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Steps Middle Market Companies Should Take Before a Revival in M&A Activity

By Rob Budden and Rocky Gor

Controversial proposals to radically increase capital gains tax rates for high earners could revitalize M&A and debt markets for middle market companies. The resulting M&A activity will have strategic implications for the majority of companies.

The reaction of investment markets said it all. When the Biden administration announced controversial changes to capital gains tax that would almost double current rates, stocks slid the most in over a month on the news, with the S&P 500 down 0.9% at close on the day.

“When this came out people were concerned,” recalls David Iannini, CEO at William & Henry Associates, a firm of investment bankers.

There is widespread doubt the proposals will be passed in full. But, even if the current capital gains tax proposals fail to get Congressional support, many tax practitioners believe that capital gains tax rates are only going in one direction: up.

Increases in capital gains tax are likely to drive the M&A and debt capital markets in a meaningful way. During the Obama years, a similar tax code related rush to exit was predicted. Nothing came of it as the tax rates were not changed.

This time, given the magnitude of planned deficit spending, things are likely to be different.

The M&A market is likely to be to met with the following conditions:

  1. eager buyers in PE firms ready to deploy their dry powder;
  2. lenders flush with capital ready to finance LBOs; and
  3. competitive strategic buyers bolstered by a robust economic recovery and cheap debt capital.

While there is no guarantee that tax laws are going to change for sure, companies that have considered the strategic implications of such changes will come out ahead. Consider the following actions before:

 

Selling            Buying           Neither Buying Nor Selling

 

Potential Sellers

Whether you are actively seeking a buyer or being opportunistic about selling your company, preparing early on for the sale process will lead to a more favorable outcome. Here are five steps you can take now.

1. Get your financials in order

  • Are your annual financials reviewed or audited? If reviewed, consider engaging a reputable CPA firm to audit last two to three fiscal years’ financials.
  • Prepare a monthly financials spreadsheet with company prepared income statement, balance sheet and cash flow statement for the trailing 12 month period as well as for the last 2-3 fiscal years.

2. Consider a quality of earnings report

  • Did the pandemic affect your business unusually over the last 12-18 months?
  • Did your business suffer from any other unusual one-time events which depressed your earnings, e.g. unexpected production disruptions,
  • labor strike, unfavorable legal settlement, unusual change in raw materials prices or availability, etc.?
  • In the absence of such one time events, would your business have performed in line with the historic performance, or better?

If so, a quality of earnings report prepared by a reputable accounting firm would be helpful. A QoE would not only identify and explain the impact of unusual or one time events, it would allow the company to adjust their EBITDA to reflect a more normal operating environment.

Consider using an EBITDA bridge analysis.

3. Quantify growth and cost cutting opportunities

  • Do you anticipate growing your business by entering new markets or by introducing new products or services?
  • Can you grow organically with operational cash flows or can grow much faster with investment of additional capital?
  • Do you see opportunities to reduce costs and improve margins?

Create a financial projection model to quantify potential improvement to the business through such growth and rationalization opportunities over the next 3-5 years. Consider using an EBITDA bridge analysis to summarize the factors that can drive growth.

4. Get insights from investment bankers

  • Are your annual financials reviewed or audited? If reviewed, consider engaging a reputable CPA firm to audit last two to three fiscal years’ financials.
  • Prepare a monthly financials spreadsheet with company prepared income statement, balance sheet and cash flow statement for the trailing 12 month period as well as for the last 2-3 fiscal years.

5. Make a list of potential buyers

Make a list of direct strategic buyers – competitors and complimentary products/services providers, as well as PE buyers that could be interested in your company for strategic reasons or for platform acquisitions.

Potential Buyers

Whether acquisitions are part of an established growth strategy or a new initiative, consider the following steps to recalibrate your strategy.

1. Understand your capital capacity

You may want to buy a competitor or enter a new market through an acquisition, but how much can you really spend? Consider the following questions:

  • How much cash or equity can the owners of your business invest?
  • What is the maximum amount of debt your business can obtain to supplement your equity investment?
  • Do acquisition targets have sufficient assets and/or cash flows to support additional debt? In other words, would an acquisition target improve or diminish your ability to borrow?
  • Can you obtain a minority equity investment to supplement your debt capacity?
  • What would be your overall cost of capital and debt capacity post acquisition?

2. Identify the targets

You will probably already know your most relevant acquisition targets. However, potential increase in capital gains tax will likely motivate inactive sellers and the abundance of cheap debt could increase your capital capacity meaningfully. Targets that were a stretch, either because they were too expensive or were unavailable, can now be within your reach.

Neither Buyer nor Seller

Even if you are not considering an acquisition or sale, remember that your competitors might be. So, think about the costs of doing nothing.

  • What’s the cost of inaction?
  • If other industry participants are more prepared than you, they could steal a march on you. So consider the following:
  • Can a competitor make an acquisition and thus strengthen their position?
  • Can a competitor sell to a rival to become a stronger competitor or to a private equity investor to be a part of a larger well-resourced platform?
  • Is your company more valuable as a part of a larger enterprise or a private equity company rather than a stand-alone company?

Tax practitioners like Margaret Amsden, Clayton & McKervey’s Private Client Services Practice Lead, expect any planned changes to be passed in some form this calendar year.

She believes the proposed changes could drive up sales prices of some middle market companies as business owners push for higher selling prices to compensate for possible higher tax charges. Owners of some middle market companies “whose value is coming in lower than they would like, may be looking for a higher multiple or some kind of earn out,” she says.

Conversely, if more private companies hit the auction block at the same time, buyers will have more to choose from and that may put a natural ceiling on prices.

Either way, with some form of capital gains tax rises likely over time, this could be just the nudge that some owners of middle market companies need to accelerate any sales plans. Companies that prepare now – regardless of their M&A strategy – will be in a better position to outmaneuver their rivals.

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