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Christopher M. Lee
Private Party M&A Outlook
A New City
Count Us In
Taking the Plunge
Utah’s Legacy of Innovation Continues
State of Fraud
On the Horizon
It’s a Wrap
Now that the first month of 2012 is in the books and the Dow and S&P have logged their best January performance in 15 years, it is tempting to wonder if the worst of the economic turbulence is behind us and some degree of normalcy will finally return to the economy. For private mergers and acquisitions in particular, there appears to be good reason to think that 2012 will provide improving opportunities for both buyers and sellers. Moreover, possible changes in the tax laws could very likely make 2012 a good year to sell your business.
The two big-picture factors perhaps most likely to drive increased M&A activity are the potential loss of currently low capital gains tax rates for sellers and the improving availability of financing at still attractive rates for buyers. Since one factor is subject to political wrangling during an election year and the other is subject to a multitude of markets still struggling to digest current events, I would not want to bet the house on either outcome. However, there is at least some reason to believe that these could contribute to increased activity.
December 31, 2012 is the last day taxpayers can be assured of more favorable long-term capital gains treatment. After that date, the federal long-term capital gains rate is set to increase from 15 percent to 25 percent (21.2 percent plus the 3.8 percent Medicare tax). That is an increase of 66.7 percent in the effective rate. The after-tax impact of this increase would mean that a person selling a business on January 1, 2013 would net approximately 13 percent less on the gain portion of the same transaction. That could provide a significant cushion for dealmakers to close transactions in 2012.
The last time we faced a similar apparent deadline for favorable capital gains treatment in 2010, I personally worked on and was aware of multiple transactions where the deal was expressly conditioned on the transaction closing before the end of the year. There is probably good reason to think that this cycle may repeat again this year.
Politics being what they are, there is certainly some possibility the date could be pushed back (again); or, if some republicans have their way, the favorable capital gains rates could be made permanent or even eliminated. However, to the extent the situation is not definitely addressed, I would expect the possibility of increased rates will lead to more tax-motivated selling in 2012.
To be sure, there are headwinds facing potential sellers. Many have experienced business conditions and results that mirror the overall economy. Traditional transaction valuations based on multiples of earnings will tend to work against sellers trying to get what they perceive is a fair price for their business.
The second big driver of deal flow could be increased loan availability at favorable rates. Interest rates still hover around historic lows. However, available funds and previously available liberal financing terms have been in short supply.
The ability to use leverage has been curtailed in most transactions and loans are, in most cases, receiving a higher level of scrutiny. This has been critical because significant leverage had provided private equity with the potential for the high rates of return required by investors for the risk taken and high costs of investment. Its absence or scarcity has probably been the single biggest factor in decreased private equity activity.
Anecdotally, there seems to have been a significant easing in finding debt for larger transactions but smaller transactions still remain a bit of a challenge. Strategic buyers have been less affected by this dynamic and my own experience has been that many of these types of transactions have continued through the recent slump. In fact, you could probably make the argument that the low cost of financing has actually made it a pretty healthy market for strategic buyers over the last several years.
Several other factors could also lead to increased private M&A activity this year. The baby boomers continue to age, and it has been upwards of five years or more since there was a good market for selling many businesses. Potential sellers may be looking towards a retirement or retrenchment and would like to get a good price for their business in the face of so much uncertainty—not only for taxes and borrowing costs but also the multitude of other factors currently making markets highly volatile.
Additionally, there simply is a lot of money on the sidelines waiting to be deployed. Recent estimates suggest that there is approximately $425 billion of committed but un-deployed private equity capital. Even using less than historical leverage ratios, this could represent up to $1 trillion of buying power. Moreover, private equity firms are generally going to prefer spending the funds (thereby generating fees for themselves) rather than returning the capital to investors. Simple supply/demand mechanics suggest a more robust 2012.
It is certainly possible that intervening circumstances may trump the factors listed above. However, anyone who may want to sell a business in the next few years should take a hard look at whether it would make sense to close a transaction in 2012.
Kyle Jones is a shareholder in Fabian Law’s Business Organization, Tax and Transactions practice group.