Why M&A is Red Hot this Summer?

It’s going to get really hot this summer. Southern California in summer; hot, dry, and happening. Despite rankings among the least friendly states to do business, when Californians get happy feet, the rest of the country starts jumping. That means as the velocity of money (spending) increases, the value of small businesses across the nation will increase as well, making for a hot summer and banner M&A activity this year.  Why now? Here’s why;

Not since 2007, has the NFIB (National Federation of Independent Business) reported that their leading index of business optimism, the Small Business Optimism Index, topped 96 in May. While 96 is still below the Index’ historical average, it’s the trend that matters. And that trend is distinctively up so far this year.  And while we’ve seen these uptrends before, this time is different. Famous last words if things don’t add up, but they do. Take a look.

The drivers of middle market business value is growth; sales growth, market growth, resource growth. And despite a frigid eastern winter which put the brakes on spending in Q1 with GDP contracting 2.9% in the US, and summer concerns over global conflicts and energy prices, for the moment at least, the economy is still projected to grow 3% or better this year. And the NFIB index projects that thinking.

Meanwhile, as the benchmark 10-year Treasury Note remains below 2.6%, research firm Factset reports Consumer Sector M&A topped $26B in the first 5 months this year, the hottest since 2008.

Climbing over a Wall of Worry, and in the face of potentially higher energy prices and job eliminating new technologies, employers are hiring more and firing less according to Dept of Labor reports this month. Consumers are feeling more confident, and signs of life and spending indicate US consumers awakening from what seems like a long Rip Van Winkle slumber and stepping up to spend again. And when the trend is your friend you stick with it, especially when in good company. The S&P and Dow indexes both continue to make new all-time highs in May and June with no signs or reasons to abate just yet. The VIX (S&P Volatility Index or “the worry gauge”) is under 12, far below the 60 high mark it hit in October 2008 during the height of the Great Recession.

So how long will this market frenzy last? And what does this mean for business owners in the middle market?

An increase in CEO Confidence is likely the most fundamental and significant leading indicator of expansion. And it’s not a data silo of one or two points either. There are many. According to S&P IQ research US companies are able to borrow more than at any time during the last 7 years. Senior debt multiples (Debt/EBITDA) could top 5x this summer. The previous high was 4x and even less during the recession. Not since 2007 have banks given such leeway. Banks have also loosened formerly more restrictive covenants. Today’s covenant-lite issuers are finding they have to compete more for quality loans, hence the easing (see the article in Mergers & Acquisitions). Covenant-lite loans open the door for more lending by allowing new borrowers access to more third-party debt, higher leverage ratios and lower interest-coverage ratios. When businesses can borrow more for less they tend to invest the additional capital in capital projects, stock buy-backs, dividends and M&A. And the sharp increase in M&A activity in Q1 2014 as noted supports that trend.

Private equity funds in the meanwhile, are still looking to find and invest in high-quality solid cash flow companies and are paying up big time. According to Factset M&A buyout deal premiums for the last three months ending May 2014 topped 56%. That’s a whole lot of over-paying in my view.

Still, with increasing competition across most business sectors and economic drivers reflecting higher GDP growth for the balance of this year, when added together the billions of bucks on the books of S&P 500 companies and Private Equity Funds are enough to continue to fuel the flames of a market on fire. And as more buyers seeking high-quality assets compete and bid prices up, like a prime cut of beef, when it’s gone, buyers tend to work their way down the slab. That’s the trickle-down effect as cycles go. They go up, they go down. And while it’s always too risky to time the ups, it’s also too risky to look a gift horse in the mouth.

My point in this summer bulletin is simple. Add all these data points and index measures together and the 2014 uptrend is clear. Increasing confidence, increasing demand, increasing consumer spending all translate into increasing valuations for small and middle market businesses this year. So if you’ve been waiting to enter a better market to sell or buy a business, evaluate your options carefully as the heat of summer looks pretty cool for the middle market this year.