The merger and acquisition market has cooled a bit since 2015. But it remains strong and is forecasted to flourish in 2017 as private equity looks to deploy capital and strategic buyers look to buy growth in improving conditions. This article looks at the current M&A market in distribution and what’s on tap for the rest of the year.
While the volume of merger and acquisition activity across distribution has leveled off since its peak in 2015, the market is ripe for a flurry of deals as the economy improves, private equity prepares to deploy piles of cash and company valuations soar.
For the first five months of 2017, however, M&A has been hindered by a supply-and-demand imbalance, with more buyers sitting on capital than sellers ready to cash out.
“Private equity groups have incredibly strong interest in distribution today,” says Reed Anderson, managing director at Houlihan Lokey and head of the firm’s industrial distribution practice. But while PE firms are aggressively looking for platforms, “there is a lack of quality assets for them to acquire, particularly assets of scale. There is a substantial imbalance right now in the amount of private equity capital that wants to invest in distribution versus the available options for them to deploy that capital.”
‘M&A market set to accelerate’
According to data from Supply Chain Equity Partners’ proprietary distribution database, there were 425 wholesale distribution transactions completed in 2016. Of those, 272 were strategic buyer transactions, 96 were private equity-backed strategic buyers and 57 were private equity-backed platforms. (See Figure 1).
The 2016 total was down 15 percent from 2015 (see Figure 2), which, in addition to a higher volume, saw a large number of blockbuster deals among some of the largest distributors, including Air Liquide-Airgas; Builders FirstSource-ProBuild; Anixter-HD Supply Power Solutions; and Home Depot-Interline.
The soft economy has been the primary driver behind delayed, smaller and fewer deals – especially in the industrial space. Wolseley CFO Dave Keltner in September said the “industrial recession in both the U.S. and Canada” negatively affected the company’s sales, and the distribution giant wasn’t alone in feeling the effects of the slowdown.
But the slight drop-off in deals from 2015 doesn’t mean the market is dead, says Brad Keyworth, managing director and head of the distribution group, Lincoln International. “It’s not where it was a couple of years ago. It’s a little off the high point, but it’s still well above average. It’s a very active market right now.”
That activity should increase as end markets continue to see improvement, according to T.J. Monico, head of distribution, investment banking, KeyBanc Capital Markets.
“Last year, in a number of sectors across the industrial distribution landscape – particularly those that had direct oil and gas exposure – the market was pretty soft,” Monico says. “Who wants to sell when earnings aren’t at good levels? We saw more commercial products, building products, construction products last year as a percentage of the overall M&A market. This year we’re starting to see more true industrial distribution companies come to market or plan to come to market as earnings recover.”
If the first quarter is any indication, M&A activity should surge as the year progresses. Industry revenues averaged 3.4 percent in the quarter, their highest level in two years, according to the most recent MDM-Baird Distribution Survey. That mark was well above the 0.4 percent decline in the fourth quarter and even higher than the ambitious 2.3 percent growth that respondents projected for the period.
Higher revenue should bring stronger quarterly earnings reports, which should strengthen the supply of distributors across all sectors that buyers are looking to target.
“Over the last few years, organic growth has been challenging in the industrial supply and energy sectors, and M&A activity has slowed accordingly,” says Jason Kliewer, co-head of Baird’s distribution group. “Other sectors, such as building products, have been very active on the equity side. Given the strength in the public equity markets, several of our building products distribution clients have gone public in the last year. So there’s been a slowdown in new platform opportunities overall given the importance of these end markets. However, as organic growth improves across these and other end markets, the M&A market for distributors is set to accelerate.”
The sluggish economy has been pushing deals back for the last 18 months, but that’s not the only drag on market volume. Some deals that might have happened in that span had been pulled forward around 2012 because of the impending health care legislation and then again in 2015 because valuations were higher than expected.
“People prefer to sell when they’re feeling good and when earnings are going up. They’re less inclined to sell when things aren’t going well,” Anderson says. “Certain businesses have been pushed back for M&A because of industrial headwinds and certain businesses were pulled forward. We’re in this middle ground. That starts to loosen up a little bit in the near term, in the second half of this year, which I think should be good for M&A.”
That’s especially good for sellers, thanks to high demand and a favorable financing market, according to analysts. Companies that didn’t have extensive exposure to oil and gas end markets – and even those that did, as oil and gas prices are starting to rebound – should be well-positioned in today’s M&A market. “There’s never been a better time to sell your business,” Anderson says.
That’s true if you’re looking to sell to private equity buyers, who have retained a keen interest in distribution and boast plenty of spending power, or to strategic buyers, who are still on the lookout for the right opportunities, Monico says. “I think strategics want to be increasingly active. In the last couple of years they’ve been more active on the smaller deal front. Time will tell if they get more aggressive with the larger deals. You’ll see a pretty good balance between financial and strategic deals.”
Another boon for sellers: Even with the economy picking up, organic growth is still slow enough that strategic buyers continue to seek assets to boost their top lines, Keyworth says. “The publicly traded companies are not generating the organic growth to justify the stock prices that they’re trading at,” he says. “They have a need to go out into the market and complement their organic growth via acquisition.”
One more advantage for sellers is what Keyworth calls the “power of the adjacency,” in which companies target growth opportunities outside their core businesses.
“As these corporates have been seeking growth, it hasn’t come in their core product categories and/or channels,” he says. “But what they’ve done is expand or looked at expanding their business models to adjacent product categories, channels and end markets in order to get creative and find those avenues of growth.”
With the rise of active buyers, Monico points out that selling doesn’t have to be a zero-sum game for company owners, who can instead consider a partial transaction or a partnership with a private equity firm if they’re not looking to retire.
What could alter M&A’s path in 2017?
Transactions should continue at the current steady pace, according to Jim Miller, a principal and founder at Supply Chain Equity Partners, but three factors will affect M&A volume for the rest of 2017 – two of which revolve around the new administration and one that involves a well-known industry threat.
The first is President Trump’s actions on imports and tariffs. “People are uncertain what the Trump administration is going to do with tariffs and how that could impact importers or distributors that have a significant import component to their business,” Miller says.
Second, distributors that have Disadvantaged Business Enterprise status could see some changes, prompting shifts in their selling timeline.
“We have seen a big pickup in volume in DBE special status distributors; that spread like a brushfire during the Obama administration,” Miller says. “There are several folks that don’t believe that the proliferation will continue at the pace it did under the Obama administration. The volume of opportunities that are special status DBE is up significantly in 2017, and usually when this stuff happens in distribution, the distributors are concerned and looking to cash out.”
And third, Amazon could alter the M&A landscape as companies choose not to try and compete with the online retailer that has upped its B2B game, Miller says. “The businesses that are susceptible to Amazon as a competitor, more and more of those are looking to cash out,” he says.
While the Amazon threat applies to companies of all sizes, it will likely affect smaller companies more “since larger distributors are able to provide services and capabilities to compete with Amazon in certain sectors,” Miller says. “The smaller ones aren’t as well-capitalized and don’t have all the tools and resources to compete.”
Trump’s potential tax reform could also play a role in companies’ decisions to sell or not, Miller says. “Now owners are indicating a similar hesitancy because of looming tax reform,” he says. “They’re anticipating that the tax situation is going to be better.”
A rosy outlook – for now
Despite these potential roadblocks, the outlook for the rest of 2017 is positive. The already robust demand from private equity and strategic buyers should be met by growing supply as the economic landscape improves, valuations climb and sellers look to strike while the window of opportunity is wide open.
“2017 is shaping up to be another very strong year,” Kliewer says. “The credit markets are very strong, private equity buyers are sitting on record amount of dry powder (cash to deploy), and strategics are looking for ways to enhance organic growth. So the drivers are in place and strong M&A activity looks set to continue.”
However, most analysts concur, valuations and the market can change quickly, and those that don’t move forward can risk losing maximum value. While the market’s improvement has been a “gradual ascent,” Anderson says, it “typically drops off a cliff.” And no one can predict when that will happen.
“As soon as somebody sees that crack on the horizon, that crack hits you in the face. There’s no lag time to it,” Anderson says. “We don’t see anything right now that will cause the market to change. But we do know from past experience that when that catalyst hits, it’s not something where you have a three- or six-month window to adjust to it. The market tends to adjust immediately."