M&A, Capital Markets Update: There’s Improvement for Sure, But We’re Years Away From the Glory Days of High Valuations
In the following article, Tim Stute, managing director and principal at Milestone Advisors, assesses 2010 in terms of merger and acquisition activity in the commercial finance sector. While such activity has increased in the later half of last year, valuations remained low due to lack of competition from banks. In looking forward to 2011, Stute expects steady improvement in M&A activity with modest, yet rising deal values for the near term.
The year 2010 proved to be an important year of transition in the commercial finance sector. During the year, access to senior financing improved, leading to increased private equity interest in the sector. Surviving independent commercial finance companies deserve congratulations having persevered through an extremely difficult credit cycle and financing market, but challenges remain. Strategic and financial initiatives of acquirers, versus distress among sellers, have started to drive merger and acquisition activity over the last six months. But for the most part, valuations remain low due to the lack of competition from bank buyers that typically drive up valuations for commercial finance businesses.
Moving into 2011, while valuations will likely not increase significantly for selling businesses, merger & acquisition activity appears to be on the upswing as more banks regain health and seek lending diversification away from troublesome real estate loans, non-bank finance companies look to supplement organic growth, and financial buyers such as private equity firms, family investment offices and hedge funds seek attractive investments before valuations increase towards pre-crisis levels.
How Did We Get Here?
Beginning in the second half of 2008 and continuing through early 2010, nearly all merger and acquisition transaction activity in the commercial finance sector involved distressed target companies or sellers. Many independent commercial finance companies were forced to find new financing sources or seek an acquirer amid pressure from their senior debt provider, oftentimes through no fault of the actual company. Additionally, captive commercial finance companies were told to curtail new originations, or even cease new fundings. Unfortunately, in many cases, both for independent and captive finance companies, the only option proved to be shutting down the platform and placing the portfolio into runoff.
During this period, M&A deal pricing centered upon portfolio par value and downside risk rather than earnings capacity and projected performance. Shareholders that would have had a chance to earn 20% to 40% premiums on assets (or up to ten times pretax earnings and two times shareholder book value) at the height of the market in 2004 through 2007 were now taking haircuts on their equity or in the best of circumstances, earning premiums via an earnout structure with proceeds contingent upon credit quality going forward. Further, the universe of acquirers contracted as banks and large non-bank finance companies faced mounting asset quality deterioration and, in the case of non-banks, significant funding problems.
For those companies that were fortunate enough to survive the credit crisis and remain independent, the set of challenges was no less formidable. Many healthy finance companies experienced tightened lending terms from senior financing providers or, in the worst case, not so friendly requests for repayment in full or non-renewal of facilities. A market that was not long ago filled with a plethora of lending options for finance companies looking to borrow to fund their assets was now down to a market of only a tiny handful of senior debt providers. Only the best operators with the healthiest credit quality were able to roll their facilities, let alone obtain a new facility from a new lender.
The combination of inadequate funding and deteriorating credit quality resulted in minimal acquisition activity and new capital investment, beyond the previously noted distressed transactions, in the commercial finance sector. Fortunately, the last few months have brought a glimmer of optimism that could signal an improved market for acquisitions and capital raises in 2011 and beyond.
Where Are We Now?
Today, as we move forward into 2011, banks that were active lenders to the commercial finance sector before the recession and banks looking to diversify away from real estate exposure have slowly emerged as willing to consider senior financing for commercial finance companies. Terms on new facilities are not as unattractive as you might think; however, lenders are still very selective. The welcome return of senior financing, albeit slowly, is creating renewed interest in the sector from private equity investors, many of whom have spent the last few years attempting to navigate the failed bank regulatory minefield.
Over these last few years of the credit crisis, private equity and hedge fund investors were reluctant to consider investments in non-bank finance companies due to the uncertainty of the leverage markets. The classic “chicken and egg” scenario exists because the equity investors will not put their money in unless they know that attractive senior financing is available to drive their equity returns, and the senior lenders will not provide debt without an appropriate amount of capital subordinated to their position.
But with more financing available today, private equity investors that have stockpiled capital are willing to entertain finance company opportunities with good management and pristine credit quality in growth sectors. Within the commercial finance sector, private equity investors are typically looking to make growth equity investments (versus buyout investments, unless the valuation makes sense), though such investments must typically be for a controlling interest in the target company. As you might imagine, valuation is always a key factor in private equity investment. While things are looking positive in the sector due to increasing availability of senior financing, valuations will continue to lag historical averages due to the lack of banks seeking acquisitions.
The high water mark for valuations in the commercial finance market naturally coincided with banks recording record profits and growth. As bank performance improved, so too did their stock prices. As a bank’s stock appreciates relative to earnings, so too does its spending power and ability to pay big prices for acquisitions. That led to the previously mentioned valuations that are typically only experienced at the top of a credit cycle. Today, however, while select banks have crawled back to the financing markets, most are still dealing with too many asset quality issues in the residential real estate, commercial real estate and construction lending markets to return to profitability, let alone pay up for an acquisition.
This becomes a dream come true for financial buyers like private equity firms. At the height of valuations, private equity firms cannot compete with a bank that wants to pay a big price because a private equity firm will not bring the funding and leverage synergy to a finance company like a bank can. A bank may pay ten times pretax income for a commercial finance company, but after it replaced higher cost senior debt with low cost deposits, it is like it paid well below ten times pretax income. Private equity firms can’t compete with that, but when the banks aren’t buying, competition is lighter and valuations are lower. This, coupled with improving financing conditions, results in greater interest from private equity and hedge fund buyers.
Displaced as a result of restricted growth, shuttered operations or termination of employment agreements, experienced managers have teamed up to start new commercial finance companies to exploit the pull back of banks as small business lenders. While private equity interest is returning to the sector, investors remain focused on top management teams who have built comparable businesses before, preferably from scratch, and achieved a high returning exit price for investors.
However, many private equity investors are reluctant to pursue startup opportunities because first, investors do not like to take the risk that a new venture will get through its startup phase and become profitable. Most start up finance companies endure some period of losses before turning profitable, which means an investor’s capital will take a hit right from the beginning of an investment, which isn’t ideal to institutional investors. Secondly, private equity investors typically like to invest in established platforms that have demonstrated they are scalable and operated by successful management teams.
Management teams looking to start a new finance company by accessing institutional equity capital should consider identifying a target company or portfolio to be acquired in conjunction with the capital raise. This will serve to show the equity investor (plus the prospective senior lender) both a day one tangible use of their investment and provide for day one interest and fee income to offset the costs of launching a business.
An excellent example of this structure is the recently announced North Mill Capital LLC transaction. In this transaction, the proven management team at startup North Mill, with experience growing and exiting successful commercial finance companies, had a signed letter of intent in place to acquire an asset-based loan portfolio from Summa Capital Corp. prior to soliciting an equity investment from the private equity community for the new venture. In searching for an equity partner, the signed letter of intent was a critical selling point that ultimately led to a partnership with private equity firms Monitor Clipper Partners and ALDA Capital. The portfolio acquisition allowed the new equity investment to fund earning assets, which are now generating cash flow for the new business.
Despite the many issues facing banks, the truth is that some banks remained healthy through the recession or have regained financial health and are therefore back to being active as prospective acquirers. A perfect example of this is Crestmark Bank’s recent acquisition of assets from Westgate Financial in New Jersey. Community banks and some regional banks continue to struggle with asset quality issues, but some banks that successfully accessed the capital markets are looking for opportunities to deploy the capital. Initially expecting to pursue lucrative government-assisted bank transactions, newly recapitalized banks are now facing tough competition for failed bank opportunities and less advantageous transaction structures. Some of these institutions are turning attention to other asset classes that could provide balance sheet growth while also diversifying interest and fee income sources.
Likewise select non-bank financial services companies have increased their level of interest in acquisitions as they too have been able to access the debt markets to obtain more leverage at improved terms as compared to the last two to three years. For example, NewStar Financial’s recent acquisition of CORE Business Credit enabled the acquirer to add a complementary asset-based lending platform that provides slightly smaller, higher-yielding loans than the legacy NewStar loan product offering. NewStar has successfully obtained senior financing this year that will provide the liquidity for CORE to continue its growth.
Where Do We Go From Here?
More buyers of commercial finance companies have emerged as a result of access to financing and healthier operating results; however, valuations will likely remain close to those seen during the recession for years to come. Improving profitability and credit should drive valuations higher, but it could be years before pre-recession valuations are obtained due to bank and thrift peer groups trading at only a fraction of the valuations seen from 2004 to 2007.
For example, companies comprising the SNL Bank and Thrift Stock Index had an average stock price to book value multiple of over 240% at the end of 2004. Throughout 2010, this same valuation metric has ranged from 90% of book value to a height of 120% of book value earlier in the year (Source: SNL Financial). Bank valuations are slowly improving, which bodes well for their ability to pay more for commercial finance companies. However, with credit quality only slowly improving and revenues flat or declining in the banking sector, bank stock valuations will only slowly increase, which is why it could be years before valuations for commercial finance companies return to the levels seen in the last great market cycle.
We expect to see slow and steady improvement in merger and acquisition activity in the commercial finance sector, however, both in terms of number of deals and deal pricing. Buyers and investors continue to be very sensitive to asset quality, and any questionable assets will need to either be fully reserved for prior to closing or excluded from the transaction in total. Buyers, particularly banks, will be very focused on minimizing goodwill creation, which decreases tangible equity, a major consideration for bank regulators that continue to scrutinize regulatory capital. To that end, the highest valuations will be realized through earn out structures for management and selling shareholders with future proceeds contingent upon portfolio performance and growth in earnings. Deal volume will be driven by banks and non-banks looking for diversification in asset classes and revenue sources, and private equity firms looking to find scalable platforms and top management teams to back. As competition slowly increases for deals and the financial condition of target companies improves, deal values too will rise, but not significantly in the near term.
Tim Stute is a managing director and principal of Milestone Advisors, LLC. At Milestone, Stute is responsible for the origination and execution of corporate finance and financial advisory assignments for the firm’s community bank and specialty finance clients, with a particular focus on the asset-based lending, factoring and leasing sectors. Since 2004, Milestone has been the leading M&A advisor to the commercial finance sector based upon the cumulative number of transactions closed (Source: SNL Financial).