By Jack Calderon, Managing Director of Lincoln International and
David Kidd, Vice President of Lincoln International
The last few weeks have seen a substantial drop in the financial markets. Since the beginning of September the Dow Jones Industrial Average has declined 22%, continuing a downward trend that began over a year ago; over the past 12 months the market dropped more than 35%. At the same time, the U.S. unemployment figure is at its highest level in 14 years, and many economists expect unemployment to increase further in 2009. It is also widely believed that the current financial crisis could lead to a worldwide recession. From an M&A perspective, sellers and buyers of companies must understand that transactions are likely to be more difficult and time consuming. Private equity is somewhat hampered by the credit crunch, and many strategic buyers, including the largest controls companies, have watched their market capitalization erode, dampening enthusiasm for acquisitions in the boardroom. The positive news is that fundamentally sound, growing businesses are more likely to stand out in today’s M&A market, and garner strong interest from both private equity and strategic buyers. In addition, for automation companies, and specifically the top 20 controls companies, as ranked by Control magazine, have been involved in as many transactions in YTD 2008 as they were in all of 2007. This suggests that M&A activity in the industry is stronger than the M&A market as a whole.
One of the primary factors in the M&A market is the availability of leverage. The current credit markets are straining the ability for all parties, private equity groups in particular, to get adequate financing for acquisition opportunities. In addition, cash flow loans are now almost exclusively limited to companies with strong financial performance and in industries thought to be recession resistant. As a result, asset-based lending doubled to an average of 14% of total loan volume by September 2008, compared to 7% during 2007. To bridge the financing gap there’s been a spike in the use of mezzanine debt, which increased to 31% of total debt in Q3 2008 from only 5% in Q3 2007. The changes in these metrics have caused total debt multiple leverage for transactions to drop to approximately 3.9% for Q3 2008, down from 6.0% (close to a record high) at the same point last year.
In simpler terms, this means that private equity firms cannot pay the same purchase prices that led to unprecedented high levels of acquisitions in 2006 and 2007. This is despite the fact that private equity raised record levels of capital, and is under pressure to put that money to work through acquisitions. For example, $222.6 billion was raised as of Q3 2008, an 11% increase from Q3 2007, exhibiting the availability of funds looking for attractive investments. Sponsors have realized that they will need to use more equity to close transactions in the current market environment, as exhibited by the increase of equity as a percentage of total capitalization to an average of 44% during Q3 2008 from 33% in Q3 2007. Firms are seeking financially strong companies that can structure these types of transactions, with the thought of refinancing when the market turns. The result has been a 30% decrease in the number of middle market transactions executed by private equity buyers as compared to this same time period last year.
Middle market M&A activity, defined as transactions with enterprise value between $10 million and $250 million, as a whole declined 21% from its Q3 2007 level. Aggregate average purchase price multiples for completed transactions have declined to an average of 8.4x EBITDA for the first three quarters of 2008 as compared to 9.3x for this same period in 2007, consistent with lower debt multiples. However, while overall middle market activity has slowed, cross border activity has increased month over month from August 2007 to September 2008. This highlights the importance of companies being able to access foreign buyers, as they provide an advantage because of strong currency exchange rates.
Specific to the controls and automation sector, the top 10 controls companies saw their average market capitalization decline over 50% YTD 2008 as compared to the first three quarters in 2007. Price to earnings multiples of these companies also declined over 55% during this same time period. What we see in the market, particularly for controls companies, are many companies that remain fundamentally strong yet have lower valuations because of uncertainty regarding future performance and general economic conditions. Some of these companies have been aggressively seeking to acquire more businesses, particularly as there is less competition from leverage-constrained private equity firms. However, others—particularly those that have experienced a dramatic decline in market capitalization—are proceeding cautiously with acquisitions, even if there is ample cash on hand.
Also within the controls and automation field, there have been nearly as many transactions in YTD 2008 as there were in all of 2007 among the 20 largest companies. This compares to the M&A market seeing a 21% drop in transactions over the first three quarters of 2008. Similarly, 60% of the top 10 controls companies are on pace to close more transactions in 2008 than they did in 2007. This is impressive, especially considering the market capitalization declines for the sector. These same 10 controls companies were able to increase EBITDA by 12%, on average, from Q3 2007 to Q3 2008 while growing top line revenue by 10%, on average, over the same period. The top 10 controls companies, and the sector as a whole, will be looked at favorably from a transactions perspective if this financial momentum continues.
Whether these trends continue through Q4 2008 and into 2009 remains to be seen. However, what we can say confidently is that the controls and automation industry has been a more attractive place for capital for the first three quarters of 2008 compared to the market as a whole. The industry’s largest strategic buyers are still very active, and private equity firms are becoming more creative with transaction structures as they still have plenty of equity capital to put to work. If an automation company can continue to grow profitability in the current economic environment, there will be interested suitors.
Lincoln International’s Electronics Group is led by a former CEO of a public electronics company and a former leading Wall Street analyst covering the electronics industry. The firm’s Electronics team provides transactional, financial and strategic advisory services to electronics companies and private equity groups, with a focus in the controls industry. Lincoln covers the major economies of the world with offices in Chicago, Frankfurt, London, Los Angeles, Madrid, New York, Paris, Tokyo, and Vienna and with strategic partnerships in China and India.
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