Editor’s note: David Gilroy is managing director of Hyde Park Capital.
_______________________________________________________________________________________A July 18, 2005 Business Week article began with “Tech companies aren’t just rich these days — they’re filthy, stinking rich”.

This story went on to discuss how companies like Oracle, Microsoft, HP, Motorola, and others are expected to be actively on the prowl for logical acquisitions given their enormous amount of cash on-hand and the intense pressures for fast growth applied by public markets.

In my last article a few months ago, I reviewed several of the forces at work that led to a breakout year in mergers and acquisitions in 2004. How are we doing overall through the first half 2005? Are large companies really out hunting actively for innovative young companies to acquire?

The answer is that conditions are good, not great — or, at least, not great yet. The two fundamental metrics — the number of closed deals and total value are moving in opposite directions, somewhat ironically. Through the first half of 2005, there were 5,259 closed M&A transactions in the US compared to 5,779 in the same period last year (down 9%). And yet the total value was up 36% from $478 billion to $649 billion. We attribute this to two factors:

  • An ongoing stream of mega-deals or “bellwether” transactions (e.g. deals such as Sprint — Nextel, J&J — Guidant, BOA — MBNA), that bring overall dollar value up quite high

  • Fewer tiny, “fire-sale” transactions involving companies sold under conditions of distress or just for whatever residual value the market would bear. There were relatively more of these kinds of deals in 2004 coming out of the awful market conditions from 2001 through 2003 that caused many companies to cry “uncle”.
  • Focusing on the middle market, or transactions with values less than $500 million, we still see similar dynamics. While the number of deals was down 10% during this period, average valuation as measured by EBITDA multiple expanded from 8.5X to 11.7X.

    Other Exits

    Now let’s focus on tech, healthcare, and growth services and look specifically at VC-backed exits just in the last quarter (Q2 2005). Here are the highlights:

  • The IPO market continues to flounder, as the number of IPOs declined significantly from a year ago – only five U.S. companies completed offerings, raising total of $232 million. That compares to 24 IPOs in Q2 2004 raising $1.35 billion. Q2 VC-backed IPOs were at the weakest level in two years. This is a function of cumbersome legal/regulatory requirements, the elevated cost to be a public company (some estimate this at up to $2 million per year), the lackluster prior performance of recent offerings, and the uncertain outlook in the IPO market

  • M&A continues to be the dominant channel to exit and liquidity for private investors. 77 venture-backed U.S. companies were acquired in Q2 2005. The total amount paid of $6.8 billion, a 14% increase from Q2 2004, although the number of M&A deals declined from the 100 that were completed the same quarter a year ago. For 1H 2005, total amount paid in M&A transactions was $14.0 billion in 165 deals, an increase from the $12.3 billion paid in 204 transactions in 1H 2004. Again, we see the higher value, but lower total # of transactions

  • On the very positive side, good companies are getting purchased for good value — again there are fewer and fewer “fire sales”. The median amount paid was the highest on record in Q2 in nearly 5 years ($70 million).

  • Health care and products/services companies were acquired at higher prices than technology companies. The median amount paid for a health care company in Q2 $172 million, and $171 million for products/services companies. Tech companies sold for median value of $38 million

  • Many start-ups that were acquired in Q2 were initially financed around 1999 and 2000. 5.4 years was the median time between initial equity financing and acquisition (longest time period in over 10 years). As a reference, the median age of companies completing IPOs in Q2 was 6 years.
  • Looking Ahead to Rest of Year

    Now, what about the back half of 2005? How strong is the outlook for M&A in the middle market? Our answer – plenty strong. Let’s look at the underlying drivers:

    The supply side of M&A markets is driven by:

  • Improving financial performance and better market conditions giving sellers more confidence

  • Ongoing corporate divestitures as large companies hone portfolios strategically

  • Lower historical capital gains tax rate of 15% on sale

  • Diversification of net worth and “2 bites of apple” strategy. This is about owners who believe this year is still too early to sell completely, but want to take considerable money off the table while participating in substantial upside later. Thus, they consider selling 50 — 70% of their company.

  • Preference for M&A over IPO (liability/ risk/ expense/ liquidity/ Sarbanes Oxley)

  • Pent up demand from retiring company owners who have waited (the demographics are unyielding — so many 50- or 60-something business owners ready to retire)

  • Aging of VC and PEG portfolios and chronic need for exits.
  • The demand side of M&A markets is driven by:

  • Increasing strategic buyers interest

    A. Increased business confidence by corporate BODs and CEOs
    B. Renewed focus by corporate buyers to augment organic growth through acquisition
    C. Opportunities for consolidation, economies of scale and synergies
    D. Generally increasing stock market values
    E. Key driver of innovation
    F. Accretion to earnings
    G. Cash on-hand!

  • Increasing financial buyer interest

    A. Proliferation of private equity funds looking for deals
    B. Large VC funds increasingly moving from investment to acquisition
    C. More leverage available and aggressive lending resulting in ability to pay higher prices

  • International demand

    A. Strong interest from UK and Europe due to depreciated value of US $ versus EC (“25% Off Sale”)
    B. Increasing demand from Asia/China (e.g. IBM/Lenovo; Unocal/CNOOC)

  • Clearly, the fundamentals call for steady to improving conditions in M&A. In my next article, I’ll look at the non-exit side of M&A, or the increasingly common trend of two small, private companies coming together to create shareholder value through a stronger product/service value proposition, lower fixed cost as a percentage of sales, and the advantages of scale.

    Dave Gilroy is Managing Director and heads the Charlotte, North Carolina office of Hyde Park Capital (www.hydeparkcapital.com ). He focuses on M&A advisory and expansion stage financings for technology, healthcare, and growth services companies in the Carolinas and Atlanta.

    Gilroy formerly spent more than five years full-time at Wakefield Group, a leading North Carolina venture capital firm where he remains a partner in the third fund, and is a board director or advisor at three technology and healthcare companies here in the Triangle (Bloodhound Software, Biolex, and Integrian). He also spent several years as a corporate acquirer of middle market businesses at European conglomerate, CRH plc., and at McKinsey & Company both in the US and in Asia. He is an honor graduate of Princeton University’s School of Engineering and Harvard Business School.