For those of you who are regular readers of my blog, you will note that it’s been pretty silent around here the past few months.  I promise you, it has not been for lack of trying.  There have been many capital market items of note over the summer but nothing seemed to maintain sufficient momentum as to be blog worthy in my opinion.  That said, in my conversations with others the market context I have been able to convey, through firsthand experience, has been eye opening for them.  As such, I thought it was worthwhile to catalog a few observations here.

Generally speaking the market is giving off mixed signals.  On one hand all the ingredients necessary to  produce a robust M&A and equity capital market in 2012 are evident.  These include continuing unprecedented liquidity in the hands of private equity sponsors as well as on the balance sheets of Fortune 1000 companies.  Notably, private equity fundraising in 2Q2012 was the second best quarter in the past three years according to Pitchbook.  Additionally, there are over 4,000 private equity backed companies who received outside capital more than three years ago meaning they are of “sale vintage” (typically private equity investors look to exit within a 3 – 5 year window).  Further, the public equity markets, which appear constrained by the macroeconomic climate and political rhetoric, is heavily rewarding both size and growth, making M&A an attractive shareholder value creation opportunity.  Finally, you have pending tax code changes providing sellers’ impetus to do a transaction in 2012, when capital gains are likely to be lower absent political upheaval.   The last time we faced this same tax cliff (2010), M&A volume in the second half of the year, relative to the first half, increased by over 50%.

On the flip side of the coin are the facts with respect to actual market activity.  Private equity volume in 2Q2012 was down 10% sequentially and down 36% on a year-over-year basis according to Pitchbook.  While U.S. M&A market activity was up in this same period, according to Thomson Reuters, on a sequential basis it was down 18% on a year-over-year basis.  If one digs through the data weeds the sequential uptick was driven by a small number of deals in the oil and gas sector, and therefore not indicative of a broad based rally.  Net net, through June, year-to-date M&A activity was down nearly 30%.

The net result of the above is the market has bifurcated into what we call as “Tale of Two Cities” transaction economy.  On one hand you have large $15+ million EBITDA businesses that have the ability to garner significant amount of leverage to finance a leveraged buyout.   As a result of possessing this optionality it is forcing the hand of interested strategic buyers when it comes to M&A valuations involving these properties.  Small companies (sub $5 million in EBITDA) have fewer arrows in their quiver if a strategic buyer is not a willing suitor — take an equity deal and a lower valuation or stay the course.

Notwithstanding the above, we are seeing that some small companies that can affect sales and financings on attractive terms relative to historical norms.  Said differently, deals that are getting done are closing at attractive multiples.  These companies tend to have a number of common characteristics: a) growth — not just growth but sustainable above market growth with generally accepted barriers to entry (e.g., culture of innovation, intellectual property, contracts, etc.), b) best in class gross margins —  firms with thin margin profiles are viewed as higher risk and therefore ascribed lower valuations, c) customer attachment — brand value as evidenced by repeat customer relationships at attractive economic rates, and d) scarcity — market leaders are receiving premium valuations even if they are smaller companies.

Ultimately, I feel these conditions will prevail throughout the balance of 2012.   The pending presidential election is offering voters a choice between two widely divergent economic roadmaps.  Until one is anointed and investors or buyers are able to assess the potential for growth over the next four years, buyers will remain cautious.  As a result, bankers should expect long execution cycles and “take it or leave it” negotiation tactics in the interim.