Merger activity down but company valuations rising.

Mergers and acquisition activity declined for the eighth successive quarter to 445 publicly reported transactions, a 20 per cent fall on both the third quarter of 2009 and the same period in 2008. Deal activity during 2009 was supported by the growth in distressed transactions driven by pressure from the banks. More recently, there has been a fall in the level of bank-driven activity, which has reduced the overall number of transactions.

The recovery in public market multiples particularly during the second half of 2009 has been very marked. The average public company price - earnings multiple for the FTNF (Financial Times Non-Financials Index) rose by 78 per cent to 15.1 times between the first and last quarter of 2009, and by 22 per cent in the final quarter alone. This is the highest level experienced since the first quarter of 2007, which interestingly was around the peak of the M&A boom in terms of transaction pricing.

According to BDO Stoy Hayward, private companies are generally owner-managed, and therefore reported or disclosed profits tend to be suppressed by various expenses that may be non-recurring under a new owner. While this will have been factored into the price the purchaser paid, it may not be reflected in the profits declared publicly. Consequently, the P/E paid, as calculated from the publicly available information, may be overstated. Over the last six years, deals included in the PCPI have had a mean size of approximately £21 million and a median size of around £6 million, though the PCPI is an average measure and guide rather than an absolute measure of value.

Despite the low level of deal volume, the prices paid for privately owned companies has shown a sharp rise since the trough in the beginning of 2009. The PCPI, which tracks price/earnings (p/e) multiples paid by trade buyers for private companies rose to 11.9 times, its highest level since Q1 2008, and an 18 per cent increase over the last three quarters. This is broadly consistent with the Private Equity Price Index (PEPI), which shows comparable multiples on sales to private equity. The recovery in pricing has been a function of a number of conflicting factors. On the positive side, primarily, is that rising public company valuations has given buyers greater confidence to pay higher price; secondly, a lack of supply of decent assets; and thirdly, a pent up supply of private equity capital. Countering this is the limited availability of debt and general economic uncertainty. Whilst the availability of credit improved during 2009, it is still only available for the very best assets, and even then at significantly higher margins.

What we may be seeing, however, is a return to normality on two fronts. Firstly, in the past the FTNF traded at a premium to the PCPI by around 30 per cent reflecting greater liquidity within the public markets. Secondly, trade buyers should be capable of paying similar or even higher prices for businesses than their private equity counterparts, by extracting synergies that enables them to pay a strategic price. The ability to access higher levels of acquisition debt (at competitive margins) between 2005 and the middle of 2008 fuelled the higher prices paid by private equity. The current rationing of debt has removed the advantage private equity had bringing them back in line with trade buyers.

During 2010 we expect to see both the PCPI and PEPI continuing to recover, but only at a modest pace. Again, there will be upward and downward pressure on business valuations. On the upside, improvements in the debt markets are likely to continue, as will inventory restocking following de-stocking during 2009. This will be countered, to a degree, by uncertainty as we enter an election year, and the need to address the public finances.

Whatever the outcome of the election, cuts to public spending and tax increases are anticipated in the second half of the year, which will have downward pressure on the recovery. Deal volumes are expected to rise more significantly in 2010 from stability in pricing that will help align the expectations of buyers and sellers. In addition, private equity houses, which in most cases have funds with predetermined investment periods, have for the most part lost 18 months of deal activity. They will be looking to deploy unspent capital, as well as realise value from their investments.

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