Ridgemont Equity Partners, a Charlotte financial sponsor, has been an active buyer this summer of companies worth $10 million to $100 million, and it has plenty of company.
Last month, Mill Road Capital in Greenwich, Conn., completed a $91 million purchase of Rubio's Restaurants Inc. in 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 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 transaction pace.
Thomson Reuters has reported 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" giving people incentives "to take that inventory out [of] 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. It recently 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; though debt market conditions have improved, how much a sponsor firm can borrow is capped. Others say the activity is propelled by the fact that private-equity funds get paid to put money to work.
In the second quarter, according to Thomson Reuters, 257 U.S. deals, worth $17.7 billion, were announced, involving companies with enterprise values of $10 million to $250 million. A year earlier 199 such deals, worth $10.7 billion, were announced.
GF Data Resources, which collects data from more than 150 private-equity firms on transactions valued at $10 million to $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 last year's second quarter.
Private-equity sponsors and M&A bankers say that, though this year's volume does not match that of the heady days of 2005 to 2007 (three years when, by some industry estimates, buyouts totaled more than $1.6 trillion), "record or near record" numbers of companies are up for sale now, and these companies want to close 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 earnings before interest, taxes, debt and amortization in the third quarter of last year to 5.2 in each of the succeeding two quarters and 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 given deals an impetus this year. "The debt markets are facilitating transactions very actively," he said, "whereas the debt markets were a real impediment to deals last year."
In addition, the deals' equity and debt structure 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 this is 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. Activity may be truncated as a result, they said.
"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 a 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."