In April 2012 with the calendar year only a third of the way through, commercial finance merger and acquisition activity was suddenly rampant with both bank and non-bank acquirers jockeying for opportunities to pick up platforms that could originate high credit quality assets that generate above average risk-adjusted returns in asset classes that didn’t involve the slow and still-recovering commercial real estate and construction lending industries. Companies from PrinSource Capital in Minneapolis to Marquette Equipment Finance in Salt Lake City to Greenfield Commercial outside of Detroit and Celtic Capital in Los Angeles all changed hands during the first four months of 2012 leaving industry participants with an optimistic view of greater deal activity, albeit at pricing that while improved from the recession, had yet to reach the heights of the 2004 through 2007 deal period.

But with 2012 at a close, M&A deal activity has slowed. True, the asset based lending, factoring and equipment leasing sectors aren’t necessarily a hotbed of M&A activity historically, and only a handful of these transactions are consummated each year. But the pace of closed deals in the first half of 2012 seemed to demonstrate that 2012 would be an above average year for dealmaking. Deals are still getting done – Hennessey Capital in suburban Detroit sold to Hitachi Capital and Equilease Financial Services in Connecticut sold to Colford Capital, for example – but the question now must be raised of whether activity will pick up in 2013.

We believe the answer is “Yes.” It may seem like a self-serving statement coming from an active advisor in transactions such as these. At the same time, we are uniquely positioned to know about deal activity in the commercial finance sector given our industry specialization and focus. We have seen a continued interest from a variety of possible buyers looking for many types of specialty lending businesses, including asset based lenders, factors and equipment lending and leasing companies.

A variety of factors continue to persist in today’s market environment that help support our bullish view. First, banks are still in great need of asset origination capabilities that will simultaneously help them find balance sheet growth while also earning yield, particularly given the low interest rate environment that continues to hamper net interest margins. Even after hundreds of banks failed during and after the credit crisis, over 7,000 banks still exist in the U.S. and the vast majority maintain loan portfolios that are heavily weighted towards some form of real estate exposure, whether single family mortgages, commercial real estate, multifamily lending, or land and construction lending. Generally, these sectors are not currently fueling loan growth for banks, with the exception being some pockets of single family mortgage lending, which have enjoyed a profitable run given the low rate environment. But even those gains came mostly in the form of fees rather than net interest income.

These real estate concentration and interest margin issues are expected to be a continued thorn in the side of bankers across the country for the foreseeable future, which in turn should generate greater interest in non-real estate asset origination. Non-bank commercial lending businesses with good credit quality, strong management, solid internal controls, and well organized credit files are the perfect possible targets for these banks in need of yield, thus the acquisitions in early 2012 of both Marquette Equipment Finance and Celtic Capital by Pacific Western Bank in Los Angeles.

In addition to the bank sector, a second source of current interest in commercial finance company acquisitions has been the non-bank strategic buyer universe. Many of these potential buyers, which include other finance companies that may see a particular commercial finance sector as being either additive as a new line of business or a source of greater market share, have successfully raised third party debt and equity capital from banks and institutional investors with deep pockets who are willing to invest additional capital if a possible acquisition presents the right return characteristics (i.e., possible equity returns on their investment of over 20% for most).

With significant competition among commercial lending businesses for both loans and quality business development officers, some finance companies conclude that buying another company can help solve numerous issues. These include: loan growth, finding experienced people, and enhancing product offerings. This helps justify having to pay premiums to acquire companies because the capital needed to consummate an acquisition can ultimately help a buyer and its shareholders achieve their return goals in a shorter period of time. North Mill Capital (acquired PrinSource Capital) and Gibraltar Business Capital (acquired Greenfield Commercial Credit) both have supportive institutional investors who invested fresh equity capital to help finance their respective acquisitions. As a result, both acquirers are larger today with broader geographic footprints and more developed product offerings than they otherwise would be.

While both bank and non-bank buyers are expected to continue to be acquisitive in 2013, an equal number of compelling reasons exist as to why sellers should be willing partners for able buyers over the next year. The commercial finance sector is largely made up of owner-operators whose equity in their platform represents the largest component of their net worth. Many of these owners have operated successful lending businesses for many years and are inching closer to retirement age. The uncertain economic environment presents risks and challenges that have become harder to navigate, making a sale more attractive than it may have been years ago.

Separately, many of these operators simply do not have adequate succession plans in place for the future. As we see in almost all of our transactions, a buyer wants to retain key personnel for some period of time post-transaction. This means an owner-operator looking to retire in a few years needs to think about selling now. In addition, the same private finance companies that have been fortunate to attract strong equity partners know that ultimately, those same equity investors (particularly private equity investors) will require an exit sooner than later.

We believe the above buyer and seller dynamics will help contribute to a more active M&A environment for commercial finance companies, much like we saw in the first half of 2012. Of course, one reason that more deals weren’t consummated in the second half of 2012 may very well be due to the gap between buyers and sellers when it comes to valuation. Little information is available publicly on this topic due to the small and private nature of most sellers in this sector. However, as an active advisor to the space, we can safely say that while valuations have improved dramatically since the recession, we are still short of the pricing seen from 2004 through most of 2008. During that time, commercial finance companies regularly traded hands at premiums on loans/leases (or net funds employed for factoring companies) of 30% to 50%. This resulted in many companies being sold at earnings multiples of over 10x after tax income and 200% to 300% of shareholders’ equity. Of course, in that market environment before the recession, many publicly traded banks with high return on equity were trading at valuations north of this, which enabled them to pay these kinds of valuations for commercial finance companies.

Today, with higher regulatory capital requirements from the likes of Dodd-Frank and Basel III coupled with the net interest margin issues cited above, getting to a 10% return on equity is a challenge. Thus, public company valuations suffer as do banks’ ability to pay higher premiums for acquisitions. This is having an impact and will continue to do so, likely for the long term due to the new world of bank capital constraints.

That said, attractive valuations can be achieved – just ask Celtic Capital who, as was publicly disclosed by their acquirer, Pacific Western Bank, sold for $18 million in cash which was over a $9 million premium. That compares quite favorably to the few deals that happened during the recession at only a very slight premium, no premium, or in many cases, a haircut to par value. Comparable deal data like the Celtic Capital pricing will help to establish a more favorable market for commercial finance company valuations. But we are not predicting a return to valuations of 2004 to 2008 any time soon because if banks aren’t going to pay huge prices, then the non-bank buyers won’t have the need to stretch on price to win an acquisition from a bank or other buyer.

Still, the market is ripe for further consolidation, and we expect both banks and finance companies to continue to be the active players in 2013.