The prognosis for the distribution M&A market was mixed in the recent MDM Webcast Distribution M&A 2008 Update: Redefined Value in a Tough Market.”Three industry experts spoke on concerns of the credit crunch, valuation drops, a strained economy and inflation in relation to prospects for distribution mergers and acquisitions in the next couple years. Here’s a summary of the two-hour event.
Deal activity has fallen significantly from the boom years of 2005 and 2006, but the market has not yet fallen off a cliff. Still, companies are less willing to take a risk in the current market unless the acquisition target is top-notch and hitting its numbers, says Jon Skelly of PCE Investment Bankers.
“Distribution M&A activity has fallen dramatically from the record levels of a couple of years ago,”says Jim Miller, managing director of Supply Chain Equity Partners. “But the interesting thing is that the volume of potential distribution investment opportunities has not declined by a meaningful amount. There are still a lot of distribution companies out there on the market today.”
Some of the factors driving the market: private business owners in the 55-plus age bracket looking to sell; foreign buyers taking advantage of currency trends; an abundance of private equity money that still needs to be invested; and buyers looking for value acquisitions.
Strategic players -like Airgas, Sonepar and Wolseley -have more power in the current market. “If you’re a strategic acquirer right now and you have the courage and the capital to do so, it’s an excellent time to be in the marketplace looking for transactions,”Skelly says. “There is a lot less competition among the private equity community and a lot less competition in your strategic peer base.”
Strategic activity has fallen in most subsectors of distribution; some have seem more dramatic declines such as those attached to residential construction. For example, building materials and plumbing distributor Wolseley -a busy acquirer in years’past -has completed substantially fewer deals since the start of 2008.
But many strategic buyers are taking advantage of a less competitive environment to execute deals that fit with their strategic growth plans, Skelly says.
“Most strategics are willing to pay a little bit more in terms of multiples for a company if it is a type A and a top performer,”he says.
Many distribution companies in the marketplace, however, are not ready for sale, the panelists say. “The strategic acquirers will tell you what they’re interested in acquiring if you call them and ask them,”Skelly says.
“I think that’d be a good lesson for a lot of folks who work for distribution businesses: Go to the source, ask the buyers what they’re looking for and then cater the transaction to that desire. Try to keep some of the less profitable, low-growth businesses on the sideline.”
Evergreen Consulting President Brent Grover says that now is ripe for good values. “This is a good time to jump-start growth with a series of small acquisitions,”he says.
“I always like to err on the side of caution: avoiding excessive leverage, not cutting corners on due diligence and insisting on excellent 90-day integration with an oversight by a seasoned executive.”
Financial buyers, or private equity firms, drove the market from 2005 to the start of 2007, thanks to an abundance of cheap debt -which drove multiples up. In 2007 that changed when private equity firms had to start contributing more equity to close deals at committed pricing. Their ability to pay top dollar weakened.
Though private equity is no longer driving the market, they still remain interested in distribution. Valuations have retreated from record levels, but still remain historically high. “Last year they were still very high,” Miller says. “They were just starting to show signs of weakening … and they’ve fallen substantially in the past year. But again, with the state of the private equity markets in wholesale distribution from a historical perspective, valuations are better than they were in their trough in the early part of this decade.”The median overall distribution EBITDA valuation multiple dropped by nearly 25 percent in the past year.
“Banks are not as willing to take the risks lending into larger transactions right now,” Skelly says. “They’re more comfortable in making a $20, $30, or $40 million loan than they are making a $200 million loan into a company for an LBO (leveraged buyout). While the terms are tighter, there’s more capital being lent into the smaller end of the middle market than there is the upper end or the larger market.”
The number of small transactions completed in 2007 was less than in 2006, and the aggregate value was less, Grover says. Data up to first quarter 2008 show a significant drop from the zenith in the second quarter 2007.
Bank credit is available for smaller deals -more so than for larger deals, he says. “But the price is higher and the terms more stringent. When I say the price is higher, I’m not just talking about interest rates,”Grover says. “It’s also the terms, the restrictions and the loan covenants, and the bells and whistles that can make the credit become much more expensive over the terms of the loan if everything doesn’t go very, very well.”
Profitability right now is a concern, he says. “When companies in this industry catch cold, they often have a significant drop-off in profitability, which can cause lenders to get very uncomfortable.”
The panelists were mixed in their prognosis for the rest of 2008 and beyond.
Miller says that the market will improve by this time next year due to the volume of dollars in the private equity market that need to be spent. He says lenders will start to lend money again. “About this time next year I would think we will go from a grade D to a C,”he says.
Skelly agreed that the market is “not going to completely fall off a cliff.”He says he is having more conversations with large regional distributors who are interested in doing acquisitions.
“I think you’re going to have a new wave of buyers coming to play,”he says. In addition, ESOP-owned businesses have extra incentive to acquire, if they take care to think acquisitions through on a strategic level.
Grover says that he sees the M&A market as basically the same a year from now. “A lot of companies I’m close with and other companies we talk to in distribution are struggling with their profitability right now.”That is the most important factor in pricing a deal and whether the deal will happen, he says.
Grover advises distributors to “keep up the curb appeal of the company.”That includes the people, the systems, the asset base of the organization, the way assets are managed, managing gross profits and naturally being ready when an opportunity appears. Be ready for it because sometimes they come out of the blue.”
Other Topics Discussed in Webcast
Financial buyer activity and trends; strategic buyer activity and trends; valuations by sector and company size; M&A activity by end market; preparing for a sale; what buyers want; overview of due diligence and transaction process; small company M&A trends; exit strategy options; and the outlook for distribution M&A.
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