M-and-A and VC: Down, not out

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Merger and acquisition deals are experiencing a flight to quality.

Multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) are holding steady, but volume has dropped.

During the seemingly invincible days of 2007, average multiples were 6.2-times EBITDA.

In 2009, multiples lowered to 5.4-times EBITDA.

“That really is not that bad,” said Chris Blees, CEO and director of mergers and acquisitions for BiggsKofford.

Blees was keynote speaker at the latest Colorado Springs Technology Incubator’s Business Series breakfast.

“The upper end of the M&A market absolutely took the hits,” Blees said.

But not the lower end. In Colorado, middle market for merger and acquisition deals is $10 million to $50 million, which is lower middle market elsewhere.

Only one-third of the deals are being made, compared to the before the recession, but the deals are of higher quality. And when debt financing (raising money by borrowing money) all but disintegrated with the financial crisis, equity financing (or “share capital,” raising money by issuing stock) replaced it.

During 2009, equity financing comprised 59 percent of the M&A market, while subordinated debt was 13.3 percent, and senior debt was 27.7 percent. By comparison, in 2007, equity financing was 42.5 percent, and senior debt was 44.7 percent.

“Since 1997, we’ve had more money going into the venture capital markets than we’ve ever had coming out,” Blees said. “There’s a ton of pent-up cash still in the private sector.”

And return on investment is not, shall we say, stellar. In the third quarter of 2009, about half of all venture-capital backed M&A exits were less than the total venture investment. If that sounds dismal — there is a shiny side to it.

There’s been a shift to smaller deals and a smaller percentage of ROI, so “people are paying attention to us who never paid attention to us before,” Blees said, which means that two widely disparate groups are obtaining venture capital funding: existing portfolio companies that show promise, or “tragic stories.”

“If you’re not in camp A or camp B — you’re probably not getting VC funding,” he said.

And investors have forgotten the meaning of “exits” because there haven’t been any — “either the exits are few or bad, or they’re reinvesting” in yet another round of financing.

“The banking world is a terribly confused world,” Blees said, because the political side tells them to lend money because they’ve been given funds from the Troubled Asset Relief Program.

“But reality check is that (the administration’s) own regulators are telling the banks not to make loans because it’s too risky. They can buy securities and make money, and it’s not as risky,” Blees said. “It’s a serious cycle that’s causing banks to lock up. Bankers would love to make loans — that’s what they like to do — but the regulators are telling them not to.”

And subordinated (or “junior” or “nonrecourse”) debt is gone. “Nobody’s making loans anymore without collateral,” he said.

This leaves a financing void which is partially filled by private equity firms or venture capital funds.

“They will take these opportunities — that used to be senior or junior debt — and turn them into equity opportunities. The bad news is that they’ll be refinancing that debt in the upper teens or low 20s.”

The Rocky Mountain Region has $600 billion in outstanding loans, and an estimated $750 million of subordinated debt available, which is an opportunity for suppliers of junior capital. And nearly $200 billion in middle market loans will mature in the next three years. Blees quoted Horace, the Roman poet and satirist: “Adversity has the effect of eliciting talents which in prosperous circumstances would have lain dormant.”

So, here is the opportunity. Tight credit markets and depressed valuations have led to a significant increase in minority investment activity.

Some VC and PE firms will finance debt in exchange for minority interest in a company.

“Considering the entire economy is down, minority investment is off-the-charts crazy,” Blees said. A few years ago, all deals were majority recapitalizations or 100 recaps.

“Today, all of them said they’d do minority investments — the same people who were laughing at it a few years ago,” he said.

But, there’s a caveat, of course. Terms are different.

“You don’t get full valuations. You get 25 percent of the $8 million you’re discounted at — not the $10 million you think you’re worth,” he said.

Typical transaction terms for minority equity investments include board seats, voting rights, consent/veto rights, etc.

“This is how they insert control provisions. The VC firms know they can get debt-level risk with equity-style returns. The good news is that the terms now have to be competitive — because everybody (VC and PE) wants minority investments,” Blees said.

So there is opportunity for business owners.

“If you’re a good seller, there’s tons more money to be had. If you’re a distressed seller, then it’s a buyer’s market — I don’t care what condition the economy’s in.”

Rebecca Tonn covers banking and finance for the Colorado Springs Business Journal.