The deal market remains hot, but many believe we’re coming to the late innings of an economic cycle. So, as the first quarter of 2019 wraps up, local executives, investors and advisers are watching closely for the slowdown that could be on the horizon.
Thus far, prices are holding up in terms of multiples, capital is still readily available for private transactions, and the mergers and acquisition climate in Pittsburgh remains fairly strong, says Jim Altman, senior vice president and middle market regional executive leader at Huntington Bank. However, the transactions funded in the public markets are somewhat turbulent from concerns about China, interest rate uncertainty and slowing global economic growth.
“Capital for private deals should remain favorable in 2019, as there remains enough unused powder with private equity funds,” Altman says. “But the sales price multiples may be impacted by an expected slowdown in economic growth.”
That slowdown could come in 2019, but he says it’s more likely to hit in 2020 or 2021.
As Western Pennsylvania dealmakers prepare to gather in downtown Pittsburgh on March 21 for ASPIRE 2019, Smart Business spoke with some of the players who drive local M&A activity about what they saw in 2018 and what they anticipate next.
Winds of change
When dealmakers are asked if it’s better to be a buyer or seller, the answer depends on your perspective.
Altman doesn’t believe the market has shifted from a seller’s market, yet. Demand still exceeds the supply, which favors sellers.
Christian A. Farmakis, shareholder and chairman of the board at Babst Calland, agrees that sellers still have the advantage. They were able to obtain higher than expected enterprise value on sales in 2018. There also weren’t as many distressed businesses available for buyers to take advantage of bargain pricing.
However, he knows that could change.
“We are keeping our eyes on political and economic factors, which could cause a slowdown in 2019 or beyond, like slowing economies in Europe, tariff concerns and the effects of absorption of the recent federal tax cuts,” Farmakis says.
Greg Steve, senior vice president and regional sales manager at Wells Fargo, says strong valuations and market liquidity make it a great time to be a seller, but that doesn’t mean there aren’t good opportunities for buyers to create value via improved operations, expanding geographically and M&A synergies.
He expects the regional M&A market to remain solid in 2019 but understands the window for higher valuations may be closing if expectations of future earnings start to slide.
“The opportunities for distressed M&A buyers may expand later in 2019 if the economy finally slows and corporate orphans and/or underperforming companies are put on the market,” Steve says.
“It is a better time to be a buyer today, and going forward, due mainly to the overall economy potentially slowing down,” he says. “This could lower multiples and take some groups out of the market.”
Buyers are looking to adjust purchase prices appropriately, but that depends on what sector the target company operates in, Donatelli says.
“The tax climate, foreign relationships, uncertainty on interest rates and overall political climate have made my clients very anxious,” he says.
He’s also seeing less cash exchanging hands and more rollover equity or mergers.
The region’s bankers, lawyers and accountants aren’t the only ones keeping an eye out.
Stephen J. Gurgovits Jr., managing partner of Tecum Capital, says his PE firm has plenty of capital to deploy, despite a record year of investments from its funds. But he is thinking more about a global slowdown, even though it hasn’t manifested within Tecum’s portfolio.
“We are certainly more aware and keeping a closer eye on markets and monthly performance, while watching key economic indicators for more clarity. We are moving into 2019 approaching deals with a little more caution, but we are also fairly conservative in our investment philosophies anyway,” Gurgovits says, adding that perhaps a slowdown will bring rationalization to valuations.
Gurgovits has noticed greater competition among buyers. More family offices and independent sponsors are acquiring privately held business. While this trend isn’t new, there’s a more disciplined approach.
“Not all of these buyers are created equal, and the market is now doing more diligence and paying closer attention to a potential buyer’s strategy, sources of capital, operating history and track record,” he says.
Family offices are viewed favorably because they’re generally willing to buy and hold a company longer than a traditional financial buyer. This appeals to sellers concerned about legacy. As a result, Gurgovits says some of the largest PE groups are forming funds with longer-term holding strategies.
Farmakis has noticed PE firms acting differently, as well. It’s become a more collaborative and positive experience for those who take on PE investors.
“More companies with PE investors are finding that investors are allowing management more flexibility to operate the business in accordance with their strategies, and that the investors can add value through their experience, allowing a more positive result in the end,” Farmakis says. “This is, in part, because there is more PE capital available. There is competition for the investments, so the PE firms have had to adjust some of their terms.”
Michael J. Lewis is intimately familiar with PE. He sold Quick Med Claims, the company he co-founded, in 2015 to Five Points Capital but stayed on as CEO. In October 2018, Quick Med sold to another PE firm, Perella Weinberg Partners, for a 7x return.
Lewis’ experience is that it remains a seller’s market, with interest rates historically low, fewer good companies available and a lot of equity money to deploy.
“They’re jumping over on top of each other to pay for businesses,” he says of PE firms.
It’s such a competitive landscape and flush market that PE and investment bankers aren’t bringing lenders into a deal until late, and they’re trying to do deals faster, Lewis says.
His 2018 deal closed within three weeks and the PE firm did a lot of the early work before it brought in an outside lender. He says you normally have between 60 and 90 days.
“The surprising trend we have seen is that usually there is a pipeline that takes some time to come to fruition, but instead there are a lot of last-minute deals that are being put together in a quicker time frame,” he says. “It is like they are falling out of the sky and are not marinating for as long as they typically used to.”
Flush with capital
Catherine Mott, managing partner of BlueTree Venture Fund, and founder, president and CEO of BlueTree Allied Angels, anticipates a venture capital slowdown will follow an overall slowdown.
“If you follow the cycles, when the general corporate market slows down, so does VC. Things get overvalued. There’s too much capital in the market,” Mott says. “There will be some pullback, and some of the companies will suffer greatly for it. Others will manage to hunker down and learn to be capital efficient.”
When Mott first started in VC 15 years ago, she was concerned about finding quality deal flow. Now, young companies are stronger, with more access to support.
“We have been in the position so many times to say, ‘Wow, all three of these are good, but we only have the capacity to do one or two. How do we pick?’ That’s a good place to be in,” she says.
There’s more VC to invest, as well. Mott says VC used to invest around $25 billion to $30 billion a year. Today, the annual investment hovers around $80 billion.
Mott also sees more corporations getting into VC, even though they approach it differently. Corporate investors keep their needs in mind first, she says, but their investment can indicate a problem is truly being solved by that startup.
However, she still sees a gap for later funding rounds.
“They might get their Series A, but when it comes time for Series B, it’s tough,” she says.
Those rounds typically come from outside the region.
“When the company needs $30 million, they need someone who can put in $10 million. We can’t do that. We don’t have that capacity,” Mott says. “We do need that in Pittsburgh, and particularly for the health care companies.”
Never easy to predict
Rocky Pontikes, managing director at Mesirow Financial, believes M&A remains rosy for Pittsburgh and the nation.
He says PE has approximately $1 trillion in investible equity capital, which is then factored up with the debt used to buy companies. That means $4 trillion or $5 trillion of purchasing power in PE firms alone.
Pontikes is based in Chicago, as are most of the firm’s investment bankers. However, he’s worked in Western Pennsylvania on sell-side M&A for the better part of a decade.
In the middle market, he’s noticed a drive toward strategic tuck-in acquisitions, especially since organic growth rates have been benign for larger strategic buyers.
Valuations have gone up in this bullish market over the past four or five years, and Pontikes doesn’t expect that to change in the foreseeable future. Even with recent stock market volatility, confidence remains high in boardrooms, where M&A decisions are ultimately made.
The middle market continues to build bigger companies by adding complementary products and services, human capital and technology. However, he says some buyers may be more sensitive to cyclical businesses.
“Investors are beginning to get concerned that we’re in the late innings of an economic cycle, but I think it’s very hard to predict when the music stops,” Pontikes says.
His nonprofit accelerator, Idea Foundry, invests in early stage companies. Its portfolio typically has 10 to 15 startups that are ripe for transaction. In the first half of 2018, three of those companies were acquired, but there wasn’t a hint of M&A activity the rest of the year. He has no explanation for the difference.
Matesic advises entrepreneurs to follow the Pittsburgh way when building a company. That means solid products and revenue streams, so the startup is structured well and mature beyond its years.
“If you’re going to build your startup and mirror it after what you see happening in Silicon Valley and you’re doing that in Pittsburgh, you may be not on the right track,” Matesic says. “If you build your business the Pittsburgh way, it doesn’t mean you’re not attractive to Silicon Valley.”
The other big mistake he sees is a too-wide business model. Entrepreneurs build a piece of hardware, while also creating a marketplace and trying to educate their customer.
The talent factor
Buddy Hobart, founder and CEO of Solutions 21, doesn’t just predict a slowdown in the financial markets, he’s already observing one with talent acquisition.
The last time the U.S. was under a sustained 4 percent unemployment rate was 1969. In addition, with 78 million baby boomers and only 60 million Generation X, there’s an 18 million person gap that needs to be filled by millennials as baby boomers retire.
Talent is a differentiator, Hobart says. Sellers that have invested in leadership development can demand higher valuations, and buyers with talent to insert are at an advantage.
In 2018, he saw three companies purchased by smaller organizations, in order to attain their markets. The smaller businesses had people ready to plug into the combined organization.
With financial buyers, Hobart has noticed pullback from long-term leadership payouts.
“Private equity firms are finding that I didn’t get what I bargained for. Joe Smith was great at running his business. Joe Smith is a lousy employee working for the private equity firm,” he says.
Rather than keeping leadership around for the long term, it might be for less time or not at all.
“It’s one thing to play to win. It’s another thing to play not to lose,” Hobart says. “If you keep me around for three years, for me to get the payout on my business, I’m playing not to lose. If I plug you in to take over my business and you’re going to run this for the next 20 years, you’re playing to win.”