Heading for the Exits 

One question dominates every conversation regarding this improbably long-lived seller’s market:

“What inning is it?”

It’s like being a parent in the first year of kid-pitch baseball.
Prognosticating about or attempting to “time” the market is notoriously risky.
How will we know if and when the market is about to turn?

While there are many possible indicators, we see three that should resonate with business sellers, buyers, money sources and advisors. 


Indemnification Cap

The idea that deal points other than price tend to be lagging indicators in a rising market (from the business seller’s perspective). Would-be acquirers exhaust themselves on price, then compete on the balance of the term sheet. It follows, then, that the same deal terms are leading indicators in a falling market – buyers pull back on these sweeteners before asking sellers to accept concessions in headline economics.

As the chart below shows, in 2018 indemnification cap jumped slightly on deals completed w RWI, while popping 6.5 percentage points on those completed without. In 2019 YTD, experience in both groups has fallen back in line with 2017 experience. 
SOURCE: GF DATA®


Adjustments to EBITDA

Business sellers have also benefitted over the past decade from a marked expansion in the nature and extent of addbacks and other adjustments to EBITDA advocated on their behalf.

Acquirers, advisors, funding sources and financial due diligence advisors have all seen the shift. Ten years ago, a seller could not expect to get credit, for example, for the benefit of closing a facility or eliminating purportedly redundant staff still on the payroll. “You’ve run the business this way yourself,” buyers would say. “Make the change, show that you’ve cut fat not muscle, and if you’re still in market in six months, we’ll give you credit for it.”

They report that adjustments on average accounted for 24.1% of adjusted EBITDA in 2Q 2019 – a steady rise from 21 percent in 4Q 2016. Going back to 4Q 2013, the adjustments share was about 15%.

Adjustments as a % of Adj. EBITDA 
SOURCE: Lincoln International® https://www.lincolninternational.com  

If the “adjustments” portion of Adjusted EBITDA reverses course and begins to decline, it will suggest that this stealthful dynamic has begun to take hold, and will be another precursor of a more visible market shift.

Commercial Bank Lending

Finally, we believe it is useful to keep a close watch on how acquisitions are being financed.

Over the past decade, we all have seen commercial banks — with a handful of exceptions – give the field of cash-flow based acquisition finance over to Business Development Corporations (BDCs), credit funds and other non-bank lenders. Limitations on leverage, government regulations, risk-averse credit cultures, and an exodus of seasoned lenders have combined to reinforce their sideline status.

However, it is possible for two things to happen at once. There is evidence that a segment of the market is coming back to commercial banks.
The percentage of deals completed with maximum leverage has declined over the past three years – from 43 percent in 2017 to 41 percent in 2018 to 39 percent in the year to date. We believe this shift reflects buyers choosing more conservative capital structures for smaller businesses, for those with cyclical or regulatory risk and for those that do not play off of the most compelling demographic and economic trends.

Churchill Asset Management’s market letter The Lead Left takes a broader view of market share in leverage finance, drawing on data from several sources. As the chart below indicates, commercial banks have gained share in the year to date, rising to 14.8 percent. This is the greatest level of bank participation since 2011. Note that this data comprises institutional loans; presumably, the profile of commercial banks would be magnified on non-institutional deals.

Primary Investor Market: Banks vs Non-Banks 
SOURCE: The Lead Left, Wells Fargo, S&P LCD Capital IQ

These three measures – with footholds in business risk, financial due diligence and acquisition finance – underpin valuation and may well point in the direction of a systemic correction before it is apparent in deal pricing.
We appear not to be in the ninth inning, but there are always some who want to beat the rush to the parking lot. 
About Us
Whether you want to sell or buy a business, Chapman Associates provides a personalized service, based upon our sixty-two years of successful M&A closings and our relationships with more than 9,300 registered buyers. Chapman is one of the most respected middle-market M&A firms in the country. What makes Chapman different from the competition?
• We make a market for our clients.
• We do not charge any up-front fees.
• Our fees are based on successfully completed transactions.
• We devote senior-level attention to every M&A transaction.
• We do not delegate work to junior staff.
• We help clients set realistic goals and then work hard to exceed them.
• We conduct in-depth research and rigorous analysis.
• We prepare all necessary offering materials.
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