Sub-prime and the impact on consulting industry M&A
by: Paul Collins
You know the story, there’s been little else discussed in the financial press over the last few weeks…the US sub-prime crisis has hit global equity markets like a bombshell, the uncertainty is driving irrational behaviour in the credit markets and corporate financiers are getting nervous.
|You know the story, there’s been little else discussed in the financial press over the last few weeks…the US sub-prime crisis has hit global equity markets like a bombshell, the uncertainty is driving irrational behaviour in the credit markets and corporate financiers are getting nervous. So if there’s a credit squeeze on the way, it would be easy to conjure up a bleak picture for M&A and you’d be excused for posing the pessimistic question:
How much is this sub-prime problem going to hurt the value I get for my firm, or even scupper my chances of selling it?
I’m not prone to living by the crystal ball (I don’t like eating ground glass!) so there’s no point in speculating on whether this turns out to be a simple ‘correction’ or a full blown financial market downturn. However if you stand back and take a birds-eye view, rather than get embroiled in the FUD (fear, uncertainty and doubt), the worst case scenario is not all that bad, so here’s my rational opinion on the situation.
If we take the pessimistic view that things are on the slide, then we have two questions on the table…
By how much are prices (valuations) going to reduce?
Is deal activity going to continue?
Well in the short term, say the next 12 months, I wouldn’t expect to see a major impact on deal activity or valuations because funds already raised by investors are still to be spent. However over the medium term in a credit squeeze (remember this is the pessimistic view) the cost of money will go up and this would undoubtedly hit prices i.e. if debt is being used to fund a purchase, then the extra cost is highly likely to be passed on by reducing the valuation multiple.
There are two main types of consulting firm acquirers, Trade Buyers (other consulting firms and service businesses) and Private Equity Houses (PE) who are in it for pure financial returns.
In this pessimistic scenario, I would expect to see fewer PE acquisitions because of their prolific use of the so called ‘Leveraged buy-out’ approach to a purchase. This is where they use cheap debt to buy a cash generative, growing firm and provide a good return for their investors. The problem is that the onus falls to the acquired firm to repay the debt, not the PE house, therefore if cost of debt rises AND valuation multiples go down, then this ‘double whammy’ effect will reduce the number of firms attracted to PE bids. When the cost of debt is expensive, PE houses are less likely to bid for lower margin firms because it is more difficult for the acquired firm to service the debt and therefore the risk of a good return goes up. It’s probable therefore that the use of this vehicle will slow down and reduce PE investment in the industry.
However trade buyers have other drivers and motives for acquisition that do not rely purely on financial returns. These motives will continue and I would not envisage a major shift in deal activity for this buyer type. In particular, globalisation is not going to slow down and this will continue to be a major force for industry integration. Also publicly-listed companies need to grow to satisfy shareholders and these growth demands cannot be met solely by organic growth. One they reach a certain size, it’s almost impossible for a consulting firm to scale up without acquiring.
Trade buyers are not immune to the higher cost of servicing debt because they too use loans to fund acquisitions, so if cost of debt goes up, I would expect to see deal structures adjust to compensate for this. For example, there would likely be fewer cash only deals and more of a leaning towards cash/equity deals.
So although a credit squeeze may impact PE investment and reduce acquisitions for that buyer type, this may well be offset by trade buyers driven by other industry forces.
What’s the worst case scenario?
We need to look at the situation relative to the current position. There has never been more deal activity, with 218 reported deals in Europe in 2006, and prices have never been as high as they have been for the last year. Right now sellers are enjoying a 40% premium for their consulting firms and achieving an average EBIT multiple of 10. This is exceptional. Things don’t get much worse than when we hit the bottom of the economic cycle in recent times during the dot.com bust of 2002/3. However even then the average EBIT multiple was 7 and there were 69 reported transactions that year.
So in summary if we take the ultra-pessimistic position…
Will valuations reduce?
Yes, but we’re in an exceptional sellers market right now, there’s a long way to go before average EBIT multiples hit rock-bottom and the lowest point we’ve seen in recent years; and even then the average EBIT multiple of 7 was not too shabby!
Will deal activity continue?
Yes. We may see a reduction in PE investment in the industry, but trade buyers will continue to drive ahead to satisfy their strategic ambitions.
However, without wishing to labour the point, this is a pessimistic view and the actual outlook may well be rosier. The best case scenario in my opinion would be the status quo. Are we going to see continuing growth in deal activity and valuations as we’ve experienced over the last five years? Probably not, if our analysis of historic data going back to 1871 proves to be correct! The more likely best case scenario is that activity will level out and plateau around the 2006 numbers identified above (and available in detail in our European Consulting M&A Report 2007).
So all in all, if you’re a consulting firm owner thinking of selling up, don’t let the current market scare cause you to lose any sleep!
About the Author
Paul Collins is Managing Director of business advisory firm Equiteq. Equiteq works exclusively in mergers and acquisitions (M&A) in the European consulting industry. For more information on Equiteq go to http://www.equiteq.com or call +44 (0)1252 724264.