We started 2011 with a sobering fact that much of the anticipated economic growth in 2010 did not materialize. While pundits continue to say that the worst is behind us, the reality is the growth in the recent past has been anemic at best. Widespread economic growth appears stagnated in 2011 and 2012 is likely to see only very modest growth if any at all. The overspending by the US government is exacerbating the situation and the European Union is facing some tough choices with some of their members facing bankruptcy or worse. Asia (especially China) and India are also cutting back on their growth expectations. The overall banking industry is facing a crisis and credit will only get tighter in the near term.
For business owners planning to retire or cash out of their business for other reasons, these are very harsh realities. Businesses are valued primarily on the potential for future cash flows (EBITDA) and acquirers use past earnings a one of the key measures of how a business is likely to perform in the future. For many business owners, it may take several years to achieve their financial goals in an uncertain economy. Some market segments such as the defense/aerospace will likely see negative growth military spending declines as a result of cutbacks mandated by governments in making tough choices on spending limits (i.e. entitlements versus discretionary spending on defense).
In 2010 and 2011, business continued to be soft, credit continued to be hard to come by and liquidity levels continued to be low for small and midsized businesses. While many of the large businesses continued to hard their cash to carry them through hard times or wait for the recession to end, small businesses saw less than stellar business valuations from the limited M&A deals that ensued and many did not close as planned. Many of the small and midsized business owners who were planning on exiting held back – unwilling to face a reduced valuation and hoping things would be better in the not so distant future.
Business owners evaluating the consequences of these environmental factors on the business sale/recapitalization process, need to keep in mind that business sale/recapitalization can take about 12 months. Most acquirers/investors look more carefully at business performance as they navigate the deal process and positive trends along the way can be helpful in closing a deal and in getting the terms sought by the shareholders. On the other hand, negative trends can kill a deal or substantially decrease the deal valuation.
For 2012 here are some key factors business owners need to take into account while planning exit/recapitalization strategies:
- Economy: While widespread growth is not imminent some industries will actually shrink or consolidate such as the defense/aerospace markets while commercial communications (both terrestrial and satellite), software, information technology and mobile media will continue to grow fairly robustly. Clean technologies or alternate energy and healthcare industries are also expected to continue growth. However, many other segments like construction, transportation and infrastructure are likely to be in the doldrums for the next several years. This mans the business owner will have to decide which segment he represents and position himself carefully for a planned exit over the next few years.
- Interest Rates and Liquidity: Long term interest rates are at historic lows, but credit markets are still extremely tight. Small to midsize business borrowers are finding it much more difficult to find and qualify for business loans even though the government has been interceding with SBA loan guarantees. Generally low interest rates not only improve liquidity, but also have the effect of making valuations higher. Many acquirers are likely to find a higher valuation acceptable in a lower interest rate regime when they can finance the deal and still meet the cash flow metrics needed. Low interest rates, coupled with improved liquidity, make the chances of putting together winning business deals a lot more likely.
- Taxes: Most of the uncertainty for small and midsized businesses is caused by the taxation laws and rates that are set and reset by the government depending on the political situation at the time and the spending habits of the “then in power” status. While we have been enjoying reduced personal income tax rates and the lowest long term gain and dividend tax rates of 15%, all of the tax rates are morte likely to go up in the future than to go down or stay the same primarily because of the “out of control” spending, the “entitlement bulge” and the increased size and scope of government in the US. Most tax experts believe that the low 15% Federal Capital Gains Tax rate is unlikely to stay at that level and there is substantial risk they could be changed to something substantially higher (25%-40%) in the future. The prospect of increased Capital Gains Tax after 2012 should be carefully thought through in the context of the business exit/recapitalization process.
- Deal Making Opportunities: Acquirers are a lot more likely to buy a business in a flat to upwards trending market than in a downward trending market. Deal making opportunities will be abundant in the in the growth segments of the markets (communications, healthcare, software, IT, mobile media, cleantech and alternate energy sectors), but the declining sectors such as defense, aerospace and construction, infrastructure and transportation industries will be more challenging. Even though the major defense/aerospace companies are sitting on “hoards of cash” right now, they will be very selective in acquisitions and consolidation opportunities. Unless there is a strategic reason for an acquisition such as improved market share, technology insertion, or accretive profitability or cash flow the defense/aerospace companies will sit on their cash and wait out the situation for the “next war”. However, we believe there will be “roll up” or consolidation opportunities for small to midsized companies in the defense/aerospace markets which will be backed by Private Equity players or Mid-Cap defense/aerospace companies attempting to grow into larger OEM suppliers. Also, foreign companies will be shopping for synergistic US companies in the defense/aerospace markets to expand and the relatively weak US dollar makes these acquisitions more attractive in the current market.
With all things considered, small to mid-sized business owners should consider whether this is a good time to review their exit or recapitalization strategies and determine how to approach the sale/recapitalization process for optimum financial return.