“2014 was very much a record year for the middle market.”
To learn more about 2014, its major drivers, and what 2015 could look like, we had a deeper conversation with Scharfstein.
A 2014 Retrospective
According to Scharfstein, 2014 was a particularly active year because of the stockpiles of capital. “There is a lot of cash out there waiting to be deployed — by both strategics and PE firms — looking for the right transactions,” he explained. “We see a lot of activity being driven by strategic purchasers who are finding that it is increasingly difficult to grow businesses organically given the limited growth in the overall economy. As a result, add-ons and strategic acquisitions are often the most efficient vehicles for growth.” This demand for inorganic growth strategies is supported by the significant number of PE-to-strategic transactions in 2014.
And, it is not only domestic strategics and PE groups that are seeking acquisitions. “Another factor driving activity in the middle market is the tremendous interest we are seeing from foreign players,” explained Sharfstein. “Eurozone companies, in particular, now believe that, if they are not invested in the US, they should be. If they are invested in the US they should probably increase their exposure in this market. The US is coming out of recession faster and better than European countries and, as a result of the weakness of the dollar until recently, US companies have pretty much been on sale.”
Although cross-border transactions are rife with their own challenges, Scharfstein still believes that American business owners often love the concept of selling to foreign buyers.
He said, “In many cases, the dollars are better — but there are a number of ancillary benefits, too. One of the biggest benefits is that foreign buyers often look to keep existing infrastructure, employees, and relationships in place. As a result, owners can sell while still having the confidence that the company they spent years building will very much remain intact. There is not a lot of disruption to key employees, and many times the professional services firms, (accountants, lawyers etc.) will stay on as well.”
Looking to 2015 and ahead
Although 2014 was particularly robust for M&A, Scharfstein believes that 2015 could be as strong. “We are starting to see increasing concern among business owners, who have been holding on to their businesses and enjoying the positive market dynamics, and are now asking how long this bull market has to run.” This uncertainty is causing many business owners to “question at what point they should be looking to take some or all of the money off the table.” These questions drive private companies to start a transaction, seek the counsel of investment banks and engage with potential investors.
While Scharfstein doesn’t believe the bull market will wane in 2015, it is realistic to expect that there could be a slowing in 2016. “As a result, 2015 is the year that business owners should really consider getting transaction ready,” he explained. “We are having a lot of conversations to help CEOs plan and position their business so they can quickly execute on a transaction once they decide to pull the trigger. One thing we don’t want a business owner to do is look in the rearview mirror a year or two down the road and think they missed an opportunity.”
2015 could also mean a high price for selling business owners. “I do think that the run up of multiples is reaching its peak,” said Scharfstein, “but that doesn’t mean valuations are necessarily peaking since valuations depend on a number of factors including corporate earnings, which remain strong.”
A Younger Crowd
In addition to market timing, this desire for preparedness could also be due to a much larger trend: sellers are younger than ever before.
“Another interesting trend we are seeing is that the selling shareholders of privately-held middle market business are becoming younger and younger,” said Scharfstein. “This trend indicates that business owners are becoming less married to their businesses and are looking at the businesses as one step in the business career. As a result they are willing to part earlier in their career with the company.”
He continued, “Owners are also being students of the cyclical nature of business — they are smart enough to know that what goes up, often comes down. They want to hedge against the risk. Business owners seem to perceive increasing risks in owning a business and that it makes sense to take some (or all) money off the table…a more strategic and less emotional approach to exit strategies.”
While some of this cautiousness may be due to 2008, Scharfstein and his team “think the single largest driver of this trend is the changing nature of customer relationships. It used to be that if you had a high performing business with good products and services, you would expect your customer base to stay with you,” explained Scharfstein.
However, it appears things are changing. “In today’s world, business owners have less faith in their clients,” he explained. “They fear that cheaper products or international options might replace them. Even high performing businesses are questioning the loyalty of their customers and the viability of long-term business.”