To the relief of dealmakers, a much anticipated rebound in M&A activity occurred in 2010. The M&A market found its footing during the second quarter of last year, marking the pivotal turn that signaled the beginning of the next M&A cycle.
As painful as the most recent M&A downturn felt to most of us in the deal world, it was not extraordinary either in terms of the fall-off in activity or the length of the market lull. From the most recent peak in 2007 to the trough in 2009, domestic deal activity (dollar value) fell 64 percent. By comparison, the domestic M&A downdrafts during the early part of this decade and the early 1990s represented peak-to-trough declines of 75 percent and 64 percent, respectively. Similarly, most market retreats have averaged two to three years and, as shown in the chart below, were without false starts – i.e., there was no double dip at the bottom.
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An assessment of underlying fundamentals provides reason for optimism on the road ahead. First, corporate coffers are flush with cash. According to the Federal Reserve, U.S. non-financial institutions have nearly $2 trillion of cash on their balance sheets – an all-time high. While the economy appears to have stabilized, expectations are for the recovery to proceed at a moderate pace. With the outlook for organic growth muted, corporations are likely to look to M&A to drive growth in their businesses. Second, U.S. private equity funds are sitting on roughly $500 billion of uninvested capital, much of which is approaching investment period horizons. Moreover, the willingness of financing sources to provide credit for leveraged buyouts (LBOs) by private equity firms has improved dramatically. The total debt / EBITDA lending ratio for LBOs has increased from an average of 3.7x in 2008 (on extremely low volume) to 4.9x during the fourth quarter of 2010. Lastly, consumer and corporate confidence continues to improve. An essential ingredient to a healthy M&A market is the belief that the economy is not heading over a cliff (again). On the supply side, the market pause in 2008 and 2009 created a backlog of private, sponsor-owned, and corporate businesses waiting for an exit event. For example, according to Pitchbook Data, the average time from buyout to exit for private equity portfolio companies increased from 3.5 years in 2007 to 5.1 years in 2010. On balance, the high-level supply / demand dynamics are positive for continued momentum in M&A.
A more granular look behind the aggregate data reflected in the chart above supports this conclusion. From June to December 2010, monthly domestic M&A activity averaged north of $60 billion – roughly 50 percent higher than the first five months of the year. More dramatically, LBO volume increased 520 percent from its cyclical low of $13 billion in 2009 to $79 billion in 2010, with 91 percent of that volume occurring after April 2010. (However, this volume remains substantially below the 2007 LBO peak of $434 billion and the trailing ten-year average of $118 billion.) Valuations have increased alongside M&A activity. The median enterprise value / EBITDA multiple for target companies rose from 9.3x in 2009 to 10.4x in 2010. Improved valuations are removing one of the final hurdles for a return to normalcy in the M&A market – the bid / ask spread that exists between buyers and sellers when exiting a trough in the cycle.
While cycles are rarely ever "average," history does tend to repeat itself. M&A trended upward for six years following the recession of the early 1980s. The recovery after the recession of the early 1990s led to a bull run in M&A that lasted eight years. The M&A market grew from 2003 through 2007 following the burst of the "dot-com" bubble earlier this decade. This history suggests an average M&A cycle of roughly eight years, with a rise in M&A activity lasting six years followed by a two- to three-year downturn. This data also implies increasing M&A activity through the middle part of this decade. More anecdotally, the general buzz of activity continues to increase, and the number of business owners preparing for a 2011 or 2012 exit is on the rise. Ultimately, the combination of ample acquisition capital, increasingly aggressive credit markets, a stable economic backdrop, and a general feeling of optimism - together with historical trends - bode well for the M&A market.