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George Spilka and Associates
Investment Bankers & Acquisition Consultants

The Impact of the Financial Crisis on
Middle Market Acquisitions

As this article was being written during the fourth week of September, and updated in early October, the U.S. was in the midst of its greatest financial crisis since the Great Depression. Congress approved a $700 billion bailout package for the financial industry on October 3. This infusion of capital is the most massive governmental intervention in the financial markets in this country’s history. After the initial rescue package was denied, the second version passed relatively quickly, as the consequences of not doing so were too dire. Had Congress not approved the package, there would have been a complete freezing of the credit markets.

Congress’s delay in passing a rescue package caused an intensification of the anxiety and fear gripping the financial markets. This significantly contributed to the overwhelming crisis of confidence that now impacts the U.S. financial markets and has spread to all global financial markets. Subsequent aggressive measures instituted by the Federal Reserve and U.S. Treasury, (i.e.), the direct lending by the Federal Reserve to industrial companies, and the reduction of the fed funds and discount rates, amongst others, did not immediately stem the panic devastating the financial markets. However, the former will eventually loosen up the commercial paper and general credit markets for numerous reasons, and the latter will have a positive impact on overall economic activity. More dramatic actions are likely to occur over the next few months. I believe that the world central banks and most national governments are now generally making the right moves, while operating in a tremendously complex, unique and opaque environment. These moves will eventually bring stability to the world financial markets.

In my opinion, we are definitely not facing a financial Armageddon. The market should hit bottom in the near-term. At that point, the return to normalcy will begin. Normalcy should arrive much before most people expect. Despite what you have witnessed, there is no reason to panic.

What brought the country to the brink? – Very simply, the reckless, verging on idiotic, residential mortgage lending that took place starting in 2004 combined with the use of modern technology to design exotic financial derivatives that almost nobody fully-understood the consequences of. The massive use and distribution of these derivative products was almost completely funded by debt.

Why did it happen? – The crisis was fostered by a culture of greed that has permeated this country since the “dot com” explosion of the 90’s. This culture reached its apex on Wall Street, where the “Wall Street Whizzes” felt that no amount of money was enough. It was nurtured and brought to maturity by the easy money policy of the Federal Reserve under former chairman, Alan Greenspan.

This resulted in the most excessive and imprudent lending and use of leverage seen in U.S. history. The consequences should have been realized by all at least 3 or 4 years ago.
The eventual consequences of their actions were evident to the Wall Street Whizzes. However, why should they worry? They already would have made a vast fortune from it. Their personal wealth would be secured before the problem became evident. Others could deal with the carnage. The others turned out to be the United States and the taxpayers.

What hasn’t happened in the financial crisis? – The impact has been limited to the financial industry, which has been devastated by the losses sustained in the residential mortgage lending market and the losses related to credit default swaps and other derivative products, and the consumer market. At the peak of the financial crisis on Wednesday, September 17 as financial institutions became concerned about extending credit to anybody; thereby almost causing a meltdown of the U.S. financial structure, the Federal Reserve and Treasury stepped-in and proposed the bailout package.

This brought a degree of renewed life to the credit markets. However, while this scenario evolved, U.S. industrial companies (both manufacturers and distributors) had their strongest balance sheets since the 1970’s.

There has been no massive borrowing by America’s industrial companies during this period, nor has there been any meaningful disruption in the manufacturing and distribution segments of our economy. The immediate impact has been limited to the financial markets, and to a much lesser extent the consumer market, and this is where the impact will be contained.

Although the country is in a recession, and probably has been since early in the second quarter of 2008, the profits of U.S. industrial companies remain strong. The results for public companies indicate that although profitability is moderating, it remains at reasonably high levels.

My clients are realizing moderate to strong profit growth this year. In my opinion, the intermediate and long-term impact of the financial crisis on the economy is going to be negligible, if any. I believe that by early in the 2nd half of 2009 the U.S. will be coming out of the recession.

My major concern regarding future economic performance is the amount of guarantees that are being made by the Federal Reserve and Treasury. These could lead to a significant worsening of the Federal deficit with potentially serious economic consequences. If it does, it will exacerbate our dependence on foreign countries.

In this scenario, without foreign governments increasing their already large purchases of U.S. debt instruments, we will likely have a significant increase in the inflation rate and a further weakening of the dollar. Obviously, this foreign ownership of the United States is not only a political concern, but it also has potential long-term business consequences. However, despite the aforementioned concerns, I believe the financial crisis will have limited impact on the intermediate and long-term economy.

Owners and executives of middle market companies, such market defined as companies with a transaction price between $5-$250 million, will now continue to get their endless calls from brokers, intermediaries and low-grade investment bankers. However their storyline will now be, either upfront or as a deal progresses, something similar to, “you better sell at a discount price before the carnage gets worse”, or “you should be thankful to receive this price due to current financial conditions”. There is no justification for those type of statements.

Most acquirers will tell you the devastation in the financial markets means you will have to accept a substantially discounted price. You will be told that pricing will be “dirt cheap” into the foreseeable future and might even deteriorate further. Don’t pay any attention; this is hogwash. Acquisition pricing will likely return to normal levels near the end of the second quarter of 2009.

The Impact of the Financial Crisis on the Sale of Middle Market Companies

1. Short-term impact – (up to 1 year) - There might (or might not) be a period of six to nine months where there is some turmoil in the acquisition market. There will likely be a degree of transaction pricing weakness through the end of the 2nd quarter of 2009.

2. Intermediate-term impact – (1-3 years) – There should not be any impact on transaction pricing, unless the effect on the Federal deficit of the guarantees made by the Federal Reserve and the Treasury have a greater impact than I believe they will. At this point, I don’t anticipate that happening. Therefore, I expect deal pricing to be similar to the 1st half of 2008, which was reasonably solid.

3. Long-term impact (3 plus years) – None. Many things will affect pricing, none of which will be the current financial crisis.

Based on this economic outlook, I don’t feel the financial crisis should have a significant impact on potential sellers of middle market companies.

The Recommended Course of Action
Don’t change the overall strategy regarding the sale of your company. If selling satisfies your personal and business objectives, you should proceed with the process. You might delay contacting potential acquirers until the end of the 2nd quarter of 2009, but that will not be necessary in some cases. In addition, don’t modify your expected transaction price.

Companies not yet in the market or ones at the very start of the sale process (whose fundamentals and business foundation are somewhat deficient) may want to delay the sale, while they strengthen and reposition the company. However, where there is no need to strengthen the company’s fundamentals or foundation, I see no reason why approaching acquirers should be delayed past the end of the second quarter of 2009.

Conclusion
Do not be intimidated by acquirer’s “doomsday scenarios”. The financial crisis has not changed anything in the industrial sector of the U.S. economy. Most companies remain very profitable and the intermediate and long-term business outlook remains good. Don’t allow yourself to be overly anxious, because so many are unjustifiably in a panic at the current time. There should not be any transaction price concessions made. Patience and courage will provide you a bountiful reward.

These are times when you truly need a strong-willed, determined, knowledgeable investment banker that understands the causation of the financial crisis and how it is likely to play out. They will provide you the proper guidance on how to proceed in these exciting, but turbulent, times. If you have this strength and expertise on your team, you will get a premium price. Don’t let acquirers intimidate you!! Don’t accept less than you deserve!!!

 

George Spilka and Associates

Email: spilka@georgespilka.com

Phone: 412.486.8189