This article was written by:
Wade Kozich, CPA, CMAA, CEPA
Director of Transaction Advisory Services at GBQ Partners and Senior Advisor to Footprint Capital
GBQ’s Transaction Advisory Services group (TAS) had another busy year in 2017 and signs are pointing to a strong 2018.
In reviewing our 2017 results, GBQ’s TAS Group participated in 122 transactions including:
- Assurance and Tax Due Diligence and Structuring (41 )
- Capital Markets including those completed jointly with Footprint Capital (12)
- ESOP Feasibility Studies and ESOP Formations (21)
- Purchase Price Allocations, Pre-Transaction Valuations and Fairness Opinions (48)
While we worked on 122 transactions, we probably looked at hundreds of other deals when considering all that we get to review.
Certain team changes were made in 2017 to our TAS group to further strengthen our efforts.
Chris Dean joined Kaz Unalan to lead our Tax Structuring and Diligence efforts. Both are Tax Partners in our firm.
Brad Daugherty and Ben Forquer joined Tom Powers to drive our Financial Due Diligence and Quality of Earnings efforts. All are partners with Tom and Ben residing in the Columbus office and Brad in our Cincinnati office.
Joe Borowski was promoted to Partner in our Valuation group and will be focusing on ESOP formations as part of his new role. He works alongside Brian Bornino and Craig Hickey to lead our Valuation group’s transaction activities.
Footprint Capital, led by Josh Curtis, brought on Greg Hicks to form a new service focused on Deal Origination work. Greg had a background with Lincoln Financial Advisors in Chicago and Desco Holdings here in Columbus. Footprint Capital also brought on Steve Lundregan as a Senior Advisor focused on assisting clients with sale readiness and strategic planning.
Josh Curtis obtained the CEPA (Certified Exit Planning Advisor) designation this year to join Kaz Unalan and me as three of only six holding the CEPA designation in Central Ohio.
The TAS team served as speakers at various events and participated in a number of panels and workshops throughout the year as well as routinely participating in AMAA, ACG, ESOP and OSCPA conferences.
We are increasing our efforts to educate our clients and prepare them for an eventual transition of their business. Kaz Unalan has been leading the charge on Liquidity Planning and doing various presentations on this subject. We are also we sponsoring an event on Feb 22 for the first time entitled “Grow. Transform. Exit.” This workshop will be conducted by Steve Lundregan and James Rores. It is being designed to help business owners to become more valuable and be better prepared to go through a possible transition of their business.
We believe we have a strong team that covers most financial aspects of deals including Buy and Sell Side Investment Banking, Deal Origination, Assurance and Tax Diligence, Tax Structuring, Valuation issues, ESOP formations, and Liquidity Planning, all in one office.
Developments and Trends we are seeing in the Deal World
The M&A climate
The M&A market continues to be robust with the number of deals increasing. That is what we are reading and that has also been our own experience. Strong economic indicators, combined with low interest rates, decreasing tax rates and reduced government regulations all seem to support a robust M&A market. Typically, what is good for the stock market will also be good for the M&A market. Thus far, stock markets have responded positively to the recent environment. There was anticipation of what changes the tax law would bring but now that picture is clearer and it appears to be a “pedal to the metal” environment. Infrastructure spending, if it happens, will further drive this market.
Another observation, most people do not realize how much the Private Equity world is driving the whole M&A market and how many companies out there are owned by PE. It is a staggering number. They are extremely active and pervasive both on the Buy and Sell side.
Baby Boomers looking for liquidity before the next downturn.
I heard a presentation a year ago by Jeff Mortimer, BNY Mellon’s director of investment strategy at the AMAA Winter conference that has stuck with me. Jeff leads a team that sets capital expectations for his firm and he predicted late 2018 or early 2019 as his best guess of the likely timing for our next recession. While the stock market has been driven to new highs recently, the current bull market has been a long one. While no one can predict the next downturn, as time goes on, the chance of our next recession increases. There are a number of aging business owners who want to do something prior to the next recession. They have seen the “face of the devil” and do not want to see it again. The truth is, no one knows when the next recession is coming but we do know from history that it can come on fast and unexpectedly.
More companies are looking to acquire to meet strategic objectives.
Organic growth has been hard to come by for many companies in many industries making acquisitions the only way those companies can achieve their growth objectives. In addition, companies are making acquisitions to add strong people, expand geographically and add to their intellectual property. It simply turbo charges strategic plans.
Also, it is a proven fact that companies that have acquisition strategies are more valuable than ones that do not. This pertains to Public and Private Companies alike. For many of the same reasons, we are seeing much smaller companies attempting to enter the acquisition game.
It’s still a really strong Seller’s Market
I just attended the Association of Mergers and Acquisition Advisors Conference in January and there was a constant theme of how tough it was out there on Buyers and how high the multiples were for good companies. The competition for deals is tougher than ever. The number of Private Equity firms has risen well above 7,000 in the United States and that does not include the ever increasing number of Family offices that are functioning in part as PE as well as an ever increasing number of Independent Sponsors (PE without their own fund). Of course, the Strategic Buyers are very active, have huge resources and have increased the amount they are willing to pay for companies. Previous to 2017, Strategic Buyers were getting outbid often by PE but that has changed and they are probably now on a par with each other as far as the prices they are willing to pay.
As an observation, the Private markets for companies have become so efficient that strong companies are getting multiples not all that different than Public Companies when you consider how those multiples are calculated. As most of you are aware, the P/E multiples in the Public Markets have been very high and, to a great extent, the multiples for Private companies are following in a similar manner.
Leverage multiples are also increasing
Along with higher prices, we are seeing higher leverage multiples both in terms of Senior Debt and especially the amount of Mezzanine Debt being used. This is especially true when the Equity investors in a deal are trying to increase their ownership percentage for the same amount of Equity dollars contributed. Of course, as with process, leverage multiples vary a lot with size and quality of the underlying company.
Cross border Deals are becoming increasingly common.
On certain kinds of deals like Software and Technology, probably now over 50% of Buyers of US companies are foreign. Of course, the highest prices are usually obtained through running an Investment Banking process but Strategic Buyers are very good and organized about trying to go direct to companies in their industries and do what we call “proprietary” deals; meaning they are the only one talking to the target company.
The Rise of the Family office in the Deal world.
There have been a strong number of Privately Held companies being sold over the last 6 or 7 years for large amounts (in excess of $100 million) and many of them are forming their own Private Equity teams. What is changing is that these groups are getting much more sophisticated and hiring their own staff with strong M&A backgrounds or subcontracting some of that out to groups that specialize in M&A.
There are a few notable differences with Family Offices as compared to traditional PE. One is that they have a tendency to value the culture of a target organization more than PE might. Those cultural differences may translate into them valuing certain characteristics of a company like religious inclinations, political inclinations, stances on the environment or a host of other preferences that heads of the Family Office’s highly value. Another thing that is notable is that they typically do not have limits on holding periods for their acquired companies because they don’t have Fund Mandates like typical PE. In other words, they are much more inclined to buy and hold indefinitely as long as it makes economic sense to do so.
Effect of the Tax Reform Act
The Tax Reform Act is so new that everyone is still trying to digest it and figure out what impacts it will have. First, let me say that the Tax aspects of deals can make a large difference in the economics of a deal and can involve some of the most complicated applications of the Tax code. The Tax Reform Act simply makes things more complicated and you really need to do your homework and work with people who really understand the issues. Otherwise, you are likely to leave hundreds of thousands or millions of dollars on the table in a deal.
A couple changes in the Tax Reform act are notable. The large drop in the corporate tax rate has a lot of people scratching their heads about entity selection when setting up a company. While the Double Tax inherent in a C-Corp is still higher long term than the single tax inherent with a pass-through entity, the new, lower corporate tax rate is something to think about. Another change to watch is the limitation on Interest expense to a percentage of an EBITDA type calculation. This will particularly affect acquisitions that are heavily leveraged. It will also become an increasing concern as interest rates rise.
What we have found is that tax considerations can really move the dial in deals and you really need to run the numbers hard and think of all the various ramifications. You cannot think in terms of generalities when it comes to analyzing tax impacts. You really need to do the hard homework.
As a side note, the changes in the Tax law should increase the value of deals. Why? It just makes sense that if an investment can return a higher after-tax cash flow, then its value should go up. This logic, of course, should extend to the Public markets as well. Indeed, we did see a bump in the Public Markets leading up to and in the wake of passage of the tax bill. It is yet to be seen what this impact this will have on Private Markets but I do not see any reason why similar dynamics should not drive up the price of Private Company deals.
On the tax structuring side, we are seeing more complexity and sophistication.
It is common for a seller to want to defer tax on equity they reinvest upon a sale to private equity. Most of the deals where we have served as the sell-side advisor have been in the $5 to $30 million range, and most of those owners who have sold to a PE buyer have rolled equity in this manner. The tax deferral on the rolled equity can amount to hundreds of thousands or millions of dollars of savings and it is not obvious or always easy to accomplish. It takes a fairly sophisticated tax group to get this piece right. We had a situation recently where a Vice President of a Selling Company had a somewhat large Deferred Compensation benefit that he wanted to roll into equity of the newly formed company. Doing this without immediate recognition of Tax proved to be somewhat challenging and complex but we got it done.
State and local taxes continue to rear their head in deals. Both buyers and sellers underestimate how sales tax, use tax, unclaimed funds, property tax and other indirect type tax issues can sneak up and add additional complexity and potential liabilities to deals. We have had at least one deal blow up because of potential exposure in this area. In some cases, we have needed to set aside special reserves at closing to fund potential costs related to these issues to the Buyer.
Traditionally, small deals were almost always done as asset deals.
Now, a good number of the deals we are involved with are stock deals with 338 (h) (10) or 336 (e) elections. This is being done primarily for the purpose of making the deal simpler and getting to a close faster, especially where a number of contracts would need to be transferred with an Asset deal. These elections allow for a Stock purchase from a legal perspective to be deemed an Asset purchase for tax purposes only. Attorneys for buyers seem to be getting more and more comfortable with the risks associated with a stock deal and covering their risks with adjustments to reps and warranties provisions and required escrows. Having a strong M&A attorney really pays off when it comes to these issues.
In the Due Diligence area, we are seeing more standardization of Due Diligence and Quality of Earnings reports and more Sell Side Diligence.
While previously used only on larger deals, most buyers are having outside diligence performed on even smaller deals (under $10 million in size). The practice of having a Quality of Earnings report completed by sellers prior to closing a deal is also becoming more and more common. For a seller, it offers up a sort of “Good Housekeeping Stamp of Approval” to potential buyers. We see this especially where the readers of the Confidential Memorandum are going to have a number of questions about accounting treatments or EBITDA normalization adjustments. Many private equity firms are now doing sell-side diligence whenever they sell a company.
In general, we see less stringent diligence performed by strategic buyers than we do by PE type firms. This probably speaks to their higher level of familiarity with the respective industry. We are also seeing very standardized diligence checklists and processes by companies that are doing multiple acquisitions of similar companies in the same industry. They are also incorporating integration plans into their diligence process.
PE firms buy and sell companies and that is their business. Consequently, they will be usually be more sophisticated and faster to the table on a deal than a Strategic buyer.
LOIs getting longer and time to close getting shorter
LOIs continue to get more detailed and, in some cases, come close to what is contained in the actual Purchase Agreements. A more detailed LOI gives a seller a chance to ferret out more issues with the Buyer before agreeing to a signed LOI which gives the buyer exclusivity. This, in turn, then also significantly reduces the time to close and increases the chance that the deal will actually get done with that particular buyer because certain thornier issues are dealt with up front as opposed to at the end when disagreements can cause a deal to fall apart. This trend is particularly common on more sizeable deals.
Continued lack of sophistication of smaller companies in the M&A market.
Whether they are on the Buy-Side or Sell-Side, smaller companies have a significant lack of experience when it comes to deals. Consequently, without the right outside support, they generally get eaten alive and may not even realize it. On the Sell-Side, we see smaller companies that are woefully unprepared to go through a transaction leaving them in a position of being unsaleable or not reaching nearly their potential as far as sale price or terms. Frankly, it is a sad at times to see companies that someone has devoted a good portion of their life to, fail to be able to be transitioned successfully to new owners.
In response to this, we have ramped up our efforts to educate our clients and prepare them for an eventual transition of their business. See workshops referenced above.
We are seeing more ESOP deals.
While ESOPs still make up only a small percentage of all companies sold, we are seeing more companies looking at ESOPs and at least doing a feasibility study of ESOP as a possible solution. We will be running soon a series of workshops on this subject. Click here to read more on ESOPs. As mentioned above, we participated in 21 ESOP deals in 2017 as well as consulted regarding many more. Our ESOP leaders are considered experts on a national level and are frequent speakers at ESOP conferences.
Every deal is unique
One thing you quickly learn in the deal world is that every deal is different. While there are many trends and common themes, each one must be examined on its own merits and the only way to really learn deals is to do them. Each year, we become 100+ deals more experienced.