Consistent with what’s happening in the larger economy, merger and acquisition activity is likely to slow down in Orange County.
For companies here looking to grow through acquisition, a lower volume of M&A deals may in fact be good news. That’s because M&A deals in the region increasingly are made up of strategic buyers—companies themselves—as private equity acquirers keep much of their deep capital reserves on the sidelines for now.
A little moderation of M&A activity should actually set up a sweet spot of sorts for both sides of a transaction: acquirers will be able to secure better values, and sellers will still be able fetch good prices in the market.
In Orange County, no one industry dominates. We have a diverse distribution of industries such as healthcare, defense, manufacturing, hospitality, industrials, construction and real estate. The county is no doubt a microcosm of the national economy. So looking at key global and domestic trends will shed some light on what’s going on in the region, and give insight on what to expect going forward.
Global M&A volume for the first half of 2019 decreased by 8.3% to $2.2 trillion, down from $2.4 trillion from a year earlier, according to Dealogic, a firm that tracks deals. Part of that decline is due to private equity players pulling back a bit. For example, in the United States, private equity deal volume fell to $297 billion for the first half of the year, among roughly 2,100 deals, well off the pace of last year’s $713 billion in volume among 4,800 transactions, according to PitchBook Data, which follows the space. While the second half of an average year often yields an acceleration of M&A activity, it’s more than likely that this year numbers will come up short, given that dollar volume was on pace midyear for a 16% decline.
Why M&A Slowdown?
There are a few reasons for the M&A slowdown. One is economic uncertainty as a result of the trade tensions and the tariff war with China.
In OC, this uncertainty has had an effect on importers, from bike manufacturers to makers of electronics to distributors. Moreover, real gross domestic product—which factors in inflation—grew in the second quarter at an annualized rate of 2%, compared with a rate of 3.1% in the first quarter, and 3.5% from the same period in 2018, according to the Bureau of Economic Analysis. The slower rate was in part due to slower investment growth in areas such as inventories, real estate investment, and plant, equipment and software, the agency said. The stronger dollar—as a result of deteriorating economic conditions overseas—has also crimped exports, which impacts manufacturers here at home.
Another cause of the M&A slowdown is buyers perceive valuation multiples have climbed too high. For example, among private equity deals, multiples have risen this year to 12.4-times EBITDA—a common measure of a company’s valuation in M&A, according to PitchBook. That’s up from 11.5 last year, and 9.8 in 2015. Both PE and strategic buyers are essentially waiting for price multiples to come back down.
There’s also an overhang of sorts in the so-called shadow banking market. Since the Great Recession, private equity investors have played a larger role in funding M&A deals, with banks limited by regulators how much they can lend. Starting about three years ago, PE investors loosened their own standards, ratcheting up multiples they were willing to pay, while perhaps getting too rosy with cashflow projections of their targets.
Given all of the uncertainty in the economy, many acquired companies—the overleveraged ones—won’t have enough cash flow to service the debt. The assumptions made on the underlying growth rates aren’t going to be realized. That’s going to create stress and workouts, where the lenders either restructure the deal and take over the company, or liquidate the holdings.
PE to Strategic Acquisition
So going forward, any pain felt on the part of private equity players will create value opportunities for others. We’re likely to see fewer private equity firms bidding on companies, and more strategic buying. That’s certainly the case in Orange County, where companies will do “bolt-ons,” meaning a buyer acquires a business in its niche to expand its customer reach. Or many will pursue selling their companies to their workers, creating employee stock ownership plans.
Orange County has plenty of opportunities for deals. It has about 3,000 middle-market companies, more than the 700 companies in Portland, and 2,000 in Seattle area.
Orange County demographics will help fuel these strategic options. Much like the nation, the region has a rapidly aging population, with many business owners nearing retirement and often no succession plans. While the number of companies with aging executives nearing retirement is difficult to track, broad Census Bureau numbers show a trend. About 14.8% of Orange County residents were estimated to be 65 or older midyear 2018—the latest available figures—according to the agency. That compares with under 11.6% in 2010.
Salas O’Brien, a consulting engineering firm based in Santa Ana, has capitalized on this trend. It has focused on acquiring smaller similar consulting firms, where baby boomer owners are looking for a transition. Salas has averaged over one merger per year for the last 11 years, and during that time has grown to $145 million in revenue, up from $5 million; and to 700 employees, up from 30.
With these types of deals, and across the whole lifecycle of companies, banks will continue to serve an important role in M&A. Where companies choose strategic acquisitions, banks can help achieve growth objectives. Despite the deceleration of dealmaking, acquisitions will still get done. After all, the United States has a deep and diversified economy and remains the bright spot in the global economy, with Orange County a vibrant example of the country as a whole.
And gross county product is expected to grow by 4.2% to $306 billion this year, according to a June estimate by the Center for Economic Research at Chapman University. Unemployment is still near historic lows for the county, at 3% as of August, according to the state’s Employment Development Department.
Looking forward, the M&A slowdown, coupled with OC’s strong economic base, will represent plenty of opportunity for strategic buyers. n
Editor’s note: Richard Cabrera, a member of the Business Journal OC500, is the EVP Head of Commercial and Corporate Banking at Umpqua Bank, where he leads the Corporate Bank, Debt Capital Markets, M&A Advisory and International Banking Divisions throughout California, Nevada, Oregon, Idaho, and Washington. Cabrera, who is based in the bank’s Irvine office, is a longtime Orange County corporate banker with more than 30 years of experience supporting middle-market companies throughout the region.
