It’s a call we receive frequently: “This is So-and-So from XYZ Institution. We have capital to deploy, but we have been struggling to grow assets at good yields, and we’d like to explore acquisitions.” One of our first questions is whether the would-be acquirer is willing to pay a premium (to assets or equity). A “yes” means we have some opportunities to show them; a “no” means they may need to be patient for a while. An abundance of capital and a desire for asset growth and yield has driven steady M&A activity at close to peak multiples for commercial finance companies.
Who Are the Buyers?
In a somewhat unique industry dynamic, various types of acquirers are active in today’s M&A market. This includes banks, business development companies (BDCs), and private equity firms. Even international conglomerates and insurance companies have completed transactions or directly expressed interest in doing so. A favorable economic outlook and an expected period of regulatory easing has enhanced buyer confidence and stirred proactivity.
In an effort to bolster C&I lending and increase interest and fee income, banks have been active buyers over the last 24 months, particularly for equipment finance and SBA 7(a) lending platforms. Banks have been most attracted to asset classes with low delinquencies/charge-offs and platforms with highly institutionalized practices that can adapt to a more regulated environment. Recent examples include PNC’s acquisition of ECN Capital, and Radius Bancorp’s acquisition of NewStar Equipment Finance.
After a period of less activity, BDCs have recently reemerged as keenly interested in platform acquisitions. This is driven in part by many BDCs returning to trading at a premium to tangible book value. Platforms that deliver a consistently strong return on equity tend to evoke the most interest from BDCs; growth and exit value tend to be less important. Not all commercial finance companies are a good fit for BDCs, which are sensitive to “good income.” Commercial finance companies that generate interest income (vs. operating lease revenue, for example) tend to be a better fit.
Private equity firms continue to pursue acquisitions; however, portfolio companies of private equity investors have largely driven recent M&A interest and activity. From late 2014 to late 2016, private equity firms demonstrated a willingness to aggressively price growth stories. The most recent and well-publicized such transaction was Warburg Pincus’ acquisition of Ascentium Capital. In an effort to meet growth targets and business plans, the portfolio companies of private equity firms have been pursuing bolt-on acquisitions. An example of such a transaction is the acquisition of Connext by Engs Commercial Finance, a portfolio company of Aquiline Capital Partners. Interest from sponsor-backed, strategic buyers is enhanced through readily available debt capital. Senior debt is available at low interest rates and higher leverage/advance rates, and securitization markets are active with efficient execution and significant investor appetite. Further, there is currently considerable investor interest in providing subordinated debt to commercial finance companies.
Though more sporadic in their interest, international conglomerates have pursued U.S.-based specialty finance companies when they’ve felt opportunities in their home countries were limited. Hitachi’s acquisition of Creekridge Capital last year is a good example of such a transaction. In addition, capital market-savvy insurance companies have expressed interest in acquiring or partnering with specialty finance companies in an effort to generate higher-yielding investments.
A vast potential buyer universe is always preferable for sellers, but what is particularly intriguing about the current M&A market is that there are buyers for a variety of asset classes and growth stories. The robust buyer universe has elevated the number of deals as well as valuation.
Valuation in Today’s Market
Since late 2012, the commercial finance M&A market has been functioning at fully recovered levels. Buyers have been willing to pay meaningful premiums, and there have been few distressed deals to taint the market. When looking at M&A valuation metrics, we typically evaluate (i) deal value as a multiple of trailing twelve months after-tax earnings (P/E), (ii) deal value as a percentage of tangible book value (P/TBV), and (iii) deal value premium as a percentage of earning assets (Prem/EA).
Deal value is the value ascribed to the equity of the target company, while tangible book value refers to the tangible equity or net assets of the target company. Above, deal value premium is the difference (in dollars) between the deal value and the tangible book value. In an asset-only deal, it is the difference (in dollars) between the asset purchase price and the book value of assets acquired. When considering valuation metrics, it is important to consider all three, as a metric taken individually can be misleading. Deal value premium as a percentage of earning assets is a particularly helpful metric for companies with unique capital structures or divisions of institutions with allocated capital.
Speaking generally, the current M&A market is valuing commercial finance companies at 10x–16x P/E, 150%–225% P/TBV, and 10%–25% Prem/EA. These are just general ranges, and valuation is industry and company specific. Unsurprisingly, higher portfolio yield (revenue) and earnings are typically correlated with greater premiums. However, high premiums may result in lower earnings multiples. This is particularly true for factoring companies with >20% asset yields that may trade at P/TBV and Prem/EA well beyond the range above, while their P/E is in the single digits. The opposite may be the case for a leasing company with
While the metrics above are typically used to approximate value based on precedent transactions, it is worth noting that different types of buyers have specific metrics to which they are sensitive. Banks arguably have the ability to pay the most for specialty finance companies. The combination of low cost of capital and high leverage make the pro forma numbers jump off the page. However, banks are typically sensitive to goodwill and look for the after-tax earnings of an acquisition to “earn back” the goodwill over just a few years. BDCs must distribute 90% of earnings and are valued in part based on their dividend yield. As such, BDCs are looking to generate an annual return on invested capital that exceeds their targeted dividend yield. Private equity is focused on total return from initial investment through exit and seeks an annual average return of 20% or higher.
The variety of players in the current buyer landscape means there isn’t one story or business model that buyers are looking for, and competition among acquirers has maintained attractive valuation levels. While the near-term prospects are positive -- and our phones keep ringing with would-be buyers -- the seller-friendly M&A market of the last five years will not remain indefinitely. Owners and managers need to consider their personal timeline for an exit as well as the possible M&A environment at the time of exit.