Market Conditions and Industry Growth Yielding Higher Valuations
February 28, 2018 - By: SC&H Group
M&A activity in the manufacturing industry promises to be strong in 2018, both in the number of deals and the size of transactions.
For reasons that we will explore, buyers have a ravenous appetite for M&A and considerable stores of capital to go shopping. Meanwhile, manufacturing is enjoying more than a moment, as the industry’s outlook is growing brighter as both employment and productivity are on the rise. With dynamics so favorable for deal-making — at least for the foreseeable future — it would be a surprise if the year ahead were anything but blockbuster for M&A. Indeed, SC&H Capital closed just such a deal in the opening days of the new year, the first Maryland-based manufacturing transaction of 2018.
If you are a business owner considering a sale, the following is what you need to know about the current marketplace before you get started:
Buyer Demand and Wherewithal
Due to our position in the M&A marketplace, we have a keen awareness and understanding of what many potential buyers are facing regarding strategic growth mandates. Currently there is immense interest — and, in many cases, board-level pressure — to pursue double-digit annual growth rates, to fill gaps in product offerings, or to expand customer access. And in some cases, it is all of the above. One way to accomplish these objectives, of course, is by forging a combination with another company, be it through a merger or an acquisition.
The decision to go this route has been made easier — perhaps easier than ever before — as a result of the wide availability of capital. Consider:
- Private-equity firms are sitting on an unprecedented amount of dry powder, at an all-time high of $1 trillion, according to research firm Preqin Ltd. With an obligation to generate financial returns from this committed capital, PE firms must deploy capital, or risk failing their investors.
- Banks have been eager to generate returns by lending to support growth and acquisitions by both financial and strategic acquirers. For middle-market private equity transactions last year, the average debt-to-EBITDA ratio stood at 4.3x, well above historical norms, even pre-recession norms, reports industry data provider GF Data Resources.
So, on the buy-side we have ready buyers and ready cash. Let’s take a look at what’s transpiring on the “other” side.
Industry growth is not always indicative of the growth rate for each and every business in the sector. However, the big picture in manufacturing does breed investor confidence. And continued growth is expected.
The Purchasing Managers Index, considered by many economists to be the most reliable leading indicator of growth in the manufacturing segment, has been within 5% of its 15-year peak for the past six months, indicating U.S. manufacturing is well positioned for ongoing growth.
High investor confidence combined with industry wide growth leads to increased valuations across the board. Manufacturing valuations rocketed to 6.9x EBITDA in 2017, a 15-year high (by far), according to GF Data. For example, the chart below depicts the relationship between the Purchasing Managers Index and valuations.
Valuations are tied to a multitude of factors including company-specific dynamics, however broader industry confidence and strong tailwinds, combined with positive capital market conditions, create a fertile environment for successful M&A activity and attractive valuations.
Benefits of Tax Reform
Making the acquisition landscape even more attractive to potential sellers in the manufacturing space is the new tax law, the Tax Cuts & Jobs Act. Two provisions in particular will prove beneficial:
- The legislation reduced the C-Corp tax rate to 21%, a change that will yield considerable tax savings to business owners selling equity in their C-Corporations.
- The expansion of accelerated depreciation grants sellers the ability to offer significant tax savings opportunities to buyers in exchange for higher valuations and other seller-friendly transaction terms.
Bottom line: these tax changes will be a net boost in “take-home” cash for selling business owners.
Aggressive Bidding if …
All of these factors — strong demand, available capital, a strengthening industry, and beneficial new tax rules — almost certainly will translate into aggressive bidding in the M&A process. The great Warren Buffett said as much in his 2018 letter to investors. As a buyer, he lamented that prices for even merely “decent, but far from spectacular, businesses hit an all-time high [in 2017]. Indeed,” he continued, “price seemed almost irrelevant to an army of optimistic purchasers.”
All of that said, some manufacturers considering a sale have critical work to do before going to market if they want to garner the best possible deal. Due to the heightened competitive climate, a key factor to positioning for sale is highlighting strategic differentiation from other alternatives for buyers. These differentiators may feel obvious to you, but it is worth the time and thought to carefully craft a strategic positioning (based on core differentiators) that will resonate with potential buyers.
Is it the right time for a sale? We don’t possess a crystal ball, but we do expect market conditions to remain positive for the near-term based on informed forecasts.
Predictably, not everyone agrees. None other than Alan Greenspan, the Federal Reserve chairman at the time of the housing crash, recently floated the possibility a “bubble,” and KKR, the esteemed global investment firm, issued a recession warning based on a weakening U.S. dollar (not terrible for manufacturers!), higher unit labor costs, and other concerns.
But in our view, overall market conditions should continue to be favorable for business owners considering a sale over the next 12-18 months. Beyond that is anybody’s guess, but you can be sure that we’ll be watching M&A trends and the economic landscape very closely for shifting winds.
SC&H Capital works with clients to strategically guide conversations, inform decision-making, and, should the client determine the time is right to sell, facilitate transactions. If you have any questions regarding the current market activity and how it effects your manufacturing operations, do not hesitate to contact us.