Middle-Market M&A Rebounds at Low End

Prices are rising, and deal volume is getting closer to precrisis levels.  Is this a true recovery or a blip on the M&A screen?

By Ken Tarbous

September 3, 2010

Ridgemont Equity Partners, a Charlotte, N.C., financial sponsor, has been an active buyer of companies worth $10 million to $100 million this summer and it has plenty of company.

Last month, Mill Road Capital of Greenwich, Conn., completed a $91 million acquisition of Rubio's Restaurants Inc. of Carlsbad, Calif., and Austin Ventures snapped up YRC Logistics, a Kansas unit of YRC Worldwide, for $38.7 million.

Dealmaking has picked up from a year ago and it is expected to remain lively at least for the rest of this year. Sponsors are allocating more money to lower-middle-market businesses, and improved debt markets are allowing buyers to borrow more. Also, some market players cite concerns about potential changes in federal tax policy as a reason for the pickup in the pace of transactions.

According to Thomson Reuters, there were 72 deals worth $4.8 billion in the lower middle market last month, compared with 65 deals worth $3.7 billion in August 2009. (These mergers and acquisitions generally involve companies worth $10 million to $250 million.)

Private-equity firms have $400 billion of capital on hand to invest, according to Deloitte Corporate Finance LLC, and more than 75% of the firms that have raised funds this year are targeting middle-market companies.

"We've got improved debt markets, you've got an inventory of deals that has built up during the economic downturn that people couldn't really sell, and you've got an improving economy that's incentivizing people to take that inventory out to the market," said Travis Hain, a partner at Ridgemont. "And finally, you've got potential tax incentives, depending on one's views on capital gains, and obviously there's a predominant view that capital gains is going up."

His firm, which Bank of America Corp. spun off last month, invests in basic industries, consumer and retail, energy, financial services, health care, and telecommunications, media and technology. This week, it announced it had bought a majority interest in the data network provider Unite Private Networks, and last week it said it had sold its interest in the fiber-optic broadband provider Fibertech Networks.

To some degree, the pickup in activity may be exaggerated by the sharp decline in M&A transactions that took place during the credit crisis; while the debt market conditions have improved, there is a cap on how much a sponsor firm can borrow. Others say the activity is being propelled by the simple fact private-equity funds get paid to put money to work.

In the second quarter, according to Thomson Reuters, there were 257 U.S. deals worth $17.7 billion involving companies with enterprise values of between $10 million and $250 million. A year earlier there were 199 such deals worth $10.7 billion.

GF Data Resources, which collects data from more than 150 private-equity firms on transactions valued between $10 million and $250 million, reported a similar pattern among the financial sponsors it covers. In the second quarter, these sponsors closed 26 deals in the lower middle market, versus 16 in the first quarter and 15 in the second quarter of last year.

Private-equity sponsors and M&A bankers say that even though this year's volume does not match that of the heady days of 2005 to 2007 (a three-year period when, by some industry estimates, buyouts totaled more than $1.6 trillion), there are "record or near record" numbers of companies up for sale now, and those companies have a goal of closing deals this quarter or the next.

"If even a fraction of these deals get done, it will be a very interesting couple months," said Justin Abelow, a managing director of the financial sponsors coverage group in the New York office of Houlihan Lokey. "I think one of the things that's going to happen is that there'll be a tension between getting some of these deals done as M&A deals and just doing dividend recaps of one sort or another, particularly where people think they are not going to get their prices."

Hain says the backlog and the rush to market have a positive side.

"The good news for everybody is that this inventory of deals that built up over two or three years, they're all quality companies," he said. "The first companies that come out in this environment are the best companies. We're tending to see better companies, and there are some companies that, in certain circumstances, you can afford to pay higher prices for, depending on what a buyer thinks that you can add to the equation as a buyer and investor."

Valuations are returning to what dealmakers call more realistic levels. The multiples paid for companies in the lower middle market are on the rise, according to GF Data. The average multiple climbed from 5.1 times EBITDA in the third quarter of last year to 5.2 in each of the following two quarters to 5.6 in the second quarter of this year. Companies sold in the second quarter of last year fetched an average of 6.7 times EBITDA.

Hain says improved conditions in the debt markets have provided an impetus for deals this year. "The debt markets are facilitating transactions very actively, whereas the debt markets were a real impediment to deals last year."

In addition, the equity and debt structure of the deals has been stabilizing. Debt as a percentage of the average deal's capital structure increased to 42.4% in the first half of this year, versus 28.2% for all of last year, according to GF Data.

The equity percentage dropped from 59.0% last year to 53.3% in the first half of this year, but that's still "a high number by any kind of historical standard, so it shows that the overhang of equity capital that is still to be invested that has been raised by these private-equity sponsors, that there's a lot of pressure to deploy that capital," said Graeme Frazier, principal and co-founder of GF Data.

Market participants, citing proprietary data, pitch count and new assignments, say there might not be enough middle-market bankers and private-equity professionals to handle the plethora of deals in the market, and processes may be truncated as a result.

"This is as busy as that market has ever been, after a time of relative inactivity, and there may not be as many people in all parts of that market as there used to be, but there is much more activity," said one market participant, who asked not to be identified. "I think people are trying to push a lot of water through a relatively narrow pipe, and I think that pipe is near a bursting point."

Scoping the Tech Horizon

Small deals maintain momentum and observers wonder whether large caps are set to ramp up

By Ken Tarbous

March 5, 2010

For 23 years, Jeff Bistrong has found backers for telecom and technology companies on Boston's famed Route 128 and beyond, but the investment banker says he has more assignments now than at just about any other time in his career, including Wall Street's legendary dot-com era.

Nevertheless, the Harris Williams & Co. investment banker pointed out that not all bankers focused on the tech industry are in a similar situation.

"Is that because the market as a whole is broadly ramping up right now? The answer is no," said Bistrong, who mostly advises middle-market tech businesses.

The reason Bistrong is busy has more to do with the size of the companies that are looking to do deals these days. Last year, tech merger and acquisition activity fell more than 50%, according to a Dealogic study, and 84% of the work involved transactions worth $500 million or less — the type that keeps smaller firms like Harris Williams busy. The decline in the number and size of transactions prompted some bulge-bracket firms to branch out into smaller deals, but other large firms shrugged off business below a certain size (and a certain amount of fee income).

This year the average deal size may rise because the market expects some tech giants to make strategic acquisitions. Also, divestitures of lines no longer considered central to their owners will likely spur some activity in the industry. Another factor that may buoy M&A activity: a change in venture capitalists' expectations. Owners of a private company may sell it to another industry participant, instead of conducting an initial public offering.

"If last year was the year of hibernation, I think where we are at this very moment in time is the cave door has been opened, and people are walking out in front of the cave, but cautiously," said Drew Lipsher, a partner at Greycroft Partners, an early-stage digital media venture capital fund founded by Alan Patricof, an early funder of companies like Apple Inc. and America Online. "They're being cautious, and I think they're being judicious and … prudent."

Harris Williams, which opened an office in London late last year, has doubled its tech M&A team in the past 12 months, and it continues to recruit bankers for its West Coast operations. And it's not alone — other investment banks anticipate closing more deals this year, and they have added professionals to their tech teams.

Citadel Securities, the investment banking and M&A advisory arm that the Chicago hedge fund operator Citadel Investment Group opened last year, added Gopal Garuda and John Rhine as co-heads of technology investment banking in September. Last month JPMorgan Chase put Anwar Zakkour in charge of its technology M&A team.

Before joining Citadel, Garuda and Rhine worked at Bank of America Merrill Lynch, where they worked on AMD's $4.4 billion spinoff of Global Foundries in 2008.

"You have an alignment of increased appetite to put equity capital to work, increased leverage available in the market and increased valuations and cash positions on the part of corporates," said Bistrong, who is 48. "All that, we believe, combines to support material improvements in [tech] M&A volume in the first quarter of 2010 and probably ongoing improvements throughout the year."

For all the bullishness over tech M&A, no one seems ready to proclaim the market fully open, nor does anyone predict another banner year like 2007, when $193 billion of tech transactions were completed.

Industry participants like Lipsher and Bistrong say much of this year's transactions will be driven by large firms like Oracle, Microsoft, IBM, Hewlett-Packard and Cisco Systems, which have been waiting for market conditions to improve and valuations to return to "sane levels," meaning that sellers and buyers can come to a meeting point on price.

To date there has been one tech IPO this year, but several companies, including GT Solar International Inc., Force10 Networks Inc. and Convio Inc., are getting ready go public. Also, there have been eight high-yield offerings for tech businesses this year. This week the private-equity investor Thoma Bravo announced that its portfolio company Hyland Software, an enterprise content management software vendor, has acquired eWebHealth, a company that hosts medical records, in an all-cash deal. The price was not disclosed, but the fact that the buyer did not have to worry about financing made the deal easier to close.

"From a financing perspective, we were able to do it with internal resources at the company. As a strategic buyer, that obviously allows Hyland to get something done very quickly with a hundred percent financing certainty," said Seth Boro, a principal at Thoma Bravo, which has 10 software and other tech companies in its portfolio. "We're fortunate that most of our portfolio companies generate a lot of cash flow, allowing them to then make acquisitions. Thoma Bravo has a software technology portfolio that generates about $2.5 billion of aggregate revenue and $650 million of aggregate earnings."

Last year 107 tech M&A deals with a total value of $36 billion were completed, versus 195 deals valued at $77 billion in 2008. Almost 50% of last year's value involved deals completed in November and December, and some see that as a signal that activity will pick up this year.

Despite the preponderance of small deals last year, large deals still got done. Cisco bought Starent Networks Corp. in the networking infrastructure subsector for $2.9 billion. Adobe Systems bought the Web analytics powerhouse Omniture Inc. for $1.9 billion, and EMC Corp. bought the data storage firm Data Domain for $2.1 billion.

The 2009 deals included two worth $1 billion or more in the software sector, two worth more than $2 billion for Internet-related companies, and several with values ranging from $1.6 billion to $3.9 billion in information technology services.

This year, market participants expect a mix of tuckins and carveouts. They also expect much of the activity to be tied to digital media, infrastructure software, cloud computing (which uses the Internet and remote servers to store data and applications) and semiconductors.

"Carveouts are going to be a fairly big area of activity. As the economic slowdown hit, a lot of big companies needed to rethink their core businesses and have sought potentially to divest, close down and/or carve themselves up and really focus on their core businesses," said Charles Giancarlo, managing director and co-head of value creation at the private equity firm Silver Lake, which led the group that acquired a $2.1 billion stake in Skype Technologies last year from eBay Inc.

Giancarlo started Cisco's M&A practice in 1995, after it acquired Kalpana, where he had been part of the restart team.

So far this year, three tech M&A deals worth more than $1 billion each have been completed: Xerox Corp.'s $6.4 billion acquisition of Affiliated Computer Services Inc.; Oracle Corp.'s $7.3 billion buy of Sun Microsystems Inc., and United Technologies Corp.'s $1.8 billion acquisition of GE Security Inc.

On Feb. 9, Micron Technology Inc. announced it will acquire mobile data storage maker Numonyx Holdings BV from Francisco Partners, Intel, STMicroelectronics NV for $1.27 billion in stock.

M&A this year is helping to change the look of certain aspects of the tech industry. For example, distinctions have blurred between hardware, software and services companies as they have broadened their offerings through strategic acquisitions.

"Companies are going to continue to augment and diversify their capabilities to address broader end market opportunities. You have seen successful examples of this across a number of vendors, where they have built multi-capability platforms," said Ian MacLeod, a partner and head of global software and services investment banking at Qatalyst Partners LP, which was founded by the tech banker Frank Quattrone. "For example, would you call IBM a hardware company? Hardware is a minority of their business. … Their revenues and profits are largely driven from services and software today."

Though transaction volume is expected to rise this year, the majority of deals are expected to be valued at $500 million or less. That has some participants wondering if the larger firms that have branched out into smaller deals will continue to advise these companies, since boutiques have more flexible fee structures and are probably more willing to rush out for $50 million carveouts and $5 million financings.

But Mike Wyatt, head of West Coast tech M&A at Morgan Stanley, says it remains committed to a wide range of businesses. "In tech, there are a lot of small companies and a lot of start-up companies, so there just are more smaller companies, period."

Participants say small full-service investment banks like Jefferies & Co., Piper Jaffray and RBC Capital Markets, along with boutiques like Qatalyst, Lazard, Evercore Partners and Greenhill & Co., have garnered a chunk of assignments on transactions ranging in size from $50 million to $300 million.

"I have recently been told by some clients that … other firms would not dedicate senior, experienced resources on transactions with total aggregate value below given thresholds," said Rick Juarez, a managing director in the technology investment banking group at Morgan Joseph. "Typically, these thresholds were on transactions that generated $2 million or less in aggregate fees, and when they agree to take them, they often assign juniors [bankers] to the transactions."

But even with such a high percentage of deals worth $500 million or less, the bulge brackets are still getting their share. Morgan Stanley, Goldman Sachs, Barclays Capital, Citigroup and UBS topped the 2009 global tech M&A adviser league tables, according to Thomson Reuters data.

Meanwhile, market participants said that M&A this year could be kicked up if private companies back away from going public.

The market for IPOs, one of the traditional exits for tech firms, has been soft for the past few years. Last year there were 55 global technology IPOs, according to Ernst & Young. The IPOs have been priced at the low end of the transaction scale and have not traded well. Some have been pulled.

"There was this view that somehow the [tech] IPO markets were going to open up, but people have been talking about the tech IPO window for years, and it just hasn't materialized," said Jason Hutchinson, a managing director in Houlihan Lokey's San Francisco office and the head of the firm's technology group.

Nevertheless, participants say that banks are working on a huge IPO pipeline, and that many companies in "shadow" registration are preparing to register officially and go public.

Going public may be the gold standard for many entrepreneurs at tech start-ups, but to venture capitalists, success isn't necessarily defined by taking a company public.

"The bread and butter of nice VC-backed exits is the $50 million to $250 million range," said Kevin McClelland, co-head of software investment banking at JMP Securities. "If you look at a company that perhaps has $15 million to $20 million of invested capital, if you can sell that company for $150 to $200 million, yes, that can be a decent outcome. If a company has raised $100 million, that's not going to be a good outcome. A good outcome for a company that has raised $100 million is a billion-dollar exit."