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Advisors, Private Equity

How the Economy of Exclusion Could Affect M&A

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In 2013, the top 10% of U.S. earners captured a whopping 47.5 percent of the country’s income. Federal Reserve Board (FRB) statistics indicate that the disparate concentration of wealth in the U.S. in 2007-2013 was equal to what it was in the 1920s, immediately prior to the Great Depression.

In a report to the Federal Reserve Board of Governors last year, Chairwoman Janet Yellen called income disparity “one of the most disturbing trends facing the nation.”

Christine Lagarde, Managing Director of the International Monetary Fund (IMF), lamented the current landscape in a June 2015 speech: “With these kinds of disadvantages, with this kind of inequality of opportunity, millions of people have little or no chance of earning higher incomes and building up wealth. This is – in the words of Pope Francis – an economy of exclusion.”

This economy threatens to stunt economic growth in the U.S. and worldwide, with further concentration of wealth and decreased opportunity for most.

What does this mean for the M&A markets?

Today, we continue to see positive M&A deal indicators in the U.S., despite the recent economic news from China and the corrections in world stock markets. GF Data’s M&A Report for August 2015 indicated that transaction value for the first half of 2015 was up modestly compared to the same period one year ago, with the premiums for platform investments vs. add-ons returning. Three characteristics — institutional ownership, above-average financial performance, and continuation of management post-closing —appear to enhance transactional value.

It’s hard to predict the degree to which increasing income disparity will affect M&A. But there are a number of potential long-term consequences.

  • Shrinking values – While value often increases with perceived scarcity (e.g., the current PEG mania for substance abuse treatment centers) there is a likelihood that many other sound companies will languish without qualified buyers. There are fewer buyers and they are pickier.
  • Fewer true buyers at the lower end of the middle market – With less disposable income and decreased access to capital, many lower market strategic buyers are less able to cash out While PEGs have ventured into this area with greater frequency (it’s where a significant amount of U.S. economic activity occurs), they still will not pursue these investments because they do not offer the accelerated returns that their wealthy and sophisticated investors seek.
  • A return to creative financing – When I bought my first house in 1979, interest rates were in excess of 15%. I was able purchase the home because the seller was willing to carry part of the mortgage for several years before I eventually used more traditional financing. This scenario has increasingly returned to real estate despite available low interest rates; there is a possibility that the lower middle market M&A will see this as well. In this scenario, sellers will accept a lower than expected return on their financial and sweat equity investment.
  • The new M&A advisor opportunity – Many of today’s M&A advisors are marketing their ability to help sellers diligently improve their enterprise value prior to initiating the marketing and the transaction process. This will help elevate the practice of M&A intermediaries, and may be one of the most positive outcomes of the concern about income disparity.
  • Hanging in there longer – Despite the pent up selling interest of baby boomers, there has not been the expected selling deluge in the lower middle market, including healthcare businesses. Multiple factors, including a concern about having enough disposable income given longer life expectancy, could continue to delay many transitions. Besides, what’s wrong with an 80-year-old CEO?
  • More consolidation of market segments – Lower middle market consolidation often occurs away from the headlines and involves competitors who sit down over coffee to discuss mutual interests and opportunities. Given the factors noted above there is all the more reason today for this activity to increase, outside of the realm of most M&A professionals.

The sky may not be falling, but for many middle market business owners, the American Dream is under amendment. Coupled with reductions in funding to quality education and social support, the economy of exclusion will limit opportunities for an increasing number of younger and older entrepreneurs. The impact on M&A activity logically follows, with some redefinition of what successful advisors offer to their clients.

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