AM&AA Winter Conference 2016 - State of the Market - Recent Trends & Developments

Good morning, everyone. I think we've got some people trickling in, but we'll get started here. My name is Chad Byers. I'm with Symmetrical Investments. I'm one of the co-chairs of the conference, and first of all, I wanted to thank you guys for coming here today. We've got a pretty busy schedule, and before we start, I wanted to thank Justin Kaplan. He's the other co-chair of the conference with me. He's from BalancePoint Capital. There was a lot of planning that went into this event, so I also want to thank the conference planning committee. We've got a great group. Justin was obviously on that committee, as well as Tom Kesiglo from Ice Miller, Kara Donnelly from NewSpring Capital, Sage Harrison from Evolve Capital, Graham Fraser from Private Capital Research, Mike Pfeffer from Post Capital, Tom Schramski from Veritas Advisors, Claudio Collado from Doran Mahou, and Danielle Fugazi from SourceMedia. We've got a great conference here. We've set up a lot of different events. We appreciate you guys coming in here to this first panel. We've got a number of panel sessions as well as a pitch and pour. We've got a deal bash. And we've got several breakfast roundtables, which hopefully you guys were able to get to this morning. A couple housekeeping items. This room here and the room to the left of us are where most of these type of panel events are going to be. There's a pitch and pour, which will be in the room that you guys just came from, as well as our lunch and our breakfast and other events like that. Without further ado, I want to introduce Graham Fraser. Graham's from Private Capital Research, as well as GF Data. He's going to start us off today with the state of the markets.

Graham?

Thanks, Chad, very much. I know you did put a lot of work into making this happen, so really thank you for the work that you've done, and also the rest of the planning committee. Welcome, everybody. Thanks for coming. It's the beginning, I guess, opening panel of the conference here. We got a great group put together and did a little work to prepare for this. So what I'd like to do is start by introducing our panel. As Chad said, I'm Graham Fraser. My company is Private Capital Research, LLC. We do buy-side M&A, sourcing and origination of deals. We co-invest in the deals we do with our clients. And I'm also one of the founders and a co-manager of GF Data Resources, which is a database of private equity transaction data. We have a lot of subscribers and data contributors in the room. Thank you guys all for your support. But right now, I'd love to just go down and have everybody introduce themselves, starting on my left. Jerry, if you'd introduce yourself, and then you guys can understand who we all are.

Thanks, Graham. I'm Jerry Dettinger. I'm a partner at BDO. In the transaction advisory service practice, and the emphasis of our work is quality of earnings on the buy side and sell side.

I'm Michael Poole. I'm with PCE Investment Bankers. We have a valuation shop and do traditional M&A, buy side, sell side, corporate finance, and also ESOPs. We have offices in Chicago, New York, and Atlanta, as well as Orlando.

Roger Davis. I'm with North Creek Mezzanine in Cincinnati, Ohio. We invest debt and equity. We may be a little unique in that we will invest in companies with as little as $1 million of EBITDA, and then we'll go up to about $8 million on the top end.

Good morning. I'm Nadeem Malik with Sutton Place Strategies, which is a data and technology company founded in 2009. We specialize in working with private equity firms, corporate buyers, lenders, and advisors to optimize their deal sourcing and business development.

Thanks, guys. Okay, so the outline today is that we're going to talk about valuation, volume, leverage trends, and then some M&A market dynamics that are currently happening in the market today, and some things that we see evolving and potentially affecting the market in the M&A world going forward into 2016. I'm going to start with— they asked me to start a little bit just to throw some statistics up regarding some of our GF Data material. GF Data is a database of private equity transaction data. We have over 200 private equity sponsors that contribute about 25 points of data on the deals— each of the deals they've done going back from the beginning of 2003 through present. So we have well over 2,000 deals in the database. It's the largest database of lower middle market transaction data available. The deals all have between 10 $250 million of enterprise value, and between 3 and 15 times EBITDA multiples at TTM at close. So these are traditionally purchased— or companies that are valued on a traditional EBITDA multiple. So just to give you an idea, our latest report published includes the Q3 data through 2015. We're currently collecting the Q4 data and haven't published the year-end report yet, but we will do that in about the the first or second week of February as we normally do. One of the things that we found, and it's continued— the trend is continuing, although it's not definitive yet because we don't have final numbers for the year, but third quarter valuations and the valuation numbers that we've seen so far are at a record. They're at a 13-year high in the history of our database. The average is 7.1 times EBITDA. That has been for the quarter, Q3. For the year to date, 6.8 times, also a very high number. But volume, however, has been down. 37 deals in the quarter for the Q3 numbers was versus 50 deals in Q3 2014. So the one thing we haven't seen is the volume coming back, sellers coming to market There's a tremendous amount of capital out there, but there are not as many deals getting closed as we would expect at this stage of a cycle, and that's one of the things we're definitely going to talk about today. Um, we look at a couple of things that, uh, affect the valuations. Uh, one is a size premium, and the other is a quality premium. And right now, um, the size premium is definitely in effect. Uh, if you look at the, uh, spread in valuation multiples on deals that have between 10 and 50— 10 to 50 million of enterprise value versus deals that have between 50 and 250, which kind of bifurcates the database that we keep. The multiple spread is 1.8 times. So 6.3 times EBITDA for the smaller size category there and 8 times EBITDA for the larger size category. So that's one pretty big effect. Factor. The other is quality, and we define quality by saying, okay, all these deals in the database are private equity sponsored deals. They are deals that have been closed by a private equity sponsor, so they've met that test. These are good companies that are being purchased on an EBITDA multiple. And so if we want to separate, say, the A's from the B pluses or the A's from the B's, we say, okay, if it's above average, What does that mean? And we say, okay, well, if it's a 10% revenue growth on a TTM basis at close and 10% or greater EBITDA margins, plus a couple of other nuances, but those are the basic metrics that get you into what we call the high-quality category. And the effect of that is actually, it's a 129% premium, 7.6 times multiple versus a 5.9 times multiple for all the other buyouts. So those are two of the effectors. 56% of the deals in the database are in that higher quality category. So if you look at these other factors, as let's say, okay, so you're high quality. Let's say you've got some size premium. So you're, you know, you're above average and also you're larger. And let's say you've got a professional seller. An institutional seller versus a family business owner, and let's say you've got post-closing management, we measure these types of things and the numbers that you get you there. If you are a larger company and you are— you have all those attributes, your EBITDA multiple is, frankly, if you're between 100 and 250 of enterprise value and you've got out those attributes, your multiple could be as high as 11 times right now. So those are the kind of factors that affect multiples. We did want to get into— I think Roger had some interesting slides here on data points, particularly relative to some North Creek information, and wanted to get your cut on where you think this is going.

Yeah, so what I did here is I went back and looked at our investing history starting in '11. And it's— so what I did to kind of influence the data a little bit is I took outliers out, because averages can be misleading, as you know. So I took really low multiple transactions that were just unique that I thought would influence the outcome. And it's not a surprise. You can see that the multiples have gone up. But I thought it was interesting. They haven't gone up as much as you might think. We were right around 5 and 11, and if you look at '15, 5.72. And the average EBITDA— average again could be misleading— but the average is about $5 million of EBITDA throughout the universe of this investing period. So, you know, we tend to invest in mature, stable, basic American businesses, nothing really super exciting. But what is interesting when you compare this data versus our exits this year, there's a significant gap. I'd say it's at least 2 points of multiple, probably more. I think we've averaged somewhere in excess of 8 times on our exits this year. And I think it's largely the result of professional sell-side on our exit. There's been some professionalization of the business. 'Cause what we tend to invest in is family-owned companies or first-time institutional partner companies, so the processes aren't as robust. Companies aren't quite ready for a professional exit. So it's just interesting. At the low end of the market, you can still find nice companies to invest in, not at runaway multiples.

Mm-hmm.

Yeah, no, we found there's clearly arbitrage available there if you're looking in the lower end of the market. The middle market. Michael, what do you think about the market currently and what you saw in 2015 versus today, and are we going to see the tepid volume continue, or do you think we'll see it pick up?

From my island, our business has never been better. We probably just finished our second-best year of a 20-year history, so your numbers of showing the market volume down is, for me, our own personal our position is different than that. Although when we talk to folks, we are hearing that there doesn't seem to be as many companies that want to come to the market today or seeking different ways. There's so many imaginative ways to take money out of a company today for an owner that selling to get cash or liquidity strategies have changed. So I think that's part of what's happening.

Jerry, and how are you seeing things from your perspective in terms of the activity levels that are going on?

You know, as a firm, we have been pretty much consistently busy for several years now, and we really don't see it changing. Part of that is, as I'm going to discuss later, is the continued adoption of sell-side quality of earnings as part of the M&A process. So we're being hired to perform those as well as on the buy side, but, you know, clearly valuations are high. but there's— we all know there's no shortage of capital. Um, so we feel this market is still going to be pretty steady going forward.

Okay. Well, um, as, uh, as you just pointed out, I mean, slightly there that— and I think this is Nadim. Is this your slide?

That's mine.

That's your slide. Okay. So the, um, this, this, this shows that of the deals that are actually getting done, how many of them are in fact, uh, strategic deals or of PE-backed strategic deals. Michael?

Yes, so when you look at it, the top part is what we would call platform companies, platform investments, and the gray is the add-ons that PEs do with strategic. So they make a platform investment and then they're doing the add-ons, and then the green is just pure strategic private companies, public companies making acquisitions. So you can see that the difference on the private equity in the last 5 years 5 years, they really have upped their investment in platforms. And some of it I'm sure has to do with that they raised a bunch of money in the beginning of those years, and so there was this push for deployment to create those platforms, because it's almost double what it was 5 years ago in the previous trend line. And the add-ons is about the same, and then strategics, because of that push, has been pushed down. When you think about it, companies on the strategic side strategic side, whether it be probably less on the public side but more on the private side, most private companies in America don't buy anybody during their existence of their business. All right, so the likelihood of, from us when we look at it, we think about strategic buyers buying, the likelihood of some companies who have never done an acquisition doing it, the odds are they'll never do it, because they're just not in that mindset of deploying capital to do that. We start looking at it and what the probabilities are. We'll talk maybe a little bit others' probabilities, but this is a new trend line for us to see.

Roger, how do you see the competitive balance between the strategic buyers and the financial buyers, both as a seller of investments that you've made, but also when you're competing from what you can see going into situations?

Well, we see mostly financial. Financial buyers. We've had a few strategic exits, but even those strategic exits were backed by financial buyers. So it was— we've had very few just plain corporate. When we're competing— well, do you want to get to that now, or do you— I think we've got a slide on how we differentiate ourselves later. You want me to talk about that now?

We can get to that.

Okay.

Is that Whatever, keep talking and we'll—

okay, well, yeah, so if we're competing with a strategic or a strategic that's backed by a financial buyer, I think, you know, again, it's back to making sure we've got— the best way to do it is having an operating partner. We're investing in a company with an independent sponsor who had a had an exec who was a consultant to the business for 2 years prior to us being involved. So he brought the transaction to the independent sponsor, and we quickly saw it was a great opportunity. And that's ideal. That doesn't happen very often. But anytime you have some kind of in-depth knowledge about the business or been there or invested in it, it just makes the whole relationship go much better because they know you know their business. Other than that, it comes down to, you know, the basics of doing your homework, being prepared, paying the highest price.

So, just kidding. So, Nadim, you've got a slide here on the corporate versus private equity buyers.

Yeah, just echoing off the prior slide and just focusing on the more current year, just want to pause and reflect on the fact that today, in today's environment, private equity from the buy side, either as a new platform or as an add-on, represent over 40% of all deals, $10 million or greater of enterprise value, that get done. And if you incorporate situations where private equity firms were sellers and the buyers were strategic, private equity has its hand in potentially half of all M&A activity that takes place. So So no wonder when we talk to business development professionals serving the M&A market, whether they're lenders, advisors, so on and so forth, the one thing they have in common is marketing to the private equity world. And you asked, Graham, how this is going to shake out next year. What is this balance going to look like? Well, there's a couple of— I'm a little bit mixed about it. There's a couple of factors in place. It's a seller's market. Valuations are where they are today. Not due to a massive overheating economy. It's not like corporations are growing organically, yet they have a very strong drive to grow, and they're turning to acquisitions. So I can see the perspective from the corporate side to get shareholders their growth, to get— to have acquisitions as a key part of that strategy. On the private equity side, you know, on the strength of the seller's market and the exits that have occurred in the last 2 years, With the multiple expansion, with the returns based on those exits, and the funds they've raised, there's a massive amount of capital overhang right now. So I see both factors at work. Given the Fed's indication that it looks like it's going to be, you know, 4 quarterly— 4 quarters of point increases for the year, I think it's safe to say that the lenders are going to pull back, which has been part of the reason valuation levels have been pretty high over the last couple years, but one could argue that given the desire for the private equity firms to put money to work, they can fill that gap in the capital structure. So that's a long-winded way of saying I think volume is going to continue to remain tepid next year unless you see valuation levels come down. And if I were to— if you were to ask me what this slide would look like a year from now, I would have to give the edge to private equity. I think you're going to see private equity take a a greater share, only because while the desire on the corporate side is to see more acquisitions and do more deals, over the last 10 years, private equity business development has really evolved in its sophistication, in their ability to source deals, go out there, leave no stone unturned, put technology and different resources to work. On the corporate development side, in our experience, it tends to be a little more reactive, especially if they only participate participate in certain sectors, and the perception is that those deals are going to come to them when they're relevant. So given that proactive nature on the private equity side, I think they're going to continue to take share next year. Private equity growth is going to outpace corporate.

Right. Well, leverage has clearly driven a lot of the activity in terms of the valuation side of things. I mean, there's been a tremendous amount of capital available, the proliferation of non-bank lenders, BDCs, and other finance institutions that are coming to market. You know, we've seen debt levels increasing and driving the valuation multiples. But we do start to wonder when the cost of capital increases with the rising rates, what is going to happen there? We have seen, Roger, this is a good slide of yours on leverage multiples as well, doing some comparing here. But the fact of the matter is that Debt pricing not only— I mean, debt availability has not only been at record highs from what we've seen, but also pricing has been at record lows, and it's rare to see that combination. And so we wonder how that cycle is going to play out over 2016, but as it stands right now, if the debt maybe gets a little bit constricted, you know, in terms of the availability and the pricing comes up a little bit, in our view at Private Capital Research, we believe that that's only going to serve to bring sellers to market, because the guys who have been sitting on the fence and who have not brought their company to market are going to say, wow, I don't want to miss the window again. I missed the window back in '07, '08. I've been thinking about doing something. Everybody tells me the market's great. I've printed 3 years of great results. If this is the beginning of what will be the next cycle, now's the time. And so we're really hoping that this is is going to translate into additional sellers coming off the sidelines in 2016 and really revving up the activity level for the year. Michael, are you seeing this as well with sellers and the mentality?

Definitely from a— what we're seeing is more age drives when someone wants to sell than maybe sometimes the economic side. So they keep thinking that they'll be able to sell when their lifestyle wants to change. And so even though they— you can say, hey, we're at the top or trending towards the top of a market, now's the time to go. They think, well, when I get the money, what am I going to do next? And so they're not really focused so much on that. They understand the rationale to it, but the emotional side of the capital transaction, they can't get past it.

So they're not being drawn or pulled into the market by the siren song of of higher multiples, higher valuations. It's more a life decision is what you're saying.

Yeah, I see that. It's interesting, the younger, let's say the 40s and the 50s, are more after the money, 'cause they see the lifestyle change. But when you get to 60, 65 and above, it's more about, this is my company, what am I gonna do next? And so there's more of an emotional part of selling versus the younger.

Mm-hmm, mm-hmm. So let's get to, Oh, this is actually another interesting slide here about what happens when you try and do it yourself as a seller and you're going through that thought process to bring your company to market and whether you hire an advisor to help you do so.

Michael, this is my marketing slide. You can't copy it. So, you know, so when we're meeting with business owners, always the question is, is why do you hire me? I mean, why do you pay us a couple hundred thousand dollars or more to sell your company. And this slide is the reason. This slide is pure facts pulled off of the databases that says, hey, if you hire an investment banker who then helps you manage and prepare your company for sale, take you to market, whether it's one buyer or many buyers in an auction process, the odds are you're going to get a much higher multiple.

Yeah, so there's an arbitrage with hiring advisors. So hopefully, I'm sure everybody in the room would like to see more people hired to advise on these sell-side transactions. So we're going to move a little bit more into some of the M&A market dynamics now. I wanted to get Jerry talking a little about sell-side due diligence trends. There are a lot of things happening on that side of the table these days, whereas in the past, it seemed like it was up to the buyer to do the Q of E, to do the analysis, to determine and validate the EBITDA and the numbers to get a deal done, and then many times falling on disappointment when they learn the facts. There seems to be a trend that's been going on for a while now that sellers are getting their house in order prior, and companies like BDO are at the forefront of some of this activity. So, Jerry?

Yeah, thank you, Graham. Yes, certainly when we look back, even in just the last 2 years, I would say, I would have to say, you know, in our practice nationally, and I think the industry in general, sell-side quality of earnings work continues to be a bigger part of our business, and I would have to say probably literally has doubled every year for the last 2 years. You know, it could be upwards of 100% of our business sometimes. It's really becoming part of the M&A fabric. It's not new for those who've heard of the vendor due diligence report. Ports in Europe, but that trend has certainly gravitated over here. Now—

And this is driven by advisors who are saying to their private clients, 'Look, we need to do this.' Right.

And it's an interesting dynamic as far as kind of how it's coming to the forefront of discussion. The early adopters have been really the investment banks who have really seen the value, and a lot of that has been a function of pricing and value and certainty to close, and the sell-side quality of earnings process has been used very, very effectively in leverage against buyers. Now, the irony of the sell-side quality of earnings world is, you know, the sophisticated buyers or sophisticated sellers are using it, and it's the unsophisticated seller who needs it who's not truly adopted it as yet. And what we are seeing is more and more the middle market and the boutique investment banks recommending it to their clients and, you know, trying to understand and convince them that, you know, it really does pay for itself. And, you know, we say to people, you know, a $50,000 adjustment at 7 times, it's pretty obvious that, you know, getting your house in order prior to is critical, critical to your success.

And Michael, have you been using some of these techniques?

I've tried to give Jerry business, but so far my clients won't take up the cost of it. It really is an issue of putting out $35,000 to $50,000 up front, you know, for a transaction you're not even sure you have a buyer for yet. So they're in cost minimization at the very beginning.

Sure.

So it really is, as we've tried to get some of our buyers where we think the financials are a little weak, they're not audited, they're just reviewed, even maybe compiled, have nice showing, great strong EBITDAs, but we know that they're not accruing things correctly. So working capital's off or all these things, but it's hard to get a guy to spend $35,000 on a wish.

Yeah, it truly is, you know, until they get into the process, unfortunately. Obviously, you know, we do a lot of buy-side work, and, you know, whenever we see it, you know, if there's a deal that's not run by a sponsor, an advisor, you know, that's generally going to be shooting fish in a barrel for a diligence provider. But even today's world, I mean, the reason why people are really using it is certainty to close. Right. And, you know, without it, a buyer is going in, and if they're paying top dollar, they're they're going to look for anything that they can find to extract a pound of flesh and negotiate a price reduction. I mean, we all know prices generally don't go up once diligence starts. So the sell-side process really does shift control to the seller, takes a lot of ammunition away from the buyer in that process.

So if you had a— say you've got a private seller, even Michael might be good for this. And they are not audited, okay? Would you recommend that they get an audit or a Q of E prior to taking the company to market?

It's really kind of a question of where they are in the process. If they've already retained a banker and they're ready to go to market, the advice would be quality of earnings, because the quality of earnings process is going to provide a lot more detail and transparency to the numbers for a buyer. Uh, they're really They're not mutually exclusive uses. An audit is great. It provides, you know, comfort, but there's not a lot of detail obviously in footnotes. So at that stage, we recommend quality of earnings is the right answer. More times than not, they're going to end up with an audit post-close anyway. But as far as facilitating a sale process, the quality of earnings makes more sense at that point.

Roger, have you seen a lot of a certain percentage of deals just plain fall apart because of what is learned along the way that could have been discovered in advance in a process, but the goods were not as billed. You know, the actual EBITDA for the target company was not what was expected.

Yeah, a high percentage. We probably have 2 to 3 transactions a year that fall apart during the QoV process. And again, we're dealing in the lower end of the market, and a lot of these companies haven't had an audit. They certainly haven't had a sell-side QoV done. And you get in and you find things just aren't what you thought they were. So yeah, a good percent— and that's frankly why we do a QoV on every single transaction we look at.

Yeah, that was my other question, is what percentage of the deals that you work on do you get your own quality of earnings I always and never, I try to avoid using, but I'll say always.

Okay.

It's just we've had too many situations where we thought we had a company that was doing X and you get in and you find out all kinds of crazy things. Just, you know, I don't have time to get in all the detail, but yeah, it's, uh, it's critical for us. Um, your comment, Jerry, about an audit versus Q of E, much rather have a Q of E if we're getting involved in a in an M&A transaction. We don't see a lot of sell-side at our end of the market. Michael made a comment about getting an entrepreneur to spend $35,000 before he even knows if he has a transaction he likes. So we typically don't see a lot of sell-side. Every, every once in a while, but strongly prefer picking our own firm. There are certain firms that we would use in certain transactions, and there are certain firms we'd use in others. So letting us do that, we prefer, although we We have accepted some sell-side.

So if somebody has done a sell-side Q of E and they come to market and you look at that deal, will you take their sell-side Q of E as gospel and work on that? Or are you going to do your own analysis? It depends.

It depends. If it's a larger business and they've been through a number of transactions and it's a pretty clean sell-side Q of E, we'll probably accept that. And if it's a noisier business, it may be the first time, you know, we might have somebody review it. It really just depends on the company, how many adjustments, how complicated is their accounting, how complicated is the business.

So, and here's another slide too that's the audit versus quality of earnings. Some of these slides are on a presentation deck that you guys can get from AMAA through the through the system. I believe it's uploaded. So some interesting facts there. But we definitely have seen a continuing trend in this. And frankly, from our perspective of private capital research, we're on the buy side. We'd like to see the sell side QoV because we work on a lot of deals that they just plain don't get there for a lot of different reasons, as Roger said. And a lot of times the reason why you're not going to get to the goal line is because you're learning things through the process, the selling company, the owner is learning things about his own business that he didn't even know, and they can be surprising. And when you get a multiple effect on changes in the earnings, it's real. And when it's a once-in-a-lifetime event, a lot of times these guys are just going to say, look, you know, let's just not sell, or let's wait and clean it up. And when you're doing all that work, you know, you get into— you know, you get further into that process and it gets very expensive. So being able to use a company like BDO or other, you know, accounting firms that do Q of E really helps in terms of the, you know, the likelihood of getting the deal over the goal line.

One of the things we'd like to add that we see a lot, because we do a lot of add-ons for our private equity client base, so on the flip side, we understand it's a cost issue on the lower end of market, so what we recommend when we see these things is, you know, have them use their current accountant who knows their books better than anybody to first do the legwork to get the accruals, to get it close to GAAP as possible before you retain a quality of earnings group. If you want to keep the cost down, don't hire a quality of earnings group to then go back and do the recasting on the financials for multiple years. That's where the cost is incurred. You know, thereafter, the process is you have to understand who's doing the work, because people have seen it, they've seen the reports, they try to do the work. The last thing you want is a quality of earnings product that loses credibility in the middle of a sale, because not only is that lost money, it's now going to raise the questions. It's counterproductive. You know, what else have we missed? So again, kind of understanding the process and putting the, you know, the right people on the bus in the right chairs, you know, in a process is really important on the sell side.

So this just plays into another trend that we were actually talking about when we were preparing for this, that there is a trend in the sell side representation market today that, you know, we're hearing of more limited auctions, fireside chats, companies that are getting the diligence done early where the selling company is more of a known quantity and the bankers are saying, you know what, we don't need— and the business owners are saying, you know, we don't need to go to a full-blown, you know, 500-person kind of 400-person sort of auction. We're going to target the buyers. And Michael, I was interested in your opinion on that, too, as to whether— are you seeing more of that? I know there's been a trend, particularly with bigger deals, deals that have $10, $20, $30 million of EBITDA or more, having very tailored sell approaches to specific buyers. But we're starting to also see that creep down into the smaller deals, under $10 million EBITDA targets. I'm curious how you're seeing that.

Yeah, we have a slide that shows what percentage of strategic companies are actually hiring an investment banker. Which is right around 5 to 7%. I think it's surprising for me in the industry that my competitor really isn't another investment bank. It's really the private business owner not choosing us, and it's really somebody else knocking on the door saying, hey, we'd like to buy you. That's my competitor. What we are seeing in the process is that those knocks on the doors, we're getting more calls from the business owner saying, hey, Hey, someone's knocked on my door. Would you help me with this person, with this buyer, this one-off buyer? And if it doesn't work, then maybe we can talk about going to the broader market. So we have seen a trend line in the last couple of years where people are coming for us. We're just saying, hey, I got 2 people who are interested. Would you help me do that deal?

But in terms of limiting the buyer list on a typical situation, are you advising to limit that buyer list or are you still—

We've always, when we go to market, we try to keep it to 50 people, and then maybe there might be a second tier for another 50, but when we dissect the market, we are really trying to make sure that it's not a 1,000 type of mail blast, here it is, but really strategically figure out why would this buyer wanna buy this company, and so sometimes we even tailor the pitch pitch to different buyers because we think strategically, geography-wise or vertical-wise or horizontal is how we focus it. So therefore, just by our practice, we limit the number of people we go to.

Right. Interesting. So with all these changes in the market, we're trying to understand whether selling a business today is fundamentally different than it was 5 years ago. And what are these things that are driving that with— because there's, there's online posting services for putting deals up, and that's one thing that helps it become more efficient in a very inefficient market. But the reality is that it almost seems like there's a trend going the other way at the same time, with maybe better quality deals, to limit the audience and not go as broad. Roger, have you been in situations where you're either in or out of a limited look at a nice company?

Yeah, and I think it depends. So if you're a business owner and you're looking to retire and just go on, you don't have any family, you don't— you typically see that owner wanting to sort of maximize the audience, maximize his chances of getting lucky, of getting a high price. But a lot of the deals that we're involved with, the owner wants to own a significant piece going forward. and so they've already got some strong views on sometimes the geography of the partner, sometimes the type of partner. So we strongly advocate, because it helps the entrepreneur, it helps the management team, it helps evaluation, if it's a recap where the ownership group is going to retain a big piece, it's usually a smaller the process because they've got strong views about who would be a good partner. On the other side, when we're selling, again, it kind of plays into the same factors. If the management team wants to stay on, if the owner still wants to roll some equity, the same kind of dynamic occurs. We were just involved in a process where the company went out and they probably went to 300 people, Got 40 IOIs, picked, you know, 2, 3 firms, ended up being a strategic. They got involved with the strategic and some of the dynamics the management team wanted to roll became clear that they weren't a critical part of the operation going forward, so they decided to walk away from that and ended up doing a recap. So, you know, it's not one size fits all. It's really about what the objectives are. Of the group that's selling the business and the management team.

So—

Interesting.

This sort of plays into some of Nadim's data from Sutton Place Strategies relative to private equity groups getting a look at deals and seeing opportunities that they should be seeing or that fit their criteria. This is a start of a couple of illustrations. Relative to that, Nadim, do you want to give us a little overview on how that market is shaping up right now?

Yeah, sure. So from the buyer, private equity buyer perspective, the conversation around deal sourcing and deal flow today is dominated— the thing we hear almost indiscriminately from everyone is we don't do well in auctions. We don't participate in auctions. In auctions, the aversion to the auction market, given the valuations and how competitive they can be, It's definitely understandable why. Having said that, quote unquote proprietary direct opportunities, while they're certainly there, they're not exactly easy to come by on a continual basis. So, and when you think about it though, those two proprietary and auction deals are kind of bookends in a variety of ways, in the spectrum of ways deals can be sourced. And I want to illustrate that using the league table that Graham has put up. So what are we showing you here? These are sell-side advisors, not fairness opinion providers, not law firms. These are the firms that have the sell-side mandate on a company that was sold between $10 to $250 million in enterprise value in the year ending September 2015 in the US or Canada, both private equity and corporate buyers. If you focus on the left side of this table, there's certainly a lot of concentration. The top 20 firms approximately represent about a quarter of all deals that get done. And when you talk about auction deal flow, while there's always exceptions, I think this is the universe of transactions that you're talking about, these types of processes. At the other end of the spectrum, out of the 776 different firms that did a deal just in the last year, 565 did only 1, 2, or 3 deals. And if you looked at these names, they are not the same as the ones on the left side, often running, to your point, Graham, limited, quieter processes, not exactly proprietary, but certainly more attractive and less competitive than some of the more well-run processes. Given this, and not to mention everyone in between, those are just extremes. Look at the number of firms doing 10 deals and 5 deals and so on and so forth. Given this diffuse landscape of intermediaries, if you go to the next slide, Graham, it's no surprise that private equity firms today see about 18.6% of their target market deal flow. And if the seller was represented by a boutique sell-side advisor doing 1, 2, or 3 deals a year, it's about 12%. So if you're a middle market, lower middle market buyer, companies, I hope this slide screams opportunity because it is still very inefficient from a sourcing front-end perspective. And if you are a private equity firm that has the savvy and sophistication and has a proactive approach to find deals and leave no stone unturned, it can translate to quieter processes that deals that your competition didn't even have a chance to see often at lower entry multiples, and it's going to translate to better returns in this cycle.

Incredibly inefficient. And Nadim, just to continue on that, you had this.

Yeah. So this is— we juxtaposed private equity deal flow against closed private equity M&A activity. And I just want to distinguish those two things, because sometimes we hear them being used in the same way. By deal flow, we mean the front end of the funnel, the deals that the private equity firms are seeing. By closed deals, we mean deals that actually trade in the US or Canada. And in case you're interested, we did this study last year and found that 1 out of 4 deals that a private equity firm logs, that actually gets to the point where they log in their pipeline, end up trading. So 75% do not close. So we juxtaposed those 2 things on the slide and The green columns represent closed transactions. This is once again $10 million or greater in enterprise value by quarter, and you could tell on average, give or take, there's about 2,000 deals that get done every quarter in the US or Canada. The gray bar is the trailing 4-quarter average deal flow a private equity firm sees, and if you round up the numbers, So, you know, private equity firms sees on average today about 500 deals a year. Some see a lot less, some see thousands, but on average it's 500. And you can see, if you compare the green bars, they've been steadily flat. And to your point earlier, Graham, when all is said and done, it looks like 2005— I'm sorry, 2015 is going to be flat to down probably compared to 2014 in terms of closed deals, but deal flow is steadily increasing. So how is that, you know, how is that possible? Why is deal flow continuing to go up? But closed deal, it's not. And I think there's a— there's probably several reasons, but a couple are as follows. It continues to be a seller's market, and what that means is it's drawing a lot of people kind of testing the waters and seeing if they can get a great valuation, but it's not necessarily translating to closed deals. I mean, in this type of environment, for a private equity firm to close a deal at current valuation levels, I think it's fair to say that it's prudent to model a turn or so less on exit. And when you have to do that, you have to see a real angle— growth, some kind of strategy, a buy-and-build approach— to drive the kind of returns that your investors are expecting. The second reason is increasing efficiencies in the M&A process. Deals are able to touch more buyer points today through technology, through other approaches. Approaches and efficiencies. So a deal that could have been taken to 30 buyers in the past can just as easily be taken to twice as many. So both of those factors are creating an uptick in deal flow, but given this mismatch in buyers' and sellers' valuation expectations, it's not always translating to closed deals. And if you're a private equity or business development professional, it's a pretty frustrating environment because your deal flow is going up and up, you're working harder, and You're seeing more deal flow than you've ever seen before, but it's not necessarily translating to closed deals. And it's always interesting to come up with new indicators, and it may seem counterintuitive, but I believe if you are a private equity professional or BD professional, look for that deal flow to slow down a little bit as an indication that it's becoming more attractive from a buyer's perspective.

Mm-hmm.

Well, yeah, I guess we're gonna see if That's a disclaimer slide that Nadine put in, but yep, sure.

Are you saying on average have the size of the deals gone up or down?

Do you get a total volume of dollars spent by those $1,500 to $2,000 companies that's the same or larger than $1,000 to $2,000 companies?

It's actually question. I don't have the statistics on the top. I haven't noticed that there's more bigger deals or mega deals than compared to the past. If anything, maybe it's come down a little bit, but honestly, I don't have the data behind that. That's a really good question.

That's a good question, yeah. No doubt about it. But what does a private equity firm do to differentiate themselves in that kind of situation, where you try to get a look, try to make sure that you're seeing the deal flow that you see? Roger, have you guys done any other different techniques lately in terms of trying to make sure you're getting looks, or is it more the profile of the firm that sort of shouts that?

Probably, yeah. We're targeting smaller companies. So, you know, we know if it's broadly, if it's an auction transaction, back to your point, Nadine, we're probably not going to be even close. So we're trying to make sure we communicate with the people that are representing the companies that we get involved with, first-time sellers. Family-owned companies, who are their advisors, who are their accountants, lawyers. We know that we're going to do well in the Midwest, so we make sure we're covering those markets carefully. Yeah, it's harder, so you got to turn over more rocks, you got to stay closer to home, you got to, you know, really drive down. You can't just sort of sit back and wait for a book to show up. Because you just aren't going to be competitive. There's plenty of other people out there that have different motivations for getting money to work. So, yeah, we have changed.

So, Michael, when you're, when you're going to market, what does a private equity firm do to differentiate themselves, in your view, to get a look for deals that they may— obviously, they're not seeing deal flow that they should be seeing. I mean, according to these, these statistics, there's— if you're going to 50, how do you get on that list?

It depends on, are they in the industry in which we're selling the company? That's number one. So they're not— they're technology and we're selling a meatpacking company. Those two don't go together. You get off the list, right? So it's— we really start with industry and then we start with investment size. And those are the two criteria. And looking down and seeing whether they've maybe done some transactions within this space or close to adjacent to this space. And that's how we narrow it down.

Okay. Well, good. So why don't we just go down the line here as we finish up, Jerry, and give us your thoughts on 2016, your biggest fears and hopes, and what you think is going to be different. And let's— we'll run down the line and open up to Q&A.

Sure.

We see this market continuing, again, absent probably an external shock to the system. There's plenty of money on the sidelines, as we as we know, still to be put to work. The banks are still lending, you know, but the market is very much priced for perfection, which means diligence for a buyer is going to be extremely thorough, will continue to be very thorough. When we talk about what we see from a trend standpoint, industry expertise and operating partners at private equity firms, so a lot of times people think the quality of earnings process is just about accounting. It's not. It tends to be much more of a drill-down into the business model and validating the business model, because by the time a buyer is there, they've already decided to buy that company in their heads. They're looking, what, how are they gonna, you know, what are the levers? Where am I gonna make money? You know, what am I gonna integrate this if it's a, you know, an add-on to a platform? So they're already down the road. So, you know, we see that trend in quality of earnings. Continuing, because they are paying top dollar, so they're looking for everything they can. You know, the professionalization of the M&A process continues. The institutionalization of private equity continues, and we really don't see that changing, you know, going forward. So I think it puts a lot of pressure on making sure the numbers are right, because the cost of a deal not closing is really high.

We see the market very strong for this coming year and probably for the next couple of years, just because we think there's still the older generation that needs to get out and exit and find a liquidity strategy. So we think it's there. Our biggest challenge is, how do I find you? You got thousands of companies, hundreds of thousands of companies, and we know that something's going to happen transactionally within your lifetime. You're either going to give it, you're going to sell it, or you're going to go out of business. And we're trying to just be there at that door when you're ready to walk out. I'm getting ready to do some work for a client that I've had for 19 years. I think it was almost my first client. And I know the transaction is coming any time, but I don't know how much longer I'll be in the business to sell it when it happens. So it's really about trying to be there, and we're trying to find better ways to be there at that critical moment.

And it's not just driven by a little uptick in rates that will cause them to think, boy, you know, if I'm going to do it, I better do it now.

No, we always tell them, look, if you're not selling with the rosy projections in the future and people can see it, you've already decided too late to sell your company. You've already missed the top.

Okay.

All right.

Roger, how do you see things playing out here in the next 6 months or so?

Well, I work for a guy that predicted a recession every year So, and every 7 years he was right. So I'm a little sensitive to predicting recessions. If you look back at the recessions that have been really impactful on our business, you go to the late '80s, early '90s, that was caused by a real estate crash and the RTC popped up and banks failed. The '08-'09, you could argue, really caused by mortgage crash. I think this year will be choppier than last year. I don't know how much. It depends on if there's any shocks, as somebody mentioned. I would expect if we were going to look at the leverage chart that we had, I would guess— I don't think that goes up this year. It could come down. I think there's maybe a teeny bit less liquidity in the market this year. I don't know. Again, I don't know how the BDC market's going to play out. I don't know how the bank market— these things are impossible to predict. I think it'll be choppier.

Choppier would be my guess.

Yeah.

You know, just building on that, I think the stock market over the last few months has shown that the market's a little jittery, maybe anticipating a recession, worried that there's going to be a recession, looking for any indicators to prove that and validate that. Having said that, there's a massive amount of capital overhang. Are private equity firms going to be patient and look for the right opportunities and kind of wait for valuations to come down, or are they going to, you know, continue to drive leverage levels, maintain leverage— I'm sorry, valuation levels and put money to work? So I agree with Roger that it's going to be choppy, and, you know, going back to the earlier comment, I think it's going to continue to be pretty tepid volume next year.

Yeah, I— you know, we sort of feel both at GF Data and at Private Capital Research that a lot of the multiple expansion has been driven by leverage, and then there's other reasons too. And we kind of deconstructed it to see, like, maybe as you look in different size categories, how much of the multiple expansion that's been going on is actually driven by leverage and how much of it's driven by size and how much is driven by quality and these other factors. We've tried to take apart to kind of isolate how much is leverage really driving these valuations. And the reality is, it's probably about 50% or a little bit less of the increases in valuations over the years has been driven strictly by the availability of leverage. So as that leverage market evolves, and the credit cycle is a cycle, it's a fact of life, and now we're starting to go into a different, a rising rate environment, environment where the cost of capital will increase due to the rates going up, there's likely to be an effect there, and that effect is going to bring multiples— either hold them from going up any higher or bring them down a little bit. And that's our view from a technical standpoint, is that multiples will probably cease to expand at the rate they've been expanding, and they'll either stay steady or they'll come down a little bit. The volume question is really one that It's funny because there's a lot of differing opinions. Michael's had a record year. We had a record year at Private Capital Research. If you talk to some of the bigger banks on the list, the top 20 that are the most active banks, some of those banks are having just— they had just a blowout year in 2015. I mean, bigger year than they've ever had. So there is a bifurcation in the market. There's definitely sort of the haves and the have-nots. You know, I don't see it getting better in 2016 in terms of multiple expansion for sellers, but what I do hope to see is that the environment as it's evolving does ring the bell for folks that are sitting on the sidelines where, you know, hey, maybe the decision to sell is based on health or personal situations like divorce or other family matters that really have nothing to do to do with the market, but that in fact where there is a market effect and where the seller has been thinking about doing something but is in fact kind of waiting for the right time, that 2016 will be the year where they say, you know what, this is the right time. And so we're hoping to see an increase in volume and some reasonable multiples. So the combination I think is excellent for M&A for 2016. I really am looking looking forward to what I expect to have to be a very, very good year all the way around. So now we have a couple minutes for Q&A. If anybody has questions for any of the folks up here, I'd be happy to take them. Okay, well, don't all jump at once. Nobody won the Powerball. I did hear that the Powerball ticket was sold— there was a winning ticket and it was sold in Florida, so, I mean, you know. Here we are. Anyway, OK, so if there aren't any questions, I guess we'll wrap it up.

Thank you very much to everybody on the panel.