playbookIn October, Del Monte Foods announced that they had sold their fruit and vegetable business for $1.68 billion.  While the world will still have Del Monte canned pineapple, whole kernel corn, and Contadina tomatoes to enjoy in perpetuity, the transaction speaks volumes about the attractiveness of the pet food business relative to its human corollary.  Del Monte’s pet products business will now operate under the Big Heart Pet Brands banner.

You may recall that back in 2010, when Del Monte Foods was taken private by a private equity syndicate headed by Kohlberg Kravis & Roberts (http://wp.me/piXtL-dU), I postulated that the deal was not about shelf stable fruits and vegetables but a bet on the macro fundamentals of the pet industry.  The sale of Del Monte’s Consumer Products business validates my thesis, as does the recent acquisition of Natural Balance Pet Food.  The real question is what comes next?

As a general rule, private equity backed companies are not keen to keep cash on their balance sheets.  Excess cash is used to make acquisitions, delever, or ends up as dividends to shareholders.  Given the size of the slimmed down Del Monte post sale (some $1.8 billion in revenue), I don’t see the later two options as being viable alternatives. As such, I expect that Del Monte will be an active player in the pet consolidation market, and with that much cheese at its disposal the target list includes brands others cannot contemplate.  So who will Del Monte buy? We handicap the candidates:

  • Blue Buffalo. The Blue is the biggest and best name on the block. Not a month goes by without a rumor surrounding the prospects of a Blue Buffalo acquisition by a major CPG company, but the reality is that the company has limited options for suitors at the purported price tag — $3.0+ billion.  Could Del Monte take it down?  Yes.  Will they? Unlikely.  First, Del Monte’s pet line-up is very much about a product portfolio and spending all your allowance on one product company runs a bit counter to that premise. Second, private equity backed companies do not have a propensity for being top payors.  When Del Monte acquired Natural Balance for $341 million, they paid between 1.0x – 1.5x Revenue.  I’m not sure what multiple of EBITDA a $3.0 billion deal for Blue implies, but it would be far greater than the 9.0x the private equity syndicated paid for Del Monte.  While Del Monte established the market multiples that pet companies aspire to achieve through their acquisitions of Meow Mix and Milk Bone, I don’t see them doing a highly dilutive deal with Blue Buffalo; the cost benefit tradeoff is misaligned. Odds: Not good.
  • Natura Pet Foods. The fate of Proctor & Gamble’s pet food portfolio has been a source of constant speculation.  P&G was rumored to be considering offloading its pet business when they acquired Natura Pet Foods in 2010 (http://wp.me/piXtL-cJ), which some took as an about face. They never integrated Natura, which would make it the most likely candidate among the P&G portfolio to be acquired.  Natura would provide Del Monte another power house brand in premium natural, but of greater significance is the fact it would be buying a portfolio of products (EVO, Innova, California Natural, Healthwise), not a single brand.  This would also enable Del Monte to keep Natural Balance in pet specialty, as the Natura portfolio would meet the same needs in mass.  This strategy runs into two problems, one from each side of the transaction.  First, Natura was the subject of one of the widest recalls ever in June of this year, when the company voluntarily recalled every product it made with an expiration date before June 10, 2014. It was their fourth Natura recall in as many months.  Would Del Monte buy a dented egg?  For the right price I suspect they would.  Second, a sale of Natura would only generate proceeds of less than $500 million, a rounding error for P&G, and therefore not much motivation to transact.  Odds: Possible not probable.
  • Iams Pet Foods/Eukanuba. In contrast to a Natura transaction, the sale of Iams and Eukanuba would likely fetch between $3.0 – $3.5 billion ($2.5 – $3.0 billion of that being Iams). This would be worthy of some attention for both sides. Merging Iams/Eukanuba with Del Monte’s pet food brands would make it the number two player in the market, with 20% share versus 35% for Nestle Purina Pet Care. Notwithstanding my comment about check size above, this deal would be tempting for Del Monte to consider. Iams and Eukaneuba generated approximately $2 billion in revenue in 2012 (allocating the other $300 million of segment revenues to Natura), and therefore would be attractively priced, consistent with the Natural Balance transaction. Notably, in July 2013, Del Monte tabbed Giannella Alvarez as Executive Vice President and General Manager of the Pet Business.  As part of her work history, Ginnaella spent time at P&G, albeit involved in a Latin American paper joint venture, but she may have some relevant connectivity to current leadership. However, a deal of that size would likely require the private equity owners of Del Monte to invest more equity, something private equity firms can be loathe to do.  The transaction timeline would also be elongated by anti-trust concerns.  While this deal makes a lot of sense, there are clear barriers to a transaction.  Odds: Possible.
  • Champion Pet Foods. The brand that few talk about in this conversation is Champion Pet Foods, which manufacturers and markets the Orijen and Acana brands of super premium pet food.  Champion was acquired by Bedford Capital Management in 2012, and the business has grown rapidly since the transition, benefiting from Natura’s channel exit and growing distribution offset by production complications related to a plant fire in December 2012. Champion’s regional formulations may not create production economies of scale (yet), but they garner a premium price among consumers who value a limited ingredient solution with a known sourcing pedigree.  While Del Monte wants scale in the brands it acquires, Champion is growing quickly and will become a target of major pet CPG companies over the next 12 – 24 months.  An acquisition would provide Del Monte a very compelling product stack in pet specialty.  Odds: Long, but logical.

Net net, post sale transaction Del Monte finds itself in an enviable position — with both cash and intent.  I do not expect that the company will rush into any transaction, but they have to buy and given the limited competition for premium assets in the space, look for them to strike while the iron is hot, or at least warm.

/bryan

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noseFor those of you who are consistent followers of my blog, you might recall earlier this year I was rather sanguine (on a relative basis) with respect to the prospects for the pet industry in 2013. My thesis was based upon three factors. First, that a tepid recovery would result in slower pet population growth and the waning of the pet food upgrade cycle. Second, that slowing comp (same-store-sales) growth at PetSmart was in fact a proxy for the industry. Finally, that declining influence of the baby boomers, who have slowed pet replacement, would not be sufficiently supplanted by the necessarily levels of spending growth by Gen X/Y to propel the industry forward at projected levels.

As we round the final turn in the calendar year and head for home, things have not played out quite as I had expected.  The industry has proven itself to again be resilient and more adaptable than even I recognized. The economic recovery has been aided by strong equity returns and rising home prices that have exceeded most pundits expectations. Notably, this has resulted in solid growth in industry related personal consumption expenditures that indicate the industry should deliver projected 2013 results. While PetSmart comps are in fact slowing, management has found ways to adapt — prolonging the pet food upgrade cycle through expanding offerings and more square footage dedicated to the premium aisle, resetting key categories such as canine hardgoods, and evolving service offerings to be more compelling.  Management also reported their belief that the company’s online strategy is producing above market returns. Finally, pet adoption rates, a key driver of spend, have accelerated in 1H2013 adding additional reason for optimism. While there may be clouds on the horizon, rain does not appear imminent. As such, we expect the industry to hit its annual growth projections.

In addition to strong growth, we are also predicting that 2013 be a good year for industry related transactions, both M&A and private placements. One of the best predictors of future M&A volume is trailing private placement volume. Generally speaking, private and growth equity firms have three to five year hold periods. From 2010 – 2012 private placement volume met or exceeded M&A volume in the pet industry. Investments made in 2010 are now starting to come into season. Given the number of companies that will enter their exit window over the next two years we expect transaction velocity to continue to grow. Consumables, distribution, and hardgoods are expected to lead the way. Based on 2013 private placement volume we expect this to become a long-term trend.

The year has also produced a number of trends that we expect will have long term implications. Among these, we are seeing acquisition rationales of large strategic acquirers focus on the value of acquired brands in the pet specialty channel. As an example, when Del Monte Foods acquired Natural Balance Pet Foods, it was the latest in a long line of wellness oriented pet properties snapped up by a large strategic acquirer. Historically, these acquired brands have migrated out of pet specialty and into mass where the market opportunity is perceived to be greater. Our understanding is that Del Monte intends to keep Natural Balance in its current channel. Sure we have heard this before from other buyers, but if you consider that mass is losing sales to pet specialty and currently there is a lack of large brands in independent pet specialty with traffic pull, we may be reaching the tipping point where taking share in broader pet specialty is the more attractive opportunity. Increasingly, we see large strategics seeking ways to connect with a premium consumer in pet specialty and believe that acquisition rationales will increasingly rely on this inherent logic.

Additionally, we are seeing a proliferation of direct-to-consumer models in the pet industry. While ecommerce is the most well known business model for direct sales to consumers, a number of alternative models (flash sales, curated retail, marketplace) have emerged post-recession. During the past twenty-four months, companies promoting these models have begun targeting the pet space.  Notably, Bark & Co. (curated retail), Dog Vacay (marketplace), and A Place for Rover (marketplace), have all raised significant amounts of capital. What these companies, and their backers, are betting on is that as Gen X/Y, demographics that have grown up transacting online, ascend in purchasing power these models will see increasing adoption.

As always, a more complete exploration of these topics and the broader industry are available in my report (post here or email me to request a copy).

/bryan

DVPYesterday, Del Monte Foods announced that they had entered into a merger agreement with Dick Van Patten’s Natural Balance Pet Foods.  The deal is expected to close in June, no financial information was disclosed. The fact that a transaction involving Natural Balance occurred is no surprise, the form of the transaction, well that is another story.

Some five years ago San Francisco consumer growth equity fund VMG Partners made an investment in Natural Balance, taking a minority position for an undisclosed amount at an undisclosed valuation (you might see a trend here).  The investment made a lot of sense for both sides at the time.  VMG had recently closed their first fund and was quickly able to get their brand associated with one of the leading independent players in the pet industry, a fact that would help them win the the Waggin’ Train deal later that same year.  Natural Balance was seeking to fuel growth and was able to attract the money at a valuation based on future financial performance. On paper, it was a win-win.

Generally speaking, minority investments from institutional equity funds come with a redemption right often set five years from the date of the investment (we see them range from five to seven years, but more heavily weighted towards the lower end of that range).  These rights require the company to repurchase the shares of the investor for the greater of a floor valuation (usually a multiple of invested capital) or fair market value. As a result, a minority investment often is the precursor to a larger financing or sale transaction.

With VMG’s mandatory redemption right looming, Natural Balance began to evaluate the potential for a transaction early in 2013.  While the company had grown nicely during VMG’s tenure as in investor, the San Francisco firm was a small player and had limited influence over strategy and operations.  Since 2007, revenue seemed to move up and to the right (exceeding $200 million), but profitability was elusive.  In contrast to Blue Buffalo, which is twice the size of Natural Balance, and boasts “high teens” operating income margins, Natural Balance was not thought to be highly profitable.  This would become a problem when the company went to market.   To raise sufficient capital to take out VMG (which generally invests +/- $20 million per deal) the company would need to raise a significant chunk of change. Assuming a redemption right at three times invested capital, Natural Balance would have had to raise in excess of $60 million, and likely much more. Equity funds do not write checks of that size in to companies with low levels of profitability at attractive valuations; enter Del Monte.

Del Monte was responsible for establishing the modern valuation paradigm for leading pet food and consumable companies through its acquisitions of Meow Mix and Milk Bone in 2006.  Today, when pet companies talk about being valued at 2.0x – 3.0x revenue, these are the transactions that set that precedent.  However, since that time Del Monte had undergone a transaction of its own, having been purchased by buyout giant KKR in 2010.  Notably, KKR would go on to purchase Pets-At-Home later that same year. While I have no insider knowledge of the purchase price, the acquisition of Natural Balance was unlikely to have taken place at those levels given the lack of profitability and limited competition for the transaction.  Natural Balance did not hire an agent or run an auction.  One of the driving factors for the deal was likely that Del Monte could rapidly expand Natural Balance’s distribution footprint through its Pets-At-Home franchise.

Net net, this appears to be a good pick-up for Del Monte making them an instant player in the natural category and in super premium.   It was able to achieve those objectives without shelling out the $1.5 billion Blue Buffalo has reportedly sought from strategic acquirors.  Opportunity knocked and Del Monte answered.  Expect them to keep the product in the pet specialty channel, as opposed to migrating it to mass a la Natura. VMG wins as well, likely making more than their mandatory redemption due to the valuation that would be associated with Natural Balance in a 100% sale transaction as opposed to another minority financing.

/bryan

fishySpeculation is fun.  Speculation about others is more fun.  The pet industry loves speculation.  Given the insular nature of the industry, it’s often all we have to rely on.  So when Procter & Gamble Co. (“P&G”) announced 2Q2013 earnings (P&G is on a June 30th fiscal year end), and made nary a mention of their Pet Care division a reputable pet author set the blogosphere abuzz pondering the implications of this “over site”.

The fate of P&G’s pet portfolio, which features the Iams and Eukanuba pet food brands, has been the subject of speculation for years.  That speculation has roots in a 2007 disclosure that P&G had hired the Blackstone Group to review strategic alternatives for its Folgers, Pringles, and Duracell brands.   After being a net buyer of assets from 2000 – 2005, P&G was preparing to be a net seller in an effort boost its earnings growth and enhance focus.  At the time, a divestiture of Pet Care was dismissed in favor of new management in an effort to turn around the flagging division, which in combination with the Snack group, had experienced a contraction of over 30% (revenue and earnings) between 2006 and 2007.

Speculation about P&G Pet Care end game died down after the company sold the Folgers Coffee brand for $3.3 billion in 2008 and its pharmaceuticals group for $2.2 billion in 2009, before launching a stock buyback program of up to $8 billion.  In the interim the Snack and Pet Care division had recovered its growth trajectory, even if the slope of the curve was modest.

And then P&G stunned the pet market through its winning bid for Natura Pet Products in 2010. The transaction, which likely cost them $500+ million was not the behavior of a net seller of pet related assets.  Natura was believed to be doing $200 – $250 million in sales before the acquisition. However, when P&G agreed to sell The Wimble Company (aka Pringles) to Diamond Foods for $2.35 billion in 2011 (a deal which fell through over some improper payments to walnut growers before the asset was sold to the Kellogg Company in 2012), speculation about the fate of Pet Care returned to the surface.  When Bill Ackman, an activist investor with a penchant for identifying under valued brands, made his largest ever investment in a company, the simmer became a boil, which continues today.

That said, P&G’s failure to discuss its Pet Care business on an earnings call does not have any veiled meaning.  The reality is that when Wimble was sold, Pet Care was reclassified into the company’s Fabric and Home Care reporting unit.  Pet Care as a separate P&L was no longer relevant given that Pringles made up 50% of the Snack and Pet Care divisions revenues.  Further, the fact that Pet Care on its owned is dwarfed in sales by ever other P&G revenue division by at least a factor or 8x means it was unlikely to get the same executive airtime in earnings conference calls.  In fact, the division has only received fleeting mention in ant of the three prior earnings calls.

The reality is that Pet Care does not have many places it could go even if P&G wanted it off the balance sheet.  Collectively the brands likely generate $2.5 billion in revenue meaning a market valuation of +/- $5 billion.  Most of the companies who could afford that figure would likely be facing anti-trust scrutiny if they tried to acquire the business, so it would have to be an adjacent market buyer or a foreign market entrant.  A second option would be to sell the business to a private equity firm.  However, I don’t think the numbers work.  Assuming, generously, 20% EBITDA margins and the ability to borrow 6x EBITDA to finance the deal, a financial buyer would still need to pony up approximately $2 billion in equity.  Not many firms have that sort of dry kibble.  Further, this would be akin to the Del Monte take private with half the revenue and a third of the profitability.  Pet food is not a great margin business once marketing costs are factored into the equation.  A third option would be to spin the business into a public company, a la Pifzer / Zoetis.  While having a pure play pet food comp would be nice, the transparency would make the brands vulnerable on a number of fronts.  I don’t know what a public listing would otherwise accomplish.

Net net pet industry pundits must accept that it’s not always about pet care when it comes to global brands.

/bryan

For those of you who turn into my blog when there is a pet headline attached, you will note that “the well” has been a little dry lately.  It’s not that there haven’t been things to talk about, rather there hasn’t been interesting things to talk about.  As I walked around SuperZoo this past week, many of you made it known to me that you were a little disappointed.  Then a little package was sent to all of us this morning in the form of the announcement that Perrigo Company (“Perrigo”) has agreed to acquire the assets of Sergeant’s Pet Care Products, Inc. (“Sergeant’s” or the “Company”) in a deal valued at $285 million, or approximately 2.0x fiscal 2012 revenue (Sergeant’s fiscal year end is September 30, 2012) and approximately 10.0x EBITDA (this is an informed SWAG, if such a thing exists).  Finally, one the industries big names has traded.  Whenever an industry leader transacts, it is good for the market providing guidance on current valuations and changing the competitive dynamic, both of which promote investment and renewal.

For those of you who have not followed the Sergeant’s story closely, the 140 year old Company was originally acquired by Sowell & Company (“Sowell”), a Dallas based private equity firm in 2000.  This was Sowell’s third acquisition in the pet supplies space.  Under Sowell’s ownership, the Company grew the topline over 5x, and profits by an even greater factor.   Along the way, Sergeant’s made a number of acquisitions, including the Consumer Brands Division of Virbac SA, the French animal health concern.  The Company’s solution set address approximately $8 billion of the $50+ billion pet industry.

What is most interesting about the Company’s historical situation is that it was not sold sooner.   Sowell’s ownership term was 12 years, significantly longer than the typical 3 – 5 year private equity holding period.  However, Sowell is not your typical private equity firm.  Because it does not source its capital from third parties (the money comes from the personal fortune of Jim Sowell, a Texas real estate magnate, and one of Top 100 Most Powerful People in Dallas/Fort Worth), Sowell can exercise patience and time the market.   As an example, Sowell was able to wait out an EPA investigation into spot-on flea and tick treatments in 2009 – 2010, as opposed to going to market under a cloud of uncertainty.  Sergeant’s derives over 75% of its revenue from flea and tick and health and wellness solutions for companion animals.

Also of interest is who bought the Company.  After a broad private equity and strategic sale process, Perrigo stepped up to acquire the assets, leaving behind (we assume) any contingent legal liabilities.  The courtship took over 12 months.  Perrigo is a developer, manufacture, and distributor of over-the-counter and generic prescription pharmaceuticals, infant formulas, nutritional products, and active pharmaceutical ingredients worldwide.  While the company is highly acquisitive, having done 15 deals since 2008, this is its first foray into the pet space.  The deal gets Perrigo a solution set that it can extend into its store brand product development process.  The company expects to take the Sergeant’s formulations into a wider distribution framework on a private label basis, mainly in drug retailers and the mass channel.   In short, this deal is about revenue synergy and barriers to entry, as opposed to cost and industry consolidation.

What is of equal interest is why The Hartz Mountain Company (“Hartz”) or Merial Animal Health (“Merial”) did not step up to the plate.  Rumors have it that Hartz is struggling under Uni-Charm Corp’s ownership but the chance to take out a competitor  would, on its face ,seem appealing.  Merial, whose parent company is holding over $6+ billion in cash, could have greatly enhanced their presence in the U.S. OTC market through the deal as well.

One also has to view this transaction as an opportunity for smaller pet companies in Sergeant’s secondary categories — grooming, toys, consumables — to take shelf space.  Nothing in the post deal PR hub-bub was there any mention of an emphasis on the other 25% of the portfolio.

Finally, one has to wonder whether this deal is a prelude to other major transactions in the space.  Blue Buffalo, Natural Balance, are you listening?

/bryan

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.

/bryan

They say there are two certainties in life, death and taxes.  That’s not entirely accurate since death comes at the end of life, but that is probably just quibbling.  Taxes are a certainty however, whether of not you choose to pay them.  If the 2012 presidential campaign has illuminated anything definitive to date, it is that not all income streams are equal from a tax standpoint; those who make the majority of their income through buying and selling investments (the Mitt Romney’s and Warren Buffet’s of the world) have much lower effective tax rates because their income is treated as capital gains instead of ordinary income — 15% versus 35% at the highest level.  Some form of equity is looming on the horizon.

In 1993, the Clinton Administration sought to tackle a $300 billion federal deficit through government spending cuts and increasing personal income taxes on top earners.  This resulted in a budget surplus in 1998, which grew to $230 billion by 2000. The surplus was a central discussion point in the 2000 presidential campaign.  George W. Bush suggested America was “owed a refund” and campaigned under a promise to lower taxes on the wealthy if elected.  The net result was the 2001 Economic Growth and Tax Relief Reconciliation Act and 2003 Growth Tax Relied Reconciliation Act, collectively referred to as the “Bush Tax Cuts”.

The Bush Tax Cuts lowered ordinary income tax rates 3%-5%, phased out the estate tax, reduced the marriage penalty, lowered rates on income from dividends and capital gains, and increased exemptions.   Critics argue over the long term impact of these changes, but two things are hard to dispute: a) the Bush Tax Cuts resulted in U.S. government losing billions of dollars of revenue over a 10 year period and b) keeping the cuts in place have become a central political platform for the Republican party.   While I am no political handicapper, the combination of a swelling U.S. deficit (and therefore the need for more revenue streams), the growing income gap between the wealthy and the middle class (as evidenced by the “Occupy” movement), and the clear improbability of the GOP winning both the White House and the Senate, mean the Bush Tax cuts are all but dead on the stroke of midnight December 31, 2012.

The implications of Cinderella leaving the ball are meaningful, as evidenced by the table below:

Estimated Changes Upon Expiration of Current Tax Program
2012 2013E % Increase
Ordinary Income 35% 43.4% 24%
Long-Term Capital Gains 15% 23.8% 59%
Qualified Dividends 15% 43.4% 189%
Estate and Gift 35% 55% 57%
Source: Moss Adams LLP Year-End Tax Planning Guide, November 2011

The question many are asking is whether these changes may light a fire under M&A for family owned businesses in 2012.   After all, if you own a business worth $100 million and  you sell in 2012 versus 2013 you save yourself at least 8.8%, but possibly much more if the”Buffet Rule” is enacted into law, which would put a minimum tax rate of 30% on all income streams if you make over $1 million annually.

History would tell us that taxes alone are not sufficient enough to push people towards transactions they would otherwise defer.  However, history has not seen this level of increase in the capital gains rate since the 1967 – 1972 period when rates increased 11.5%, but over a period of five years.  Here we are talking about 8.8% over night.  Further, the market has never enjoyed the levels of liquidity currently in the marketplace, from both strategic acquirors and private equity firms.  Excess liquidity tends to correlate with rising purchase prices.  Throw in a pinch of uncertainty regarding Europe over the next 24 months and you might have a convergence of circumstance strong enough to call some to action.

Despite the stars aligning only a subset of the market should be interested in this reality, and that would be companies on the larger end of the spectrum.  Yes, as enterprise value increases the impact of the capital gains rate changes increases, but more importantly so do transaction market multiples.  According to GF Data Resources, the spread between the multiples garnered by businesses worth greater than $50 million is a fully 2.0x in a leveraged buyout versus those with lower enterprise values.  The data shows that the “size premium”, so to speak, increased a full 1.0x in 2011.  Absent attractive purchase prices, people tend to sit on the sideline no matter how their tax bill changes from one year to the next.

Net net, I think 2012 will be a strong year for M&A because of the total market dynamics, but I don’t think taxes alone are going to stimulate a plethora of activity that would not otherwise be there on other merits.

/bryan