The Verit View – January 2015
The Year Ahead: Verit’s Top Four 2015 Middle Market Predictions
1. A Less Frenetic Environment for Private Equity
Over the past few years, low interest rates have allowed private equity firms to aggressively bid for targets and reap significant profits by leveraging portfolio companies with substantial amounts of comparatively low-cost debt. The Fed’s latest comments that a rate increase will most likely occur in the second half of 2015 could leave private equity firms in a less enviable position. As rates rise, and lenders become less enthusiastic about highly levered transactions (“HLTs”), private equity funds may find it challenging to finance deals with capital structures they employed in the recent past.
Less readily available (and more expensive) financing means lower valuations, lower targeted internal rates of return (“IRRs”), or both, as PE would need to backfill the deficit with more equity. This could open the door to more timely and attractive alternatives for business owners. An ESOP is one alternative that can compete directly alongside a private equity buyer and can fulfill funding shortfalls through seller financing.
2 .Expect Debt Capital Markets to Remain Competitive
2014 was a year of change and adaptation for many lenders. With increased scrutiny, regulation, and transparency requirements, many commercial banks shied away from high-risk, HLTs. Internal and external regulatory and transparency programs are likely to become streamlined in 2015 as lenders focus on Comprehensive Capital Analysis and Review (CCAR), so-called “stress testing.” Increased regulation yields an opportunity for non-bank financial institutions, as they typically provide more flexibility with structure and tenor, albeit generally at a higher rate than senior bank debt. A continued strong M&A market in 2015 is expected to fuel event-driven financings, with the potential for increasing loan volume for well-capitalized banks and non-bank financial institutions. HLTs, however, will likely constitute a smaller percentage of commercial bank deal volume.
3. The Year of Construction and Engineering (“C&E”)
While industry participants are not back to pre-recession levels, C&E began to normalize in 2014. With the Federal Reserve Bank of Philadelphia reporting an average expectation of three percent economic growth for the upcoming year, officials are speaking with growing optimism about the strength of the economy. Six years ago the C&E industry faced many challenges; one could argue the contrary for 2015 with rising economic confidence, heightened political certainty (given the recent election and spending bill passage), and thriving financial markets. The American Institute of Architects’ Architecture Billings Index (ABI) reflects this sentiment, last reporting in November with a score of 50.9 (a score above 50 indicates that firms, in aggregate, are reporting an increase in activity). While the November score is not the highest ABI growth score seen of late, the design contracts scored an impressive 54.9, signaling potentially strong demand for future architecture billings in the months ahead.
4. ESOPs Will Continue to Grow as a Transition Alternative
In 2015, a number of baby boomers are certain to retire or, at least, consider exploring retirement and liquidity options. This group of more than 75 million individuals is now aged 50 or older. According to the U.S. Census Bureau, of the four million companies with employees in the U.S., nearly 66% are owned by baby boomers. What does this mean for business owners and their advisors? Succession planning. ESOPs are growing in popularity as they provide business owners a transition alternative that can transact at full and fair market value, provide asset diversification, and a retained investment interest while instilling an ownership culture conducive to greater productivity and profitability. Business owners are searching for a solution that allows preservation of their legacy and access to liquidity. With the private equity / ESOP valuation gap narrowing, and the continued availability of relatively low-cost debt, we expect owners to further explore ESOPs as a viable transition alternative.
As always, it is Verit’s vision to bring a fresh approach and customized solutions to advise private business owners on ownership transition.