NEW YORK (LPC) - US middle market companies and their private equity sponsors are focusing on growing through ‘buy and build’ strategies, rather than transformative acquisitions despite a surge in global merger and acquisition (M&A) activity, as they prepare for a possible macroeconomic downturn.
Despite a generally benign economic climate now, toppy purchase prices and high debt multiples are encouraging sponsors to focus on smaller add-on acquisitions for mid-sized portfolio investments as they brace for a less favorable trade environment or a possible downturn in the economic cycle.
“Sentiment is split. We are still seeing great results, strong profits and businesses are hiring, but there are simultaneously things to worry about, said John Martin, managing partner and co-CEO of Antares Capital.
Making smaller acquisitions at lower multiples of 4-5x to existing deals can help to justify high double digit purchase price multiples as financial sponsors focus on adding scale through bolt-on acquisitions rather than solely emphasizing organic growth.
“If there is still room to grow a company, and you don’t have to sell it or you don’t have a good reinvestment opportunity, sponsors would rather build it out with add-ons and tuck-in acquisitions,” a middle market lender said.
One lower middle market lender said that 20% of the names in their portfolio made add-on acquisitions in the first quarter, which is notably high. Overall M&A activity was less robust than anticipated in the first three months as fewer middle market companies took advantage of the tax cuts in the New Year to make acquisitions, the lender said.
This trend has continued so far in the second quarter. NorthStar Financial Services, a portfolio company of TA Associates, launched a US$405m acquisition loan on May 4 that backs the company’s purchase of asset management firm FTJ FundChoice. Northstar is buying the FTJ platform from financial sponsor Seaport Capital. Antares Capital leads the deal with Macquarie Capital and Citizens Bank.
Also earlier in May, urgent care provider CityMD, a portfolio company of private equity firm Warburg Pincus, finalized a repricing of its US$224.4m term loan and a US$120m add-on facility that will be used to support an acquisition. Credit Suisse, SunTrust and ING arranged the funding.
Highline Aftermarket completed a US$368m term loan B in April that refinanced existing debt and funded the company’s acquisition of South/Win, a manufacturer of automotive fluids. Private equity firm The Sterling Group backs Highline, an automotive chemicals, lubricants, and parts manufacturer and distributor. The BNP Paribas-led deal brought in existing lenders and new money investors.
Debt funding remains cheap and investor appetite for floating-rate assets remains strong in a rising rate environment. Leveraged lending constraints on banks have loosened, Collateralized Loan Obligation (CLO) funds are no longer required to hold as much skin in the game and Business Development Companies have been given the green light to raise leverage.
This abundant liquidity and the ability to line up low-cost acquisition funding with flexible terms is not, however, enticing mid-sized US companies to raise new money in event-driven deals at a pace that keeps up with investor demand.
“We are in an optimal issuance environment, but issuers aren’t coming to market at a faster pace,” said a regional banker of sponsor-backed companies and corporate borrowers.
Some issuers are still waiting for further clarity on the implications of US tax cuts and trade policy discussions. There are also indications that despite a mostly positive economic outlook and continued confidence about M&A prospects, uncertainty around trade policy and anticipation about an eventual market downturn is introducing some caution into US middle market companies’ calculations.
“Rate increases are coming late in the cycle, stocks are choppier, trade talks are floating around. Concerns are rising, but it hasn’t derailed confidence yet,” Martin said.
A recent survey of middle market dealmakers by Antares Capital showed that 69% of respondents are either very or somewhat concerned that rising trade tariffs or a potential trade war could impact portfolios. Similarly, at 65% a majority believe a recession is somewhat or very likely in the next 18 months.
Despite wariness around the business impact of possible trade wars or a looming recession, the survey also found that a majority of respondents still expect M&A growth to be strong (12% of respondents) or modest (55% of respondents) in 2018.
Reporting by Leela Parker Deo; Editing by Tessa Walsh and Michelle Sierra