Mid-Market M&A Report: Riding Out The Downturn

Why is the middle ground holding while bigger deals tumble? Five experienced M&A professionals give their views.


Mergermarket data indicates that mid-market deal volume has declined less in 2016 than for mega-deals and large deals. Why do you think this is, and does this trend match up with what you’ve been seeing in the market?

SB: The year 2016 has been a record year of busted bulge-bracket transactions. In the entire history of global M&A, there have only been 12 announced transactions with a deal size of $100 billion or more, and of those 12 transactions, only five have been withdrawn. Two of those withdrawals came in 2016 alone – Pfizer’s $150 billion acquisition of Allergan, which was cancelled in April, and Honeywell’s $97 billion acquisition of United Technologies, withdrawn in March 2016. The cause of these broken transactions includes more frequent US antitrust enforcement and the US crackdown on transactions that support tax avoidance or risk harming national security. This trend has caused many company executives to think twice before contemplating complex deals that could attract government scrutiny.

Meanwhile in the middle market, although the values and volumes of US mergers and acquisitions are unlikely to surpass 2015’s figures, the deal drivers that fueled last year’s record-high US M&A values remain in place heading into the second half of 2016. The first quarter was choppy as a result of hiccups in the debt markets and volatility in the equity markets, but those issues have dissipated since then. Additionally, while the middle market is impacted by the same uncertainty that the larger market has felt, the middle market does not receive the same level of scrutiny by the government in terms of anti-trust laws and tax avoidance due to their size.

KS: Macroeconomic factors – whether it’s suffering economies, Brexit, or political considerations with respect to the US – apply equally across the spectrum of M&A. But one differentiating factor that separates mid-market deals from mega-deals is regulation, as regulatory pressures apply more to that upper price bracket than they do to the mid-market bracket, as Simon noted. We’ve seen a bunch of mega-deals worldwide that have been abandoned due to regulatory concerns like anti-trust regulation or tax regulation, and I think that’s a major factor to consider with regard to large-cap versus mid-market data.

Another factor is growth on the private equity side, and the number of firms looking at mid-market assets. I would say there is just a greater demand at that level. There’s a greater variety of interested buyers and investors, and they are being more flexible and creative in the types of transactions they are willing to take on. That, coupled with the regulatory angle, has helped support the mid-market data recently.


MG: I think of the mid-market as being less cyclical and more “The Little Engine That Could” with regards to M&A. It just keeps going and going and going. There are many assets that need to trade hands, and you have a lot of sponsors with investment horizons on their portfolio companies who are looking to sell. I think the big-ticket M&A market for really large strategies is a lot more discretionary than the mid-market. Big-ticket M&A tends to follow, for lack of a better phrase, a herd mentality. If your biggest competitor is doing a deal, you feel more of a compulsion to do one yourself. Large strategic deals tend to have more of a wave effect in that they build upon one other, whereas the mid-market has a more natural cycle of deals that need to happen and tend to happen unless the markets are really bad.

MO: As Michael pointed out, the mid-market is generally more resilient to the changes going on outside. It’s slower to transition to the new normal, so if you are seeing a big tightening in the credit markets or if you’re seeing an explosion in growth, often the middle market will somewhat trail that trend because it contains companies that by their nature are usually a lot leaner. These companies are most likely not getting the top-down edicts of “this is what needs to be done in the next six months” that you see in larger companies. These edicts can affect the behaviors of the large-cap companies’ M&A teams and what they want to achieve, but this is not typically the case for middle market firms.

BL: The middle market is definitely more resilient. Some of that has to do with the fact that it sees a significant number of transactions despite representing a smaller percentage of deal value. There’s just a larger base to work from. In the large deal market, if there are a couple of deals that don’t get done because of concerns about the economy, or because of financing market considerations, you will see a significant impact on the deal value that gets reported.

The middle market is also supported by a really efficient market on the supply and demand side. On the supply side, there are a large number of portfolio companies at private equity firms that need to be realized through exits. This creates a large supply of companies in the mid-market. Importantly, on the demand side, there is over US$500bn of private equity dry powder out there, and nearly US$1.5tn of cash on S&P balance sheets. This creates a tremendous amount of capital that can get deployed for the purpose of acquisitions. Finally, the mid-market is supported by very willing financing markets, as Matt mentioned. All of these factors combined create a pretty efficient environment for mid-market M&A.

To what extent do you think Brexit and the US presidential vote are affecting North American mid-market M&A?

MO: I think the impact of Brexit and the US elections is still very speculative in nature. What are people generally going to do with the UK headquarters of their European operations? A lot of this will depend on the exit deal that the UK negotiates with the EU. I think there will be a “follow the leader” mentality, and that many of these decisions will be industry-based. But the driver of M&A will always be the fundamentals of the business. As long as you have access to the credit markets and low rates, and as long as the company is attractive, then M&A will still be attractive.

BL: With regards to the US election, we’re down to two people at this point. If there were serious concerns about either one of them, we’d be feeling it in the market already, and we are not. I believe the only way either one of these events – Brexit or the US elections – will materially impact mid-market M&A, either on their own or in combination with other external factors, will be if they cause a large disruption to the overall financial markets, and specifically the debt markets. That could have an impact on our business, but the events in and of themselves are not likely to be significant determinants of activity growth going forward.

KS: In a normal political cycle, I think M&A players would be focused on a US election, particularly on what effect the election would have on things like interest rates. There’s a fear that interest rates may rise in the future as the US economy stabilizes, and historically, I think the preference has been towards a Republican administration implementing conservative policies. Obviously, this is not a normal political cycle, given the players involved. With that in mind, I expect there to be a preference for the status quo. People will want the status quo to remain given the players involved, meaning people may want a Democratic administration just to stabilize the political risks of what may materialize if there’s a party change this election cycle.


MG: I think the biggest issue for mid-market deals is not Brexit or US politics per se, but uncertainty. Whenever there are large macro events that cause people to doubt their ability to predict the future accurately, they tend to be a little more hesitant in doing what I would call non-discretionary transactions. As a result, the deal volume tends to decrease slightly. Brexit, I think, caught a lot of people by surprise when it happened and I think the fallout from Brexit is still being determined. I don’t purport to be any sort of sage on the EU or to know how the UK economy is going to work. But generally speaking, I think people are still saying, “I don’t really know how this is going to play out.”

According to Mergermarket, there continues to be strong mid-market deal flow in the Energy, Mining & Utilities, Financial Services, Healthcare, and Consumer sectors. At the same time, deal numbers are down from last year in the Technology and Business Services sectors. What are you seeing in your particular segments of expertise?

MO: The consumer industry has been very hot over the last few years, as a lot of these brand-based companies have been chased pretty strongly by acquirers. Somewhat analogous to the broader M&A market, the consumer space has gone through several banner years, and I think that’s one industry where the air hasn’t gone out of the balloon just yet. I think the branded consumer space will continue to be a good industry to be in if you’re a seller over the next few years. The only caveat to that is a possible recession. If a recession does actually occur, acquirers will be worried about growth prospects with consumer demand falling.


Another area I have done a lot of work in is healthcare, covering everything from general provider-based services to pharmaceuticals to healthcare IT and healthcare services. That industry has been very, very busy and has generated a lot of transactions and returns in recent times. I don’t see that changing any time soon, as there is still a lot of consolidation going on. I think there will be a lot of transactions between healthcare companies trying to figure out ways to work best within the new system, the Affordable Care Act (ACA), and changes made to ACA after the election if there are any.

BL: I work in our energy, power and infrastructure division, and there are segments of the market in these sectors that remain very stable, including utility services, industrial services, environmental services and the like. The one piece of the market that faces different dynamics is energy services, where there is exposure to oil and gas commodity prices. As a result, there are fewer so-called “healthy transactions” available to be done in the space. But there are still opportunities for deals, as investors and acquirers look to place bets on where we are in the cycle, and on which companies are at a perceived low point in the commodity price environment and in anticipation of a recovery. That’s a different type of activity than we’re seeing across our other industry segments, where mid-market M&A is driven largely by high-performing, stable companies across different industry groups.


SB: Our primary focus is healthcare, which is a huge part of the economy poised for significant growth, primarily because of the aging population. That’s not going to change anytime soon. There is a terrific upward trend – the sector is accelerating now and will continue to do so over the next decade pretty substantially. It is a very broad, deep, and diverse sector.
At the same time, the twin pressures to contain costs and improve quality continue to influence both corporate and PE activity in US healthcare. Providers will face reimbursement cuts as well as uncertainty about where future cuts will hit. Both payers and providers continue to test new payment models and new ways of delivering care through lower-cost care delivery. This environment creates a significant opportunity to build industry-leading businesses. The scale will continue to be paramount, as many companies seek to create efficiency and density in their local markets as well as looking to expand into new parts of the value chain. As a result, we expect competition for assets to be brisk and valuations to remain high.
To be successful in this environment, we are focused on several strategies: a) identifying health care light assets, where there is less exposure to direct reimbursement risk; b) building large scale businesses rapidly to realize improved operational efficiencies; c) exploring unconventional partnerships and joint ventures to get deals done or improve operational performance; d) and focusing on category leaders in fragmented markets with significant availability of add-on acquisitions.

KS: My practice specializes in private equity, and we have started to see PE funds focused on the energy, mining and utility space. These firms are becoming more sophisticated, but I do not believe there is a particular target market for them to focus on just yet. That said, there are certainly resource-based opportunities that could represent a large percentage of the M&A spectrum in Canada, given the nature of the Canadian economy. We have seen a number of transactions in that space already, including cross-border transactions like the TransCanada-Columbia Pipeline deal announced in March. Given the effect of oil prices on the market, I expect to see continued opportunity for dealmaking in these industries as senior and junior players are faced with tough decisions.
There are always transactions being reported in and around Ontario, given the economic makeup of the area. I recently acted for Baring Private Equity Asia on its investment in the outsourced services division of TELUS called TELUS International Inc., which was just one of the interesting transactions that got done earlier this year. Beyond energy, healthcare is another market that has garnered attention. There have been a number of transactions involving Canadian targets – for example, the acquisition of Canada-based physiotherapy company Centric Health by US-based Audax Private Equity for US$187m – and from an industry perspective I expect to see more growth in the year to come.

MG: Looking specifically at the data related to the tech sector, it is worth pointing out that the industry tends to work differently than most others. A lot of mid-market activity is driven by financial sponsors, and financial sponsors tend to prefer stable companies with relatively stable cash flows, assuming they can use appropriate leverage to get the returns they’re looking for. The tech sector is a much different animal. It is not quite as odd as it used to be, but it’s still distinct from other spaces like consumer or energy. Another factor is valuations. Tech businesses seem to be requiring ever-increasing valuations, and that kind of pressure can make people take a step back. With these factors in mind, the fact that M&A data is going in a different direction for tech compared to other sectors does not surprise me. I am not a Valley guy by any means, but I get the sense that while the tech bubble hasn’t popped, it is deflating slowly.

Interest rates remain at historical lows, but it has become tougher to access bank loans due to tightening government regulation. What is the current situation with access to credit in your segment of M&A?

KS: Speaking of Canada, there are still very healthy debt markets on the public side and even more so on the private side. The amount of support available to private equity investors is enormous. We’ve also started to see new players come into the debt markets, so private equity firms, including clients of ours like Apollo, have created divisions that are essentially lending vehicles. CPPIB now has lending capabilities as well and recently served as a lending arm in a large transaction – and there are other players who are capable and willing to step into the extent that there is debt financing available. Given their background, these players are likely to be creative with regards to the structures they are willing to offer.

SB: The regulatory dynamic today is affecting the activity of pure banking financial institutions. This is resulting in substantial growth in what we call the non-bank banks. There are a lot of these players out there, and they are very sophisticated, very user-friendly, very large, and very flexible. They command a big share of the market and have terrific reputations. I have been on the market for quite some time, and I see these non-banks becoming a go-to source because they offer a one-stop shop with a particular lender across the capital structure. This is very helpful from an ease-of-use perspective, as well as from a lower-cost-of-capital perspective. It is often cheaper and more efficient to use these sources as opposed to banks.

BL: We are seeing a mix of alternative lenders and traditional banks. In a lot of our processes, the alternative lenders are not as hindered by regulations as banks. We continue to see banks being aggressive in trying to get debt capital out the door, however, so I do not think the new players have been a total disruption to the market. But these new non-bank players have certainly increased the pool of capital available compared to what we have seen historically.

MO: I believe there was a bit of credit tightening earlier in the year, but it has since gone away. Generally speaking, the credit markets are still positive and available. There is a relationship between deal availability and capital availability, in that you need quality deals in order to get very good terms on credit – these two things just run together. If there is a decrease in the number of deals – even if just a cyclical decrease – you could see a pause in volume simply because there are fewer quality companies that are able to get credit. Banks and other financial intermediaries are desperate for good-quality deals, and there’s a lot of competition for good-quality borrowers. But if you bring along a company that has some challenges, or a financial investor like a private equity firm that wants to be very aggressive on the amount of leverage, I think it’s fair to say that the lenders will be less willing to give those aggressive terms today than they have been in the past. You can still get them, but they take a little more work, a little more push, and a possibly a little more shopping around.

So far this year, North American M&A remains below the record-breaking highs of 2014 and 2015, but above the figures for 2009-2013. What do you expect to see in terms of activity for the remainder of 2016 and into 2017?

SB: Dealmaking activity in 2016 and 2017 will likely grow and be driven by a) companies realizing that a very efficient way to grow in a slow-growth environment is through M&A; b) international buyer interest in US companies as the US is attractive for its stable growth and currency; c) heightened activist-fueled M&A; d) distressed asset sales, particularly in the oil and gas sectors; and d) divestitures, as companies look to mitigate operational, regulatory and shareholder activism concerns. If we continue to have available financing and optimism about a stable US economy, this will support equity prices and encourage higher levels of domestic and cross-border M&A over the next few years.


MO: It would actually not surprise me if things get sluggish in the fourth quarter of this year, because of all the events taking place. But I would still say that the pipeline for transactions is solid. There are some transactions that could flip to a slower track or possibly be pushed to next year, but even with that, we are not seeing a fundamental change in mid-market M&A. The general view is that we’re down from what we have seen in the last couple of years, but the last couple of years were high. Even if interest rates increase at year-end, as a whole lot of people who know more than I do about the financial markets are predicting, it will be a fairly moderate increase rather than a return to unusually high-interest rates. I believe that is the general consensus: that a change in interest rates won’t materially impact our ability to finance mid-market transactions. We may see an impact on valuations because even a moderate increase in rates can affect the pricing of business assets, but this does not indicate that there are huge storm clouds on the horizon when it comes to overall mid-market M&A activity. The market has been pretty resilient to shocks recently.

KS: To add to Matt’s point, not only is there a great abundance of dry powder available, but you also have a growing number of private equity firms that essentially have to make returns or they will not get to raise second funds. That added pressure is an important element to consider. The optimistic view is that dealmaking will return us to more balanced numbers in comparison to the last couple of years.

BL: We are on pace to be at a similar level to where we were in 2014 and 2015 in terms of numbers of closed transactions. Our backlog remains at a pretty stable level, consistent with where it’s been throughout the last two-and-a-half years. We think that this year will continue to be strong and comparable to prior years. Given the stability we have seen recently, there is good reason to be optimistic. If you take it all the way back to 2009 and the recovery in 2010, we are in the sixth or seventh year of an up cycle. There have been some ups and downs along the way, but overall we have been looking at an up cycle since then. That said, cycles are called cycles for a reason. There’s a downside on the other end of it that we’re always ready for, and we always remain aware of what might be coming. But there is nothing in our business today that says a decline is imminent.

MG: I think everybody has a tendency to look back to 2008. We expected wholesale changes in the way deals were done, at the way at-risk allocations were handled, and so on. And while there has certainly been some evolution with regard to reverse termination fee structures and financings, M&A definitions, in general, have remained the same. Nothing has really changed all that much. You may be nibbling around the edges, but the overall deal structure still seems to work well, with the exception of circa 2008. People tend to stick to the tried and true methods when it comes to doing deals and advising clients. For me, advising clients on the sell-side in particular, the important thing is that you are nimble, fast and that you to take advantage of whatever speed opportunities you can – because who knows what’s going to happen tomorrow?

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