Many restaurant operators and dealmakers are hoping for a return to the pre-2008 environment, when multiples were robust, liquidity was flowing, equity was prolific, and debt capital was plentiful.
We have seen a respectable improvement in restaurant company performance, capital availability, and M&A activity in the past six months, and we expect a recovery in deal transactions. We have seen some market players revert to what we'll refer to as the "new normal," in which buyers and sellers recalibrate valuation expectations and deal structures to reach the closing table. This caution has arisen from the difficult economy, and may be a factor for some time. However, we sense that the M&A market is recovering in lockstep with the general economy and expect 2011 and beyond to be increasingly healthy and active in terms of the deal environment.
While the selling process has never been easy with middle market transactions, owners and entrepreneurs must be especially strategic, educated, and prepared when going to market in today's still somewhat uncertain environment. Obstacles to successful deal completion in 2011 include:
- Political risk and costs. While we may have seen the worst from Washington and state governments in terms of more regulation, uncertain tax legislation, and mandates on new government initiatives (e.g., healthcare), reversing government programs in a divided political environment is at best difficult and uncertain. In short, sellers must be prepared to address the costs associated with these programs and defend their impact on future expenses and cash flow. Buyers generally assume the worst and project higher costs in evaluating acquisition opportunities.
- Credit and lending markets. The credit markets tightened dramatically in 2008-2010, while underperforming loans spiked and chief credit officers at financial institutions experienced days that will long remain in their memories. While financing activity is returning and lenders recognize they're in the business of providing credit, the process is slow, tedious, and littered with landmines. Equity requirements are higher and have not reverted to pre-2008 levels, and borrowers must be prepared to address any deviation in company financial performance. Borrowers cannot expect lenders to ignore uneven financial results and should have a backup plan when applying for credit. In most cases, borrowers and buyers should engage multiple lenders to underwrite transactions, even at the risk of paying higher up-front fees to avoid a change in advance rate, pricing, or credit structure.
- Operating results. Valuation integrity is based on the seller's ability to drive positive company results during what is typically a protracted deal process, and sellers must focus on maintaining positive operating trends throughout. With transactions taking longer to close, operators must keep their eye on managing costs, growing sales, and ensuring that the company's performance is sustainable. While the natural instinct for an entrepreneurial seller or middle market CEO is to micromanage the deal process, sellers are advised to focus on company operating performance and allow transaction professionals to navigate the often-changing dynamics of the deal process. The most difficult assignment for any M&A professional is to maintain deal pricing in a declining operating environment.
- Plan and over-communicate. Sellers and borrowers sometimes delay negative news until later in the process. This strategy might work in a robust deal environment, where buyers look for reasons to make a transaction happen. In challenging times the reverse occurs, and negative developments often result in deals falling apart over a perceived lack of trust between buyer and seller, without even a chance to attempt to renegotiate. If bad news surfaces, disclose and manage the situation proactively. Burying or hiding questionable information will not suffice today. Plan the transaction process, anticipate negative developments, and manage the communication and disclosure. Remember, in almost every case, the information will come out eventually.
- Understand the realities of buyer psychology. Buyers in today's marketplace are more opportunistic than at any time in recent memory. Well-capitalized buyers often are convinced that sellers have to sell and will attempt to re-trade, restructure, and renegotiate based on any unforeseen or expected development. If margins contract, sales drop temporarily, or the underlying brand or concept has a tough comparison or weak promotion, be prepared for the demand of a price adjustment. Buyers will use any tool to take advantage of a short-term correction. Be prepared, know your limits, and have a backup plan in place. Many deals need to die before they eventually close.
- Most sellers don't have to sell. Most value buyers remain unconvinced of this fact, and many opportunistic buyers think they can steal good deals in the current environment. The realities of the marketplace are that few "distressed" deals get done. In actuality, many bankrupt companies sell for higher prices than anticipated, unless the performance has deteriorated to the point where the company has questionable life as a going concern. Buyers should be diligent but realistic, and focus more on how they can logically improve the cash flow of the business than on buying for the lowest possible valuation. If buyers are too aggressive on deal pricing, sellers simply will go away and resurface when conditions improve.
M&A Slowly Recovering
The second half of 2010 witnessed a significant improvement in terms of deal activity, and we expect 2011 and beyond to improve on that momentum. While the environment has yet to reach pre-2008 levels of deal activity and buyer interest, Cypress is observing the rumblings and positioning among the industry players, evidence of their renewed and heightened interest in M&A transactions. The level of scrutiny in deal due diligence remains high, as PE firms and some underleveraged strategic buyers become more active, but we have no doubt that the players are getting ready for the game.
Sure, there is some caution in the air, but that is to be expected based on the stress the finance world has endured, and that caution is likely to continue for some time. As a result, it is more important than ever to properly position yourself to realize success.
Whether you're a buyer, a seller, or a borrower, keep these factors in mind to increase the odds of a successful conclusion to your transaction. We may not experience pre-2008 deal activity in the very near term, but Cypress believes that the M&A industry will become more robust as the general economy continues its recovery.
Dean Zuccarello, CEO and founder of The Cypress Group, has more than 25 years of financial and transactional experience in mergers, acquisitions, divestitures, strategic planning, and financing in the restaurant industry. The Cypress Group is a privately owned investment bank and advisory services firm focused exclusively on the multi-unit and franchise business for more than 17 years. Contact him at 303-680-4141 or firstname.lastname@example.org.