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M&A transactions accounted for nearly 90% of all venture capital exits in the past three years. Will the trend continue? The following is a brief look at some of the most recent strategic, financial and execution trends in the market that seek to answer this question.
In response to intensified end-user demand for product as well as pressure from institutional investors, companies are creating shopping lists of bolt-on and platform acquisitions to augment their growth strategies. Large enterprises are both expanding existing product lines and buying adjacent vertical market domain expertise in an effort to drive growth and solidify their defensive positions. The proof exists in the deals our firm recently completed where 70% of the transactions received multiple term sheets. The clear theme was a stronger focus on the strategic value of the combination. The result was better pricing.
Numbers don't lie. Total M&A transactions announced in the third quarter of 2004 were up 14% versus the same quarter last year. Average EV/EBITDA exit multiples are at their highest level in two years, partially due to the supply and demand imbalance in the marketplace. Over the past year, reported venture exits with returns of greater than four times paid-in capital have gone from non-existent to nearly 50% of reported venture-backed transactions.*
*Source: VentureXpertª Database by VE & NVCA
Valuations are being driven by strategic premiums. The auction-style M&A process has become a mainstream method to force buyers to "fully price" their offers, incorporating strategic value that is created as a result of consummating a transaction. It is not uncommon to see five or more term sheets on a single deal, with the price getting bid up 100 to 300% or more over the opening bid. Stand alone valuation multiples have become less relevant for highly strategic deals. The focus has shifted to total return on assets and accretion of proforma financial results.
Source: Mergerstat / Factset
Note: Q4 '03 includes the Bank of America/FleetBoston merger valued at almost $50bn
EMC's recent acquisition of Dantz underscores the trend of large companies aggressively targeting applications to fill solution gaps and looking for greenfield opportunities to deliver on Wall Street's revenue growth expectations. By acquiring Dantz, EMC is now poised to compete head-to-head with Veritas Software and Computer Associates in the small and medium-sized storage software backup market. EMC's strategic rationale: Immediate presence in the fast growing small and mid-sized business (SMB) market segment and the ability to extend the customer life cycle. EMC plans to accelerate its expansion into the SMB market by leveraging existing products and Dantz's expertise and presence in the SMB distribution channels. The Dantz acquisition is in line with EMC's spate of recent buys, which includes 14 other software companies since 2000. Clear customer traction, product strength and respect for the Dantz business model drove interest in the transaction.
Consolidation in the wireless LAN (WLAN) sector of enterprise communications typifies another recent driver of M&A activity—end user demand. Historical over-funding in the sector has created a highly fragmented market with many venture-backed players. As the market has matured, customer demand has shifted from point solutions to a need for holistic solutions. Due to the competitive nature of this marketplace, and in an attempt to decipher who will emerge as a true market leader, public companies have put more of an emphasis on partnerships than exits (i.e., WLAN switching company Airespace's partnerships with NEC, Alcatel and Nortel). In lieu of public consolidation, private companies have begun to merge to achieve scale and to fill out the feature sets that customers are demanding. These private-to-private transactions (i.e., WaveLink's recent acquisition of Airprism and Fortress Technologies' acquisition of Legra Systems) are the precursor to the impending consolidation in the space by public company incumbents. 2005 will see an increasing amount of consolidation by public players, some of which we have begun to see in the fourth quarter of 2004. An example is Cisco's acquisition of wireless network access company Perfigo.
The disequilibrium of supply and demand from the capital markets continues to drive interest in profitable companies. The competition is fierce, sparking a significant trend toward private-to-private transactions where private equity firms are selling portfolio companies to each other. Clearly, locating companies with sufficient growth potential has become the rate-limiting step for this class of buyer.
Debt continues to play a role in most financial sponsor transactions. Equity requirements have been relaxed and debt is cheap and plentiful. Hedge funds have entered the scene as a new competitor and they are driving the already substantial leverage available for acquisition capital. Buyers today are generally required to fund 30% of a deal with equity—down from 35%-40% over the past few years. Lenders are allowing higher Debt/EBITDA ratios, which paves the way for greater investor returns.
Source: Mergerstat / Factset
The execution phase of mid-market transactions is changing with the market dynamics. Diligence and terms negotiation are shifting to the front-end of the process prior to term sheet. This allows the target to retain greater leverage and flexibility for a longer period in the process and also enables the buyer to assess the real risk in a deal. Acquiring companies are focused on risk transfer, and are pushing this risk off to the target as long as possible. In turn, there is a much greater emphasis on deal points other than price—particularly in public-to-private transactions.
The pace of the market also gives rise to warning signs. Strategic buyers must be wary of attempting to bulk up revenues when there is limited strategic rationale for the transaction. Targets lacking brand strength, competitive industry position and revenue quality will not be looked upon favorably by the capital markets. Exit opportunities are limited for companies that are trying to use M&A as a means of disguising fundamental weaknesses in their core business or an inability to raise capital. In fact, it is taking longer for companies to achieve an M&A exit from their initial round of financing due to the desire on the part of buyers for more mature, profitable businesses.
Read about Cascadia Capital's investment banking services.
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Cascadia Capital is a national investment bank offering corporate finance, mergers & acquisitions, strategic advisory services, and capital market services to companies across North America. From its Seattle and New York offices, Cascadia Capital serves emerging growth and middle market companies, both public and private. The firm has an established track record in the following sectors: Information Technology, Communications, Security & Defense, Healthcare, and Industrial & Consumer. The firm recently established a Financial Sponsors group to more fully address the needs of the private equity community. In the past 24 months, Cascadia Capital has closed 17 M&A and restructuring transactions totaling more than $500 million and closed 19 capital raise transactions totaling over $250 million.
Read more about Cascadia Capital and its approach.
Read about Cascadia Capital in Bloomberg Business News.
Read about Cascadia Capital in Telephony magazine.
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