PERSPECTIVES: As deals pick up, stay focused on valuePosted On: Nov. 14, 2011 12:00 AM CST
Following utterly dismal years for merger and acquisition activity in 2009 and 2010, this year is shaping up to be one of the best on record. It's possible that we'll see more announced deals in 2011 than the nearly 300 that closed in 2008. This new momentum will likely continue into 2012 and beyond.
If you are a seller, this is cautionary good news. Competition is robust, with traditionally active buyers back in the game.
But these buyers have been joined by a big wave of new buyers, some of whom are backed by private equity, others of whom are strategic, private buyers. Thus, if you are a private buyer competing with the “big boys,” you'll want to be wary of increased competition and price creep.
Why this amount of deal activity? The environment is better now, despite the hangover from the past few years. We see evidence of economic recovery, albeit slow and choppy. We also see a possible firming of the property/casualty insurance market in the near future. If this occurs, buyers will benefit from future lift.
There is also evidence of pent-up demand. Due to the perfect storm created by the economic crisis and the prolonged soft insurance market, many buyers sat on the sidelines in 2009 and 2010. As a result, sellers were sidelined as well, creating a reasonably strong inventory of prospects who are now contemplating their alternatives.
Active buyers—public, bank-owned and large, private equity-backed firms—have struggled as much with organic growth as the rest of the industry. For these buyers, an alternative to organic growth may be growth through acquisition, with the resulting increased earnings as the primary driver of their value. As these active buyers acquire additional agencies, they also benefit from leveraging the discount or spread between the earnings or EBITDA multiples they use to value a target agency and the multiples at which the buyers are valued.
Value can be tricky, though. There is evidence that earnings-based multiples have expanded a bit recently. As sellers contemplate the financial consideration they might receive in a transaction, they may find that their earnings margins are down due to the previously referenced “perfect storm.” With margins down, value may be down even if the earnings multiples are up modestly.
Thus, we just aren't seeing agency values equal to those of the glory days of five and six years ago. By the same token, potential sellers should not be deluded by some of the stratospheric multiples paid recently by strategic acquirers. A one-off event does not constitute a trend.
Conversely, middle-market buyers, especially those who are privately owned, should be careful not to get caught up in deal fever brought on by the recent flurry of activity. It's easy to fall into the trap of thinking that, with all the transactions closed by active buyers and others, now is the time to go on a buying spree.
Instead, work first to define your acquisition strategy. Then design a plan for implementation and determine if that plan is a prudent use of capital and other resources. Will the capital and other resources provide an adequate return? Will a similar investment of resources in an organic growth strategy provide a better return at lower risk, a slower pace notwithstanding? Consider the impact of the human capital required to roll out an acquisition strategy. Also, think of other opportunities that might be missed if attention is devoted to deal-making.
Key factors to consider when examining an acquisition target are culture, fit and sustainability of earnings. Always value a deal based on the target's earnings, never as a multiple of revenue.
Lastly, manage and share risk and reward through an earn-out or subsequent performance-based measures. But use caution: It can be impossible to completely manage a high-risk transaction or damaged target through structure and terms.
A guiding principle embraced by prudent advisors and conveyed to clients is that sometimes the best acquisition is the one you never do. Do not be lulled into complacency by the increased number of transactions, and do not attempt to win the bidding war. Those in the active-buyer group make offers on only a tiny percentage of the candidates they review—and they close an even smaller percentage of the offers they make.
If you are a potential seller, then, plan ahead for your exit by positioning the firm to maximize your value. If you are a buyer, define your strategy first and then stick with your plan. And always be prudent with your resources.
Timothy J. Cunningham is a principal with Chicago-based OPTIS Partners L.L.C. He can be reached at firstname.lastname@example.org.
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