The One-Off M&A Market

MidasMoments: Rob Slee’s Comments on the Nation

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This year is shaping-up as a terrible year for middle market M&A.  Author after author has been bemoaning this fact, all seemingly at a loss to explain the dearth in acquisitions.  Yet it’s all too easy to explain.

Let’s start by considering the Ten Year Transfer cycle.  I discovered this cycle a lifetime ago and have made a fortune by living what it represents.  Behold the chart that I created 20 years ago.

As the chart shows, the United States middle market transfer market runs in 10-year cycles.  It is no coincidence the cycle mirrors general economic activity. Transfer cycles begin each decade with two to three years of relative deal recession. This period is characterized by a flagging economy that causes banks and other capital providers to lessen lending and investment activities. Most private business owners will not be able sell-out for an acceptable price during these years.  Most large companies tend to focus on core businesses and curtail aggressive acquisition plans. For acquirers with cash, this is a buyer’s market.

From a seller’s perspective, the prime time to sell a business occurs during the middle years of the cycle. Capital is available for buyers to finance deals during these years. During this period, the MBA crowd has again convinced Wall Street to fund roll-ups and other consolidations. Big companies are back in the game, growing income statements and balance sheets through strategic acquisitions.

The smartest sellers typically wait until near the end of the seller’s market before making a move. In this way they get the benefits of increasing profitability plus the highest transfer pricing. Economic storm clouds start forming after eight years or so of the cycle. Because of the economic uncertainty during this period, deals are harder to initiate and close, therefore waiting too long is risky.

Why a One-Off Market Now?

The 3rd and 4th years of every decade offer great opportunities to cherry-pick distressed and zombie deals.  But during these years it’s not a great time to sell mundane or average performers.  And right now, 80-90% of middle market companies are mundane or average.  How can this be?  Because 80-90% of middle market companies have not been covering their costs of capital for much of the last decade, and this has created large value gaps in the market.  The M&A market is now feeling the effects of those gaps.

Let’s look behind the M&A curtain for a minute.  For the past 15 years the primary drivers of the M&A market have been private equity groups (PEGs).  In that period, about 5,000 PEGs have acquired about 30,000 middle market companies.  Since PEGs almost exclusively acquire good/great companies, their buying represents the top 10% of the 300,000 companies in the middle market.  Now PEGs have nothing to buy, as they already own most of the “A” companies.  What a high class problem:  a couple of trillion dollars with nothing to buy.

In the meantime, the US has not been creating new middle market companies fast enough.  I think this is mainly due to several factors.  The technology crash of 2000-2002 killed the crop of middle market seedlings, while in the process shuttering hundreds of Angel groups.  At this time China was taking off, and thousands of American investors decided to place bets there instead of doubling-down in the US.

So what’s going to happen to middle market M&A the rest of this decade?  It will be more of the same.  Dealmakers who know how to create their own deals (ala MidasNation) will be plenty busy.  Owners who still hold “A” businesses will feel like the prettiest girls in school in the weeks leading-up to prom.  The rest of the market will continue to struggle with one-off deal hell math:  at most, there’s only 1 good deal per PEG and per dealmaker per year.

Now you know why I’m cherry-picking investment banking deals, but spending most of my time buying and growing zombie businesses.

– Rob

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