There is a growing belief – and it’s slowly being supported by market data – that the economy is improving. Traditionally, we would take this to mean that key indicators are accelerating; and, in some cases, such as manufacturing activity and worker productivity, they are. But the term “recovery” has also come to mean something akin to “not as bad as last time”; or, talking more like an economist, it’s become code for “a deceleration of the decline.”

So, whether we’re using lay language or professional parlance, we need to confront the fact that service sector activity, on which our economy is now largely based, continues to contract, and unemployment figures remain near historic highs. Both of these signposts should serve as a clear reminder that all is not well. And, despite professing that the current recession is “likely over,” Federal Reserve Chairman Ben Bernanke continues to urge caution with respect to the domestic economy.

If we move beyond the macro-indicators, there are also signs that a bottom in the transaction environment is imminent.

The most obvious key indicator is the public equity markets, where we have seen a very healthy recovery. The current bull market rally has driven the Dow Jones Industrial Average up 46%, the third-largest six-month rally in history. As a byproduct of the run-up, corporations have been able to pry open a new issuance window not seen in years. Further, credit spreads have tightened and issuance volumes of both investment grade and high yield debt will surpass 2008 figures. These have enabled corporations to access capital and much needed exits for financial investors, both of which are important to transaction velocity because liquidity drives the lifecycle.  In addition, CEO confidence, as measured by The Conference Board, surged in the second quarter into an “optimistic” reading. This means more views to the positive than to the negative. A favorable market outlook correlates strongly with corporate and financial buyer appetites.   Finally, there has been a spate of large deal announcements, driven primarily by large cap public companies seeking to capitalize on strategic synergies. These deals have changed the tone of the M&A market.

Based on available data, peak-to-trough contraction in M&A transaction volume has typically taken two years. The recessionary period of the late 1980s and the period at the outset of this century both conform to this pattern. As such, given that the current contraction began in late 2007, we would expect to see a bottom late this year. That said, we’ve seen improvements in market conditions, but we don’t believe circumstances are right for a quick return to normalcy for a number of reasons:

Sponsors on the Sidelines. While we have seen an increase in sponsor inquires regarding ongoing mandates, we have seen only a handful of term sheets and even fewer closed deals from this community. On the whole, the private equity industry is still struggling with problems within its existing portfolio. A lack of cheap debt capital to underwrite new deals has resulted in depressed sponsor-backed activity volumes. Year-to-date, global private equity activity is off over 66%, though.   The trailing four quarters have been slower than any four quarter period since the twelve months ended June 2002. Until sponsors are able to access cost-effective debt, total transaction volume will be muted.

Mezzanine Debt Not Solving the Last Mile Problem. Mezzanine debt was touted as the means through which leveraged buyouts were going to be effected when lenders scaled back on transaction leverage. It’s true that mezzanine fund-raising has reached unprecedented levels and subordinated debt has grown as a percentage of the deal capital structure, but company performance has declined significantly, rendering mezzanine of limited use for the buyout community. Further, lender return expectations have exceeded a level buyout professionals deem reasonable.  While mezzanine debt will be part of the solution during the recovery, company operating performance must improve in order for it to be accessed as intended.

Deal Velocity Absent in the Middle Market.  The composition of 2009 deal activity is heavily skewed toward transactions that are greater than $5 billion in value; but deal volume has dropped by approximately 23% in this segment. Even more telling, volume for deals involving companies valued at less than $1 billion (a traditional definition of the middle market) has fallen by over 50%. We’re seeing that most high-quality middle-market companies in the Pacific Northwest seem content to sit out the current market cycle. And deals that have gotten done, like RW Beck / SAIC, occurred at premium-market multiples that were justified by high levels of strategic value. The middle market makes up the largest percentage of transaction volume (33% in 2008); but until valuations improve, a true recovery in the transaction environment cannot be realized.

Strategic Buyers Continue to Show Caution.  While premiums paid for transactions in 2009 are well above the long-term historical average, this figure is skewed by a handful of large public deals. As an example, Dell offered a a 68% premium to the prior-day close to acquire technology services company Perot Systems. In reality, we are finding that strategic buyers are quite cautious with respect to tuck-in acquisitions. Most buyers views this as an opportune market to buy companies at cost-effective prices. But we don’t see these buyers stretching on valuation until operating results improve and financial buyers are able to provide a realistic alternative for sellers.

Ultimately, deal volume will return when the buyer’s ability to pay  and the seller’s expectations again converge. We now recognize that the market eroded so precipitously that a very large chasm was created; it’s also clear today that it will take time to build a solid and lasting bridge over that abyss. An improvement in the macro economy is definitely good for deal activity, but economic growth has to be reflected in the income statements of traditional middle market companies before we experience a return to normalized conditions.

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