If the economy continues to grow, even at a relatively slow rate, and capital remains available at present levels it is quite likely that we will continue to see a healthy level of M&A within the fragmented industrial distribution sector in 2012.
As we head into the fourth quarter of 2011 and look ahead to 2012, we are reminded that we live in an extremely uncertain world. The strong level of confidence that most felt toward the economy during the first half of the year has taken a serious blow stemming from a series of shocks including Standard & Poor’s downgrade of U.S. debt, continuing developments regarding the European debt crisis and, previously, the economic shock waves of the tsunami in Japan, just to name a few. Meanwhile, those external "events" occurred in the context of an overall economic recovery which continues, but at a slow pace with extremely limited job creation.
The July Institute for Supply Management's (ISM) manufacturing activity index, known as the PMI, fell to 50.9 from 55.3 in June after routinely topping 60 earlier in the year. However, the latest indicators suggest that the economy is still growing, albeit slowly, and worries regarding global macroeconomic issues, such as the European crisis appear to be easing slightly. Amid this uncertainty, one key question remains: will the equity markets lead the economy lower or will the economy lead the equity markets higher?
Add up all the economic factors and it is easy to see why there is increasing talk about the risk of a double dip recession. With that comes the risk that we fall victim to a self-fulfilling prophecy driven by falling consumer confidence and a volatile stock market that rose or fell by 400 or more points on four out of five days in the second week of August.What does all this mean for the mergers and acquisitions outlook going forward within the industrial distribution sector? One thing is certain: the last year has seen a broad resurgence in middle market M&A activity generally and specifically within the distribution industry as shown in the charts below:
Middle Market M&A Transaction Volume- Rolling Trailing Twelve Months (source: Mergerstat)
Annual Distribution M&A Transaction Volume (source Capital IQ)
This resurgence has been led by multiple drivers, including:
- Strategic acquirers in corporate America are sitting on more than $1.9 trillion of cash, a 50 percent increase from the levels they had five years ago, while seeking ways to augment their own organic growth;
- Private equity funds have nearly $500 billion of capital to deploy with more than $100 billion in funds that expire in 2012 and 2013;
- Buyers enjoy improved debt financing markets as lenders’ interest has increased during the last 18 months, remaining strongest in companies with EBITDA more than $15mm;
- Pent-up supply of unsold businesses and significant improvement in deal quality, and;
- Increased visibility and achievability of earnings forecasts have led to higher closing rates.
How is this playing out with specific companies in the industrial distribution sector? The table below summarizes select M&A activity within the industry:
The availability of massive amounts of equity capital to both strategic and private equity buyers will not change in the near to mid-term as it will take quite some time for both strategic buyers and private equity groups to deploy their existing cash towards acquisitions and/or capital investment projects. There are currently a healthy number of industrial distribution deals in the market and the pipeline of pending deals shows no signs of slowing. Importantly, the market also appears at greater equilibrium as sellers and buyers are more easily agreeing on price. This is in stark contrast to 2009 when a large gap often existed between buyer and seller expectations.
The greatest risks to any slowdown in M&A activity will be any weakening in the financing markets, which has not manifested itself thus far, and any deterioration in the financial results of industry participants. A slowdown in performance would likely lead to lower closure rates as a result of the target missing its budgeted earnings. Failure to meet forecasted results typically leads to buyers seeking to reduce the proposed purchase price or shifting a portion of the consideration towards being contingent on future performance. In addition, any pullback in financial results may discourage potential sellers from initiating a sale process, thus reducing the number of deals in the market while also causing buyers to "hunker down" and focus their energy and capital inwardly on their own business rather than on external acquisition targets.
While several indices that gauge manufacturing activity have shown some weakening, this was ultimately inevitable from the lofty levels seen in the first quarter. In fact, the first four months of 2011 saw the PMI record its best combined four month stretch in 20 years. If the economy continues to grow, even at a relatively slow rate, and capital remains available at present levels it is quite likely that we will continue to see a healthy level of M&A within the fragmented industrial distribution sector in 2012. Though one thing we all know we can expect in 2012, after the volatility seen in the third quarter of 2011, is that the markets will continue to surprise us.
About the author
Curt Tatham is a Managing Director at Lincoln International and Head of its Distribution Group. Lincoln International is a global, middle market M&A advisory firm. Curt can be reached at (312) 580-8329 or firstname.lastname@example.org