“Should I sell my company now or wait until the economy improves?”

Many middle-market company owners are asking us and themselves this question. In order to provide some guidance to business owners and their advisors, we are in constant communication with strategic and private equity investors and lenders to understand their investing appetite as this recession unfolds. Additionally, during the week of January 19, I had the opportunity to attend several “economic forecasts” presented by a number of well respected economists. What follows is a summary of what I am hearing as it pertains to valuations of middle-market companies.

The overriding issue is that the decreasing availability of credit and the ever increasing cost of capital have forced valuations down over the past few years. The market has seen a significant decline in total leverage used in deals, driven in large part by the decline in senior debt availability. The net result is that institutional investors/private equity funds are now required to invest more equity to complete transactions. However, it is important to understand that even in this uncertain economic environment private equity investors and strategic buyers are interested in investing in or acquiring good quality companies with revenues and earnings remaining steady or growing; that “supply and demand” has kept the valuation of such companies at a premium to today’s market; and that there is debt financing available for the acquisition of middle-market companies - generally from regional banks - though in smaller amounts and at higher rates than 12 – 18 months ago.

However, if owners considering selling their companies are expecting to achieve the same valuation they might have 18 or 24 months ago, it simply won’t happen. Values at that time were inflated as a result of the investors’ ability to put probably too much debt on companies’ balance sheets; there was a sense that the economy was going to continue to grow for the foreseeable future. That bubble burst; debt is now almost impossible to obtain; we are in a recession that may last for another 12-18 months; and investors will not pay today the premium of 18 months ago even for good quality companies. And, based upon what I am hearing, those kinds of values may not be seen for 5 to 6 years.

While little of what follows points to anything that is unprecedented, it is clear that there will be economic challenges for some time. Fortunately, our government and governments around the world are taking swift and aggressive action that should help quell the market’s fear and allow the world economies to rebound. However, that turnaround and recovery will take time.

With that in mind, the question that should be asked is, “In order to maximize my company’s valuation, should I sell now or wait until the economy improves?”

In order to answer that question, there are a number of issues that need to be addressed not the least of which are, “How long will this recession last and how deep will it go?” Below is a summary of what we are hearing that would lead some to conclude that it may be a wait of 3-4 years or more before valuations get back even to today’s levels.

Commercial Banks

  • Banks have written down about $1.0 trillion in loans on their books to date with at least another $1.0 trillion to go.
  • Banks cannot raise new capital from public markets as their stock prices have fallen precipitously.
  • Banks are not and probably should not be aggressively lending in this difficult economy.
  • Loans being made today are usually to existing borrowers, at low advance rates and at higher costs.
  • Not withstanding the money government is pouring into lending institutions, credit will continue to be tight for the foreseeable future.
  • Corporate borrowing rates even for good quality companies will continue to rise at least through ’09.

Households

  • Household balance sheets (home values, personal investment portfolios, 401k accounts, etc.) have lost somewhere between $7 trillion to $10 trillion since the peak.
  • People are concerned about keeping their jobs so are paying down debt, trying to save and are not spending.

Real Estate

  • Residential real estate values still have to fall another 15% to 20% to get to a sustainable level.
  • It is estimated that there is an inventory of about 3 million homes for sale nationally, about 1 million above a normal level (John Shoven, Economics Professor, Stanford University).
  • The Wall Street Journal on January 23, 2009, reported that home construction is at a record slow pace and that “a drop-off in permits for future projects suggests the declines will continue”.
  • Commercial real estate is “the next shoe to fall”; commercial mortgage defaults are on the rise.

Auto Industry

  • Inventories are rising; sales are falling.
  • It is projected that domestic sales for ’09 will be less than 10 million units, which is below the level at which manufacturers can generate a profit.

States/Municipalities

  • Tax revenue is falling.
  • Particularly in California as a result of Proposition 13 (the 1978 voter initiative that caps property taxes) with residential real estate values at record low and still falling – down from 50% to 75% at the peak, property tax revenue will be significantly lower than what it has been and will not increase until ‘12-‘13 and then at only about 1% per year (SF Chronicle, January 25, 2009).
  • There are no good places to make meaningful budget cuts.

Unemployment

  • California unemployment rate hit 9.3% in December ’08, a jump from 8.4% in November (SF Chronicle, January 24, 2009).
  • It is feared that California’s unemployment rate has not hit bottom with most sectors of the state economy still losing jobs (SF Chronicle, January 24, 2009).

Retail

  • It has been estimated that approximately 150,000 retail stores have shut down nationally in ‘08
  • It has been estimated that another approximately 300,000 retail stores will shut down in ’09 through ‘10.

Public Equities

  • On a global basis, the value of public equities has dropped by over $30 billion (Goldman Sachs January 2009 Report for Private Wealth Management Clients).
  • Look at a sampling of worrisome headlines from a single recent <em>Wall Street Journal</em> of January 23, 2009:
    •   “Chrysler, Fiat Show Signs of Mounting Trouble”
    •  “Microsoft, Too, Is Hurt by Recession”
    •  “Google Net Hit by Charge”
    •  “Sony Plans Deeper Cutbacks”
    •  “Huntsman to Cut Jobs and Close British Plant”
    •  “Hyundai Net Drops 28%”
    •  “AMD Posts Hefty Loss as Chip Sales Fall”
    •  “Nokia Forecasts Weaker Demand”
    •  “TSMC Warns of Red Ink for Quarter”
    •  “Samsung, LG Electronics Post Losses”
    •  “Resorts Atlantic City Faces Foreclosure Threat”
    •   … and is seems to go on and on.
  • With corporate profits continuing to fall, it seems that few domestic or foreign investors will want to buy equities until it is clear that we have hit bottom.

Exports

  • 50% of credit derivatives were bought by non-US investors leading to weakening economies around the world.
  • Falling consumer spending around the world is reducing the US’s ability to export – exports were the strength in our economy until late ’08.

Eurozone

  • The economy is slowing rapidly and many forecast the worst recession since the end - Very few companies are hiring BUT by law they cannot lay people off.
  • As a result, economic problems there will be longer and deeper than in US.
  • Industrial output is off with consumer spending decreasing significantly in the Eurozone and in Eastern Europe.

China

  • Industrial production is declining rapidly.
  • Until recently GDP growth has been at a 13% level.
  • It is now projected that growth for ‘09 will not exceed 7%.
  • BUT below 8% China cannot support the job demand created by population growth.
  • As a result, unemployment will rise dramatically which will significantly dampen consumer spending and demand for imports.

Conclusion

  • Adding all this up, many are forecasting:
    • Negative US GDP growth throughout most if not all of ’09 or well into ’10;
    • Return to positive growth in late ’10 or early ’11;
    • Slow recovery with “crippling” budget deficits into ’12 and ‘13.

Again, if a business owner is considering a sale or a recapitalization, these conclusions would suggest doing so as soon as possible as the wait for valuations to return to current levels could be 3-4 years.

If we at Wood Warren can be of assistance to you or your clients in determining how all this impacts them, please contact me at 510-420-3855 .

We welcome your comments.