Why Deal Makers are Cautiously Optimistic

Last night, Axial hosted its quarterly Members-only Summit at the Maritime Hotel in NYC. With 200+ senior deal professionals from around the country in attendance, it was a unique opportunity to take the pulse of the middle market and hear the outlook for the rest of 2013 and 2014.

Overall, the outlook seems cautiously optimistic. While 2013 has been less active than some hoped, many Members expressed increased hope for the next 6-12 months — with 81% of opportunities expected in the lower-middle and middle market.

John McCarty of Peachtree Equity Partners, Andrew Panico of Ascension Point Capital, and Paul Sperry of Sperry Mitchell & Company took a few moments last night to share their thoughts on the market, its major drivers, and some roadblocks that could slow activity.

The Alignment of Core Fundamentals

John McCarty of Peachtree Equity Partners believes activity is positioned to rise in the next 6-12 months. He explained, “As companies continue to perform strongly, and funds seek investments, there will likely be a rise in activity in the near future.”

The optimism seems to be shared by many deal professionals, per a recent E&Y Report. The report explained, “Almost 70% of executives expect deal volume to improve over the next 12 months.” The conflation of, “core fundamentals: positive economic sentiment, enhanced credit availability, the imperative for growth and the expectation to create jobs” is creating a particularly favorable environment for deals and deal making.

Activity will likely be driven by both financial and corporate investors. The E&Y survey learned, “over one-third of companies will pursue acquisitions in the next 12 months vs. just one-quarter a year ago. This 40% improvement in the number of companies expecting to pursue acquisitions resonates from the notable increase in the last 12 months in the number and quality of acquisition opportunities, as well as significant improvement in the likelihood of deal closing.”

Interest Rates & Favorable Lending Environment

One of the most critical “core fundamentals” is the strong lending environment. As Andrew Panico of Ascension Point Capital explained last night, fear of rising interest rates is causing many deal professionals to jumpstart their deal making.  He explained, “Many private equity shops are carefully watching the impending rise in interest rates. We saw the rates of the 10 year move up 100 basis points in June — and that scared people a bit.” He continued, “Getting deals done while financing is attractive is becoming a priority.” This race against a clock is reminiscent of the tax rush that drove activity at the end of 2012.

The importance of interest rates and the favorable lending environment was echoed in both the E&Y survey and a BMO Harris report. The BMO Harris report explained, “Debt markets continue to be supportive of this activity with stable pricing and aggressive leverage and terms.”

The E&Y survey similarly explained, “The vast majority of executives consider access to credit as stable or improving. Furthermore, the sentiment on improving credit is almost double what it was 12 months ago. This confidence, coupled with positive views on the global economy and sound economic fundamentals, will accelerate dealmaking.”

Double-Edged Sword of Valuations

While deal flow has been slower than anticipated for the second half of 2013, Panico believes rising valuations may help sellers come to market. He explained, “I think deal flow will pick up in the next 6-12 months. As valuations trend higher — some are even comparing valuations with 2007 levels — many sellers are being incentivized to come off the sidelines. In an effort to learn their business’ valuation, they are approaching PE shops and financial sponsors for different deals.”

However, problems may arise if business owners and sellers are not satisfied with their valuations. “As transaction volumes accelerate, there is a natural divergence between buyers’ and sellers’ expectations on pricing,” explained the E&Y Report. “Thirty-one percent of executives expect valuation gaps to widen over the next 12 months vs. 17% six months ago. This widening gap results from buyers and sellers adjusting their expectations at different rates.” If sellers are not satisfied with the offer, they may return to the sidelines.

On Matters of Uncertainty

Although all factors seem aligned, Paul Sperry of Sperry Mitchell & Company addressed the undercurrent of unpredictability still felt by many deal professionals. He explained, “Right now, given all that is happening, there is an air of uncertainty. The truth is we have no more certainty than we did in 2007, but we just feel more uncertain and I think there is no doubt that that is impacting people’s outlook.”

To manage the uncertainty, “Many bankers have convinced themselves that sellers want to put together 3 years of solid performance after downturn. They believe that once they get through 2013 — and have solid financials for 2011, 2012, and 2013 — the floodgates will open again in 2014. Only time will tell.”