An Important Interview with Brian O. Boyle
McGladrey Capital Markets:
The Current State of the M&A Market

M&A Chicago recently had a chance to grill Brian O. Boyle, Senior Managing Director of McGladrey Capital Markets (a global middle-market investment bank based in Costa Mesa, Calif.), about the current state of dealmaking in the US.

We have all seen the once-robust market for buyouts go from comically high valuations and hyper-liquidity to lower evaluations and under-liquidity in an incredibly short period of time. As valuations have declined, seller’s expectations have been slow to adjust. So where does the market stand, where is it going, and how does this affect you? We asked Mr. Boyle to address these issues and several more in the interview below.

Mr. Boyle is an ideal candidate to help explain where things stand today. He has 23 years of capital markets experience, including 13 years with Lehman Brothers as a senior vice president in its New York headquarters. In addition, he founded and ran his own investment firm, Capital Placement, which focused on middle-market advisory services, corporate finance, and mergers and acquisitions. Mr. Boyle joined McGladrey Capital Markets in 2000 and currently runs the firm’s Chicago office. He has successfully negotiated and completed nearly 75 sale and recapitalization transactions in a variety of industries, including food and beverage, business services, healthcare, and industrial manufacturing.

M&A Chicago: We’re hearing that valuations are coming down. How have you seen the market adjust to recent economic pressures?

Boyle: The number one thing affecting M&A is the lending environment, and the cost of debt has risen precipitously. While a fair amount of unsecured mezzanine (sub) debt is still available, the price has increased substantially. In addition, covenants on senior debt are much stricter, and lenders have drastically reduced available amounts.

There are only two sources of capital in a leveraged buyout transaction: equity and debt. If equity stays the same but less debt is available, that causes a valuation decline. On average, valuations have declined by about one multiple of EBITDA: a business that was trading at 7xEBITDA in 2007 is trading at 6xEBITDA today. Selling owners will often have to accept lower prices than two years ago, but these are still fair multiples, historically. If anything, we went from an over-valued market in 2006 and the first part of 2007 back closer to fair market values today.

M&A Chicago: Is leverage still available for deals?

Boyle: I sat down with heads of middle market lending for leveraged buyouts at both J.P. Morgan and Bank of America. The message from both companies was similar: yes, they have money and the doors are open, but the focus is on:

• First, existing relationships and customers.
• Then, people they know or have some sort of track record with.
• Last, incoming inquiries without a lot of history between the people.

The big banks are lending, but they want to know who they’re doing business with.

On the regional side, like in anything, there are stronger players and weaker players in the market. Some of the strong, regional middle players include:

• MB Financial
• Charter One
• PNC (which is Pittsburgh-based but has a Chicago location)
• Madison Capital

These are just a few of the regional banks still lending for transactions in the middle market (although I’m sure that some banks are not).

M&A Chicago: Which sectors are struggling?

Boyle: Although deals are still happening, certain industries have been hit particularly hard:

Autos – Illinois is the fourth largest state feeding into the auto industry, so we’re likely to see significant fallout here.

Real estate – The greater Chicago area has a glut of available properties, both commercial and residential. Several larger homebuilders are in trouble, and anything related to real estate is getting hammered.

Financial services –The financial industry is an interesting case: it’s creating activity because of weakness and fallout, not because the industry is insular and doing well. Chicago’s financial industry might be second only to New York City, and it has seen significant job losses.

General industrial – Chicago also has a fair amount of exposure to rust-belt industries, which have fallen off.

Consumer – Anything consumer discretionary is totally out of vogue. On the other hand, non-discretionary consumer sectors are still strong. When things are tight, people still need goods and services—they just go to some place cheaper.

The weaker sectors are often linked to the economy, consumer confidence, and/or corporate finance departments (which are driven by the economy).

M&A Chicago: Where are the pockets of strength?

Boyle: Interest has remained high in non-cyclical industries such as healthcare, food and certain business services. Money is gravitating to the less-risky industry sectors:

Aerospace/Defense/Government – Given the heavy military buildup, restocking of our munitions, and so much government intervention, these industries will probably remain strong.

Energy – Although it got dragged down with the rest of the market, I believe that was an effect from deleveraging of hedge funds and institutional investors (which invested heavily in energy). Energy has the long-term fundamentals in place to do better, and we continue to see interest despite the recent massive declines in energy prices.

Food – As import costs and ingredient costs drop, that gives better margins for food companies, which Chicago has plenty of. Food service, such as restaurants (which are more discretionary), is weaker.

Healthcare – If you’re sick, you have to get better regardless of the economy. Chicago has its fair share of healthcare companies.

Technology – The United States has always been a world technology leader, and technology and innovation will likely lead our way out of this mess. This area should stay strong.

Capital raising and restructuring, other investment banking segments, are also strong right now.

M&A Chicago: So have strong industries closed deals all the way through?

Boyle: Yes. In September, as things were starting to soften, we closed a healthcare deal. In October—the worst part of the crash—we closed an energy-related deal. The buyer, Pfingsten Partners, is a strong private equity group with good lending relationships, and they hung in there. In December we closed a bakery deal with Chicago-based private equity group Merit Capital, one of five deals McGladrey Capital Markets closed in December. For good companies with existing banking relationship and some momentum, capital is still out there.

We have also had a few deals blow up. For example, a large strategic acquirer in the metal recycling area backed out of a deal because it had its own issues to deal with during the crisis.

M&A Chicago: What trends are happening with strategic buyers?

Boyle: Strategic acquirers are considering smaller transactions than in the past. Historically, Fortune 500 companies weren’t that interested in doing a $40 million deal—it didn’t move the needle enough. But today we’re regularly seeing them coming in to buy businesses that are under $100 million in enterprise value. That’s developed as the mega deals have not been as successful for many reasons:

• Higher acquisition costs
• The amount of leverage required
• Culture difference and integration issues when merging two mega companies

Mid-market deals are less risky, easier to manage, and can offer a better percentage return on investment. Larger deals are much harder to finance and complete. Relative to the mega market, the middle and lower-middle markets will likely have much more activity.

M&A Chicago: How has the crisis affected private equity?

Boyle: We’re starting to see a shift in favor of strategic acquirers over financial acquirers. In 2006 and first half of 2007, the pendulum swung in favor of financial buyers, because credit was easy and lenders were aggressive.

Private equity hinges on how much leverage the group is able to use to compete with strategic acquirers. In the first quarter of 2007, senior debt was often trading close to 3.5xEBITDA. Today that’s closer to 2-2.5xEBITDA. What does that mean for private equity groups? They need to (a) put more equity into the deal, which affects their returns, (b) get more seller participation, which depends on the seller’s willingness, or (c) reduce the price. Something has to give. There are groups getting deals done, but it depends on the industry, company, management team, etc.

In 2006, so much private equity money was available that private companies were sometimes valued even higher than their public counterparts. That robust market was not entirely sustainable. In some respects, things are going back to normal.

M&A Chicago: What is your economic outlook for 2009?

Boyle: Consumer confidence is low. The stock market dropped more than 5,000 points in a very short period of time. It’s a huge hit to people’s 401(K)’s and to their personal pocketbooks. However, the number one thing preventing consumers from spending is fear of a job loss. Until people stop worrying that they’re going to lose their jobs, they’ll usually horde their money.

On the other hand, the economy has received – and now will receive even more - a tremendous amount of stimulus from interest rates, stimulus packages and TARP investments. In addition, oil went from over $140/barrel to under $50. In Chicago, I went from paying over $4/gallon for gas to under $1.65/gallon. It’s almost like a tax cut for the consumer.

While you’re probably not going to see any real growth in the economy for at least three or four quarters, you’ll see some stabilization. Credit markets will gradually start easing up. The stimulus factors will have time to start affecting the economy. Layoffs will start slowing. I expect unemployment to potentially approach nine percent, but we’ll form a new base and start building from there. Things need to stabilize (probably in the second half of 2009) before the economy can start growing again.

The forces for recovery are powerful and meaningful, but consumers need time to heal, and no one has a crystal ball to know exactly how long that will take. If you did, you could be a multimillionaire, because the stock market tends to lead the way out, usually six months in advance of the actual recovery.

M&A Chicago: What are the take-home messages for business owners?

Boyle: There are clearly opportunities in the face of the economic demise. Companies with too much debt on their balance sheets may not survive this downturn. That creates opportunities for other stronger player to acquire those businesses or maybe just take over their customers and let them file for bankruptcy.

As we navigate the rapids ahead, it will pay to remember:

• Overleveraging is creating issues for companies with weak balance sheets and opportunities for others.
• There are pockets of strength and weakness, depending on the industry.
• Good businesses will still attract interest.
• We will survive. It’s going to take some time, but we’ll come out of this, hopefully by 2010.

M&A Chicago: Thank you Mr. Boyle and good luck in 2009.