After a year of searching for stable ground in an environment of unprecedented declines in demand, economic uncertainty, minimal credit availability, inventory repositioning and overall fear, we expect 2010 to be a year where companies focus on growing and repositioning their business.  A year from now, we expect to look back at 2010 and say it was a year of strategic initiatives. 

For many business owners, 2009 was a very trying and tiring experience.  Owners who considered selling their business during the peak period of 2006 - 2007, may have lamented over lost opportunity and the need to navigate through extremely difficult times.  Others who did sell may have had payment of earn outs or seller notes adversely affected.

Yes, 2009 was difficult.  But for companies that survived, many have successfully restructured operations and are now more efficient.  Many companies have improved their balance sheets and cash positions by rationalizing expenses and reducing leverage.  Similarly, private equity firms have focused on improving the operating performance and balance sheets of their portfolio holdings as the tight credit markets and substantial valuation gaps between buyers and sellers reduced merger and acquisition activity.

Challenging Growth Environment

Fortunately, 2009 is behind us and a resurgence of optimism promises to make 2010 a year of strategic initiatives.  We anticipate a renewed interest in using mergers and acquisitions to augment company strategic growth plans.

We expect corporations to find organic growth challenging for the foreseeable future, due to modest economic growth as consumers need to contend with tighter credit standards and the need to maintain higher savings rates to rebuild retirement portfolios.  Also, while credit markets are showing signs of improving, we expect limited increases in credit availability as securitization markets remain stifled, and lending institutions continue to deal with credit losses and expected increases in government oversight and capital requirements.

For companies fortunate enough to be realizing growth during this economy, capital needs may become more prevalent, especially for "asset light" companies.  The majority of available credit is asset based lending with conservative collateral coverage rates and more strenuous loan covenants.  We expect cash flow lending and financing which supports speculative growth initiatives to remain constrained for the majority of 2010.  As a result, business owners of growing companies may need larger capital bases to maintain the growth.

Business owners may also realize pressure on future corporate profits as a result of government initiatives to "protect" the populace.  For example, politicians have vowed never to let the credit meltdown happen again.  This is translating into proposals of increased oversight, tighter credit standards, higher capital reserves and discussions about industry funded bailout funds.  All of which will lead to higher borrowing costs.  Corporate after tax cash flow may also come under pressure from new taxes (e.g. New York City's MTA tax) to cover budget deficits and pay for the stimulus, and legislation (e.g. potential penalties for not providing health care coverage).

A Return of Merger and Acquisition Activity

Based on weak organic growth prospects, improved corporate cash positions, and un-deployed private equity capital, we expect corporations and private equity firms alike will increase their focus on mergers and acquisitions in 2010.

Whereas the inexpensive and readily available credit of the M&A peak in 2006-2007 enabled buyers to invest a relatively small portion of the capital structure (i.e. 15% to 30%), we expect the current M&A market to be vastly different.  Buyers will need to invest considerably more equity in transactions (30% to 50%) as lenders continue conservative lending practices.  This higher equity component increases the amount of capital at risk and the overall cost of that capital.  As a result, we anticipate investors will be defined by highly focused, patient buyers, leveraging their expertise and identifying opportunities to realize operating leverage, increase market share or reshape an industry.

While we do not expect valuations to return to the peak of several years ago anytime soon, we expect quality, well-positioned companies that meet a buyer's more exacting criteria to command a premium.  We also expect the gap in valuation expectations between buyer and seller to contract as economic uncertainty subsides and parties creatively structure transactions to deal with the tight credit market by increasing the use of seller earn outs, seller financing and equity rollovers. 

Benefits of Selling in this Environment

Although valuations may not achieve peak levels for the foreseeable future, there are several reasons why this may still be a good time for business owners to consider selling or recapitalizing their business.

First, relative value.  Even with the stock market rebound, the  S&P is approximately 30% lower than at its peak.  In many cases, for well-positioned companies, value has not declined similarly.  The ability for these companies to navigate the recent downturn enhances value drivers such as the company's sustainability, strength of management and market position.  A business owner could sell all or a portion of their business to diversify their estate and possibly take advantage of attractive investment opportunities.

Second, accelerated growth.  Underperforming companies could provide well-positioned companies with attractive acquisition opportunities to increase market share, expand products or service offerings or enter complementary markets.  However, with tight credit markets, taking advantages of these opportunities will require capital.  In addition, lenders will also focus heavily on a borrower's experience with integrating operations.  Aligning with a private equity firm not only provides the needed available capital to realize these growth opportunities, but also increases the probability of maximizing credit availability.

Third, equity recapitalization.  There are increasingly attractive opportunities for business owners to sell a portion of their business in an equity recapitalization.  Not only can such a transaction diversify an owner's net worth, but it can also accelerate growth and greatly enhance the value of the owner's remaining equity stake.

Fourth, favorable tax environment.  Washington is looking to reinstate the 36% and 39.6% income tax rates and increase the capital gains rate to 20% from 15%.  These tax increases reduce after tax transaction consideration to sellers, but for a business owner who sells before the tax change takes affect there could be an added bonus.  Some analysts point to the reduction of the capital gains rate as a reason for higher stock values.  If the capital gains rate increases, there could be pressure on stock values, thus providing a seller with another attractive relative value opportunity.

Maximizing Value

For business owners interested in selling their business in this environment, appropriately structured earn outs and seller financing will often be necessary to maximize value.  This is largely due to the limited availability of third party credit and the need to limit the buyer's perceived risk from downside performance surprises.  Remember, we are only about a year past the time when even the most knowledgeable prognosticators had difficulty forecasting the future and only three months past a time when buyer's fears of "holding the bag" in case of a double dip recession was prevalent. 

Earn outs partially mitigate the unknown short-term risk of missed projections for the buyers while creating upside value for the seller.A seller rolling equity into the transaction on the same economic terms as the investor further aligns the seller with the long-term interest of the buyer, and it gives the seller a continued equity stake with considerably greater return probability than available in other asset classes. 

It also reduces the amount of capital a buyer needs to invest into the transaction which is helpful for a buyer to reach their investment return hurdles.  A recent survey of private equity firms shows that the vast majority of investors have not reduced their return expectations (at least a 20% return) and some have actually increased their expected return due to favorable distressed asset purchase possibilities. 

Increased seller financing is also expected to be an important consideration in maximizing transaction value for the seller.  As mentioned previously, we expect credit markets to remain tight and available credit will probably have conservative structures.  Seller financing is an attractive alternative because there is more flexibility in how the financing is structured.

However, with the increased use of earn outs, seller financing and equity roll over, there may be a greater potential for post-transaction disputes.  For example, earn outs are usually based on operating profit or EBITDA.  It is important that a business owner's professional advisors take this into consideration to protect the business owner from unexpected results related to items such as new strategic initiatives, corporate governance, accounting changes, restructuring expenses, future acquisitions charges and management fees.  If the acquiring party is integrating the business into an existing operation, additional considerations include overhead allocation, product substitution, and intercompany transactions.

Summary

Despite the lingering effects of this past recession and the persistent tight credit market, we believe 2010 will be very active for transactions.  For aggressive business owners, there are many attractive strategic opportunities that business owners may capitalize on by aligning with an appropriate investor.  For sellers, the prospect of closing a deal at the current low capital gains rate is very attractive.  For buyers, cash positions are strong and interest rates are also at record lows making the cost of borrowing enticing. 

While the peak valuation multiples are probably several years away, through creative transaction structuring, aligning interests with investors and capitalizing on attractive market opportunities, this may be a very favorable time for business owners to diversify their net worth and maximize the long term value of their equity stake in the business.