an ineffectual Congress, falling house prices and an unemployment rate of over 8%; hence the contradiction of improving earnings and historically low interest rates.  The expression “the market is climbing a wall of worry” reflects a scenario where the market goes up despite uncertainties.  This is positive in my mind because it represents a healthy tension between the bulls and the bears; no over exuberance with the potential of a crash but steady as she goes. According to Standard & Poor’s, the current consensus 2012 earnings forecast for the S&P500 is $103.70 which, at current levels, equates to a multiple of 13 times. Quite reasonable and therefore we are in a positive environment for M&A activity.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

The Window is Open

I noted in my last post that private company divestitures or equity financings can take between seven to nine months to complete (a financing can be quicker depending on the structure).  This may seem fast or slow depending on your perspective but that timeframe is typically not the whole story. 

Veracap's Value Enhancement Framework^TM (see “How Does an M&A Advisor Add Value to the Divesture Process?”) notes that an important part of the process is the planning stage.  For example, while preparing for sale it is critical that personal goodwill be transferred to intangible, company goodwill.  What this means is that owner-entrepreneur responsibilities and relationships are migrated to a management team that will stay with the business for an extended period of time.  The planning process may take several years to complete.

The next phase that can take years to complete is the transition phase.  Unless the owner-entrepreneur is no longer active in the business, the buyer will likely seek a period after the closing where the seller remains engaged to ensure a smooth transition and delivers on earn-outs, etc.

The planning and transition phases can add a number of years to the process, but here is the real kicker, investor sentiment and the economy.  In fact, a great opportunity to sell or raise equity at a premium may come along only once in a lifetime.  We all remember the internet bubble of 2000 and the more recent US real estate bubble in 2008.  If you assembled a good tech team and had a web related idea in 1999 or early 2000, you could fund a start-up at a significant valuation (I personally had an idea that was funded at a multi-million dollar value). 

The internet bubble crashed in 2000 and the US real estate bubble crashed in 2008 taking the whole world with it.  When a recession hits and profits are diminished, demand drops off and values naturally become depressed.  You could arguably sell your business in the 2009/10 timeframe but not at 2007 valuations.  As an owner-entrepreneur, when you thought your business was worth $20 million but you are told it is now worth $12 million, you are going to think twice about going to market.

We have seen many businesses return to strong profitability in 2010 and 2011 (depending on their fiscal year end) and with a number of years of sales and margin growth, strong valuations can yet again be achieved.  While bubbles are extremes there are always hot and cold sectors from time to time where strong valuations are realizable.  Some current examples of hot sectors include cloud based virtualization such as Software as a Service (SaaS) and Platform as a Service (PaaS), social media, mobile marketing, penny auction and deal-of-the-day web sites.  A once hot but now cold sector, ironically, is the solar sector.

We cannot predict when the next recession will begin.  The finance community refers to IPO windows; when they are open an IPO is possible, when they are closed it is not.  The process of preparing and positioning to sell your business, or equity in your business, can take many years and an economic downturn can add several more years to that.  As for right now, based on: (i) coming out of the recession in 2009 and seeing a general return to growth and profitability, and (ii) historically low interest rates, plus a tremendous amount of investible capital at private equity funds and on corporate balance sheets, I would say the window is open.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.