Examining the Deal Flow Challenge

Despite reports of record activity in years, many deal professional find the current deal landscape to be particularly competitive. Discussions around weak deal flow — in both quality and quantity — have left many firms eagerly waiting to deploy the capital sitting in their funds.

Jim Hill, Chair of Benesch Law’s Private Equity Group, believes the current environment is a result of trends in both the private capital markets and the general economy. While the trends add a new layer of competition to the middle market, Hill believes developing new relationships and being creative can help deal professionals overcome the current deal flow challenge.

The Discouraged Business Owner

One of the most significant drains on current deal flow is the non-incentivized business owner. “Investment returns are not great in general and many ‘baby boomers’ have decided to not sell until they are well into their 70s not 60s,” explained Hill. When considering where to put their sale payout, their reinvestment options are limited as returns are low across the board.

Hill continued, “[The business owner] may have a company that produces good cash flow, has built a management team so he doesn’t have to be involved every day, and so why sell?” As a result, a lack of incentive is causing business owners to postpone their exit.

While poor re-investment opportunities have been a problem for some time, business owners have more recently been discouraged from exiting because of slowing revenues. Hill mentioned, “An international investment bank did a study at the end of 2013 among a large group of middle market companies and found that the last two quarters of 2013 versus 2012 showed revenues averaging down 5% and EBITDA averaging down about the same.” Hill asked, “why go into a process when your trend is not upward?”

A Decrease in Divestitures

According to Hill, strategic inactivity has also contributed to the meager deal flow of late. “Strategic sellers are not very active today,” he explained. “Usually companies sell their non-core assets because they want to pay down debt and focus on core assets. However, as the economy stabilizes, corporate sellers aren’t being forced to sell their non-core assets. Their debt is low and they don’t need to sell.” As corporations tried to stay afloat post-recession, carve-outs offered a sizable contribution to the deal flow.

Paul Schneir of KeyBanc Capital Markets confirmed Hill’s analysis in a recent roundtable discussion. “Last year, carve-out activity was more a result of Boards identifying non-core units for strategic reasons, but there still was a hesitation to complete the deals because the sellers were focused on a loss of profitability and impact to their earnings per share.” These concerns caused a stagnation in divesting activity.

Increased Diligence

While fewer deals may be coming to market, the issues around deal quality have been exacerbated by higher standards from deal professionals. “I think from a diligence standpoint, deals take longer to get done because the buyers and lenders are doing much more diligence than they did 10 years ago,” said Hill.

He continued, “If I talked about qualities of earnings reports 10 years ago, people would have been confused as to the jargon. But now, the vast majority of financial and strategic buyers want to do quality of earnings analyses on target companies. Sometimes, the sellers even do their own quality earnings analysis on their own company before they bring it to market to anticipate the likely questions.”

As a consequence of lower returns in recent years, investors are seeking ideal opportunities that will guarantee returns and satisfy LPs. As such, the lens with which they review potential investments has become more scrutinous. Consequently, the threshold for a ‘quality’ deal has shifted upward.

How to Overcome the Challenges

Hill explained the best ways to stay competitive in this market is to understand the seller mindset, get creative, and constantly build new relationships.

One way to open dialogue with a business owner is to demonstrate you understand his concerns and relevant industry trends.  Hill recommended, “One strategy to bring a seller to the table is to demonstrate an understanding of consolidation trends that are occurring within the industry of the target. If [a business owner runs] a regional $80M company, and the behemoths are closing in, [he] may start worrying about where they will be in the future.” Hill added, “Private equity firms can help with the competition thesis.”

If there are no external pressures, helping resolve the business owner’s re-investment challenge can also be a unique offer. One example mentioned by Hill: “A seller told me that, when he exited, there was an equity piece, a senior piece, and a mezz piece. The mezz piece was about $10M, and the mezz firm agreed to split their piece with him. The business owner was happy because he was able to sell, but still reinvest in his company and get a good return.”

While these strategies may relieve certain situations, the most important strategy any financial sponsor can employ to improve its deal flow is to build new relationships. “At the end of the day, PE firms also need to be sourcing opportunities and relationships from the boutique investment banks around the country,” explained Hill. “Even if these shops do just 1-2 deals a year, when you add that all up, it is a substantial component of today’s deal flow. Having visibility and relationships with these intermediaries is critical.”

As boutiques increasingly populate the middle market and lower middle market, gaining exposure and presence to these smaller shops is critical to sourcing the best opportunities. Whether it is making more phone calls, attending more conferences, or joining Axial, identifying the smaller banks and brokers is proving critical to current and future deal flow.