Key Discussion Topics
• Intensified Competition Driving New Approaches to Winning Deals
• Attractive Sectors in a Changing Environment
• The Business Cycle: When Will it End?
Intensified Competition Driving New Approaches to Winning Deals
To start out with, this is an M&A market with inexpensive debt, plenty of cash on balance sheets and dry powder, and lots of competition for deals. What are some of the tactics you’re seeing buyers use in this climate?
Joe Conner: We’re seeing groups be much more selective in what they chase, really only going after something when they have a differentiating angle. That can be prior experience in the sector, access to industry executives, or similar portfolio holdings. Having an angle allows buyers to compete on something other than price, and can give them the conviction they need to stretch and ultimately prevail.
I’d say we’re also seeing buyers doing a better job of identifying the right assets that fit their investment parameters early, and making their interest known so they can get ahead and use speed and certainty of closing as a differentiator.
Jershon Jones: The assumption made by many investors today is that if they haven’t been in front of an opportunity or a management team well in advance of a process, they are fundamentally disadvantaged. As a result, groups often eliminate themselves from consideration for some very attractive opportunities. It is certainly a delicate balance for investors who have to constantly rationalize their investment of time and resources, while making sure they don’t self-select out of attractive situations where they have an opportunity to prevail.
Frank Mountcastle: I think for good companies in attractive niches or verticals, both sponsors and strategics are deciding to chase these deals, in some cases, a couple of years in advance. They are investing time, getting to know the team to the extent they can, getting to know the industry, doing some pre-work, doing anything they can do to A) endear themselves with the seller, or the potential seller, and B) already be out in front when they get the first call from the banker.
Because you can't run ahead if you're on the receiving end of the phone call.
Does that mean you're actually seeing fewer potential buyers for deals?
Mountcastle: For good companies we're seeing, in some cases, fewer indications of interest (IOIs) than we historically would have. Typically that’s because potential buyers are making the decision earlier and then bowing out if they don't have an angle or strong conviction to pursue the deal.
Jeff Kidd: I also think buyers are making more of a conscious effort to endear themselves to management teams earlier on in the process. They are recognizing the value of creating strong relationships and being responsive to a company’s leadership throughout the process, and not just at the tail end when it comes time to make a final decision.
As an example, we were part of a deal recently where, early on, the CEO made almost a joke about wanting certain features in how the debt was structured. The group that won the deal took that comment very seriously and went out of their way to put together a leverage package that was covenant-lite and that met the CEO’s request. That ended up being one of the deciding factors for the CEO: He was impressed by their creativity and willingness to go the extra mile.
Bob Baltimore: I think Jeff raises a good point: If a buyer is starting at time zero, they’ve already lost. They've got to come in with some perspective either on the space or the company, whether that comes from an industry expert or from prior experience. And in this environment, it’s really important to listen to management whether you're a strategic or a financial buyer.
Would you say you’re seeing more preemptive deals?
Mountcastle: I think we're seeing more and more attempts at preemptive deals, but I don't know that we're seeing any greater proportion of deals that are being done preemptively.
Graham Gillam: I think it's become a more viable process alternative in the minds of some sellers. We’re seeing the traditional process as the default being challenged more often.
Jones: In a market that is hyper-competitive, speed has become just as much of a weapon as price. Groups employ tactics from showing up at indication-of-interest day with a definitive proposal, ready to negotiate and sign, to trying to short-circuit the marketing process altogether.
Mountcastle: We're largely talking about financial buyers right now, but I do think that in this environment, for a coveted asset, strategic buyers are also showing a willingness to be more nimble. They, too, are trying to get out in front of deals and do things that maybe they wouldn’t have historically done.
For example, now we're seeing strategic buyers being more facile regarding rep and warranty insurance. Strategic acquirers are also working hard to adhere to our timelines and do the things we're asking of them.
Conner: We’re also seeing deals getting done much more quickly. More upfront work is getting done, like vendor due diligence, and the lending market is very efficient. Again, rep and warranty insurance reduces some of the friction costs of a deal. It can make contracts simpler to negotiate, so the deal can be done in days versus weeks.
Doug Kinard: That upfront diligence definitely gives buyers a good starting point and lets them move more quickly through parts of the process that took them longer a few years ago. And speed is how they're trying to differentiate themselves. They’re also coming into management visits with a sense of where they are relative to the field.
Some groups ask for access to the data room ahead of management visits, so they can front-run some of their due diligence and move more quickly than the field. They’re using speed and certainty as their angle.
Would you say that the buyers taking that accelerated approach are the ones who are confident they do have an angle on the deal?
Kinard: Absolutely. For the most part, we typically are seeing that with groups that have been in front of the asset for a while.
Anthony Basmajian: We're also seeing sellers putting in place a truly portable debt structure, which accomplishes two things. It removes the need to go to credit committees or go to multiple lenders—which can create noise in the market—and it gives the buyer certainty that they have access to very competitive financing.
This dynamic also allows sellers to accelerate the process. In several cases, we’ve seen buyers that can move from diligence to signing in three weeks, from start to finish.
Kinard: Along the same lines, we've seen incumbent lenders not just offering attractive financing packages, but offering financing that is nearly finalized and through their investment committees early in the process. The sponsor and the buyer can cut down on the typical three to four weeks it takes to get financing lined up. We can be closed much faster than we typically would have.
Basmajian: There are just so many people circling the same assets. If a buyer can move faster and is in competitive price range, they can just shorten the seller’s overall pain in dealing with diligence and process. Sellers find that very compelling. It's certainty of closing, valuation, and being less disruptive to the business.
Kinard: I think buyers are also aware of the current business cycle. Investors are starting to wonder how long the upcycle is going to last and how much longer the credit markets will be available at such attractive terms. So if you can truncate your process, you can get a deal done faster. It’s a bird in the hand. That goes a long way.
Attractive Sectors in a Changing Environment
Given some of that uncertainty, are there specific sectors that are attracting more attention right now?
Conner: We’re seeing a lot of interest in automotive aftermarket. Growth remains strong, there are good, stable end markets, and it offers some downside protection. People are keeping cars longer, and those cars are getting more complex, so there is less work owners can do on their own in terms of maintenance and repair. I think that’s a pretty strong long-term trend. In fact, historically we’ve seen auto aftermarket companies keep growing right through business cycle shifts.
Basmajian: Industries or companies with a highly contracted, repeatable revenue base, or operating in a highly regulated environment where there's a moat keeping new entrants from entering, continue to attract attention in this market. Even if there was slower growth, those types of businesses and industries will continue to be the most attractive.
Investors concerned about the end of the current M&A environment will pay a premium now for stability and consistency.
Baltimore: Another thing to think about is what kinds of businesses stand to benefit from the continued aging of the baby boomers. Home healthcare is an example. Foodservice is another.
Gillam: Live entertainment has always done well in a recessionary environment, both among millennials and boomers.
Baltimore: The pet space is probably going to continue to do well in general.
Chris Smith: On the aerospace side, there's a tremendous amount of interest in the aviation world on the aftermarket. The Wencor transaction we advised on in 2014 was the leading edge of this renewed interest in the aftermarket, and we have seen it accelerate even more recently.
Kinard: Absolutely. A large portion of the deals that we've done in the last 18 months have been in the aftermarket. Four or five years ago, it was very different, and much more focused on OEMs and the new build cycle.
We’re seeing a lot of activity in maintenance services, particularly component repair- parts or systems that can be removed from an aircraft and sent to a repair shop, which are typically very specialized repairs. These businesses are typically higher-margin and less capital intensive than repair shops that actually touch the aircraft and do airframe maintenance or major engine maintenance.
We're also seeing a lot of activity for distributors of parts to the maintenance and repair shops and to the airlines that are doing their own maintenance. That's a critical element of the repair network. So it's both distribution and supply chain as well as the service providers actually doing the repair work.
Smith: The only thing I'd add on to that is that aviation-related technology-enabled services are also driving a high level of interest. For example, maintenance technology platforms that enable maintenance and repair providers to be more efficient are getting attention from both industry and the investment community, with a recent large deal in this space trading for upper-teens EBITDA multiples. Platforms that enable real-time diagnostics of systems on aircraft, and get the data back to maintenance crews also in real time, are going to continue to change the aviation maintenance landscape.
The Business Cycle: When Will it End?
Let's wrap up with the question on so many people’s minds: When do you think the cycle is going to shift?
Mountcastle: I'm not a big tea leaf guy, but if you look at metrics that typically suggest that there could be a downturn around the corner, there's really not anything that's staring us in the face. GDP growth is solid, if not stronger, than it was last year. Employment is good. Inflation is still pretty low. Interest rates are rising, but by historical measures they're still pretty low.
Stock market volatility has shown up on the scene pretty recently, but lending markets continue to be white hot and have been for some time. In terms of the fundamentals, things look okay.
At the same time, M&A cycles are five to seven years historically, and we're in year eight now.
Kidd: While I agree with everything Frank said, it's not like it's been up and to the right across the board in every industry vertical. There was an industrial recession a couple of years ago. The surface transportation sector went through a bit of a downturn in 2016. So there has not been a wholesale recession, but there have been pockets within the economy. Just look at what happened in the energy markets a couple of years ago. Recognizing that it’s not entirely realistic to count on the current market dynamics lasting forever, maybe we're in a bit of a new normal where there are sector-specific downturns from time to time but no catastrophic market corrections.
Conner: The last time we did have a big correction, we saw growth start to slow across our portfolio of engagements. A deal or two would get hung up with lender issues. A strategic buyer would pull out at the very end of a process. We're not seeing any of that now. Business continues to be strong, performance is good, markets are flush with capital, and conditions are solid for deal-making.
Baltimore: I’m in agreement with all of that. I don't see a lot of things flashing yellow quite yet. I will tell you that I think we need to be thoughtful about the consumer price index, and whether or not companies are able to pass on cost increases. Because they're clearly seeing it, particularly in anything that's got labor associated with it.
That’s causing wage inflation, and I'm not sure we’re seeing that coming out the other end yet, which will push on margins. Eventually they'll have to compensate for that and we'll have inflation. Which is fine, except that we've been in such a low-inflation situation for so long. And you wonder if businesses still know how to operate in an inflationary environment.
Basmajian: The other thing is, we still haven't seen a robust IPO market during this cycle. There are a tremendous number of private-equity-held companies. There’s also an increasing number of patient capital and long-dated funds that intend to hold a portfolio company for an extended period of time. Even if the broader economy starts to turn or the M&A market changes, you still have to facilitate private equity exits. You've got a lot of traditional PE-held companies that will need to exit in the next two to three years to monetize current investments.
We hope you enjoyed this edition of the Harris Williams & Co. Roundtable Report. Look for our next Report later in 2018.