Financial Windfall: A perfect storm is brewing for small business acquisition

Ever since the American economy went south in 2008, we’ve been told about a “new normal” of modest growth and lower expectations. Driven by a Fed policy that favored larger and well-connected borrowers and crowded out smaller ones, the new normal period seems to have lasted a lifetime. 

Suddenly, that growth-challenged period appears to be getting smaller in the rearview mirror. Commercial and industrial bank loans rose at an impressive clip in the first two months of the year, increasing by $38.3 billion, or 19.4%, in February alone, according to data provided by the Federal Reserve. That’s the largest monthly increase since 2008, and some attribute this to the Fed tapering its bond-buying program, because now that the Fed is borrowing less from banks in order to buy bonds, less credit is being diverted away from job creators.

“We have seen a healthy recovery for a lot of people that own and run companies, that feel that their life has kind of gotten back to where it was before 2008 and 2009.” — Nathan Brinkman, president, Triumph Wealth Management

Others attribute the increase in business lending to increased appetite for risk among businesses themselves.  A recent BMO Harris Bank survey, released in January, found that 85% of Wisconsin business owners of different-sized organizations feel their businesses will either grow or remain at the same level in 2014. A majority of them (56%) plan to invest in their businesses this year, either by upgrading or purchasing new equipment (28%), expanding operations (20%), or hiring new employees (20%).

Jon Schumacher, senior vice president/managing director of southwest Wisconsin commercial banking for BMO Harris, says BMO sees the growing demand for industrial and commercial loans as more closely tied to business sentiment. After a prolonged period of low business demand for borrowing, “We’re seeing positive signs on the demand side, but the amount of capital in the market today is, we feel, very sufficient,” he stated. “In fact, in some regards it’s creating a little bit of competition in the market again.”

Whatever the explanation, the infusion of capital raises hopes for more robust economic growth in 2014. When combined with a low interest rate environment for long-term debt — an environment that could begin to change sometime next year — it creates a window of opportunity for younger entrepreneurs interested in acquiring businesses from baby boom business owners who are interested in selling, especially as they near retirement. 

Federal Reserve Chairwoman Janet Yellen offered new guidance last month on when the Fed would begin to consider raising interest rates — about six months after the tapering ends this fall — but any move away from today’s historically low prime rate (and toward less liquidity) likely would be incremental. So that perfect alignment of stronger business lending, more appetite for risk, and extremely low rates is likely to last for another year. 

Josh Marron, vice president of commercial banking for Middleton Community Bank, confirmed that his bank has been more active with commercial lending this year, both for familiar and new customers. Overall, he says banks in the Madison market are liquid, with plenty of funds to lend. “The more we are lending, the more comfortable we’re getting with the market,” Marron said. “There is a lot of opportunity right now for small businesses and/or commercial real estate developers to continue to take advantage of some pretty decent interest rates.”

Multiple motivations 

Whether they preserve their businesses with second- or third-generation family members or with trusted longtime employees, business owners have a sense of legacy. When they look back, they want the satisfaction of knowing they handed their business off to the right person.

A low interest rate environment isn’t the only motivation for buyers or sellers. There’s also timing. Nathan Brinkman, president of Triumph Wealth Management, helps business owners with their financial planning and retirement. Five or even seven years ago, a number of them had targeted early retirement dates and then, due to the economic downturn, had to delay those plans. Now that they feel the ground is more safe and secure, they are re-engaging in the active processes of retirement planning, or at least slowing down their work activities.

“We have seen a healthy recovery for a lot of people that own and run companies, that feel that their life has kind of gotten back to where it was before 2008 and 2009,” Brinkman said. “They are looking at the fact that in order to stay competitive in business, it’s going to take some capital improvements and structures in which they most likely won’t get all their money back, given their time frame and timeline. So what it does is create great opportunity for them to maximize their dollars with the sale of their business. 

“It also gives those interested in acquiring businesses a good opportunity to buy a business that has been through the ringer, that is probably as strong if not stronger than it was pre-recession.”

Ron Smith, who owns Smith’s Service Center along with his wife, Diane, is planning to transition the business to his son Scott, who represents the third generation of the family-owned auto and truck repair center on Madison’s east side. At age 59, Ron Smith will spend the better part of the next year developing a succession plan, which starts with updating the value of the business. The process has already begun with Scott’s elevation to service manager, and will continue over the next three years. “We don’t know if it will be a 100% outright sale and we’ll just retain the building, or whether we’ll retain a portion of the business as well,” he says. 

Bank financing likely will be involved, but today’s low interest rate environment isn’t influencing Smith’s thinking. The timing just happens to be right, and he’s fortunate to have some of the lead time that succession-planning experts say is crucial to executing such a transition. For Smith, the lead time is necessary because this succession process will be much more complicated than the last one. That transition occurred 25 years ago, when Smith took over the business from his father. Since then, he estimates, the value of the business has increased tenfold.

“We have more people involved in helping us make the decisions,” Smith noted. “We’re working with somebody that specifically does succession planning, as well as our accountant and our lawyer. Back when I bought the business from my dad, it didn’t have the value that it does now, so it was a lot easier to do. Back then, we didn’t do it with any bank financing. I bought him out through the business, so it was pretty simple. We were able to sit down, and over the course of a dinner with our accountant and lawyer, we got it all done.”

With the help of a loan from State Bank of Cross Plains, Aaron Gibbons recently purchased a 50% interest in K&M Concrete in Middleton. In January 2013, he looked into purchasing another concrete business, but the owner hadn’t taken the step of appraising the business and had let go of his employees the previous month. “By the second week in January, the guys had kind of moved on, and there weren’t other contracts out there,” Gibbons recalled. “That had ceased to be a business already, and that’s why I wanted to move as quickly with this [K&M acquisition] as I could.”

Gibbons was able to secure financing, but historically low interest rates were not much of a motivator in acting before the end of 2013 — it was the continuity of bidding on work. The company is a subcontractor that provides concrete foundations for residential and light commercial projects. “The factor that was motivating me, for the speed in which we pulled this together, was that all the employees were here and working, and I wanted to keep them working so they didn’t need to find a job someplace else,” Gibbons stated. “In a lot of ways, this is a business that makes all of its money between April and October, and you’ve got to be in a position to hit the ground running as soon as the weather warms up. If you’re not bidding that work in December, January, and February, it’s going to be hard to be successful.”

(Continued)

 

For a variety of business reasons, Mallatt’s Pharmacy & Costumes of Madison purchased Harris Pharmacy in Waunakee and Lodi in late 2012. Since taking ownership in 1992, Mallatt’s President Mike Flint has been slowly growing the business, which now includes four retail pharmacies and a long-term-care pharmacy. The recession had a delaying impact on his growth plans, and he has never before seen banks scrutinize a loan like they did with the borrowing needed for the Harris Pharmacy acquisition. 

“The auditor from the bank went so far as to have me prove that I actually dispensed a particular prescription for a particular patient,” Flint stated. “It has never been as detailed as that.” 

Rich Harris, longtime owner of Harris Pharmacies, had a “conglomeration” of reasons to sell, including the fact that long-term capital gains rates were scheduled to increase from 15% to 20% in 2013. In addition, the business had grown to 44 employees, profit margins were lower, the regulatory environment was more cumbersome, more pharmaceuticals were obtained through mail order, and even with pharmacy backgrounds, neither of his daughters were able to assume ownership. “If this had been 1955, I could have kept it in the family,” he lamented. 

Still, “if you run a profitable business, you’ll find a buyer,” he said of his fellow baby boomers looking to sell. “If you’re struggling and things aren’t going too well, you’ll have problems.”

Sales call

In 2012, Frank Peregrine, vice president of business development for the Markham, Ontario-based Enghouse Networks, sold CustomCall Data Systems to Enghouse Systems Limited for $7.3 million. Peregrine and his wife, Laurie, owned 80% of CustomCall, which provides telephone billing systems to telecommunications companies. When Peregrine first entertained selling the business, he thought it might take 10 years to complete a transaction.

Given the difficulty small technology businesses have in the M&A market, Peregrine considers himself fortunate that some investment banks focus on smaller transactions like his. The number of companies that make bids on smaller firms is very small, he explained, and it’s a real challenge to get a good offer from somebody who actually is writing a check.

“There are middle-market firms anywhere from $1 million to $100 million in value, so it’s a wide range,” Peregrine noted. “Bigger players doing regular acquisitions of technology companies don’t look at these small companies. We would have been a great fit for somebody like Oracle. We compete with them in a few areas, but we are just way below their radar.

“Our business was not $10 million in revenue and not $10 million in market value, and we’d probably have to be at $100 million before they’d even consider taking a look at that.”

After treading water the first five years, CustomCall grew to 30 employees and paid off its debt by year 10. The business had weathered the recession and was hitting on all cylinders by the time the Peregrines entertained offers. “We were in the upper 50s and thinking, ‘one of these days, we’re going to want to sell the business and retire anyway. Why not now?’” he recalled. “You never know — in two or three years, things could go horribly wrong and you’re wondering why you didn’t do something before.”

Pending tax increases were another factor in the timing. Not only were long-term capital gains rates scheduled to increase, one of the funding mechanisms of the Affordable Care Act was a 3.8% tax on couples earning more than $250,000 per year. Needless to say, CustomCall’s shareholders were happy with the timing. “When you sell a business, you are going to make more than $250,000 that year,” Peregrine noted. 

Since the sale, Peregrine has represented Enghouse in a business development capacity. Most potential acquisitions come to his attention through investment banks; others are uncovered in direct conversations with business owners. So despite the fact that CustomCall’s sale came together faster than expected, Peregrine has a fresh angle on the disadvantage small firms have in comparison to the big boys.

“For corporations right now that are big enough to borrow money on a bond note issue, rates are cheap. I mean, they are really cheap,” Peregrine stated. “There are companies like Apple out there raising money through the issuance of debt, yet they are sitting on however many hundreds of billions of dollars in cash. Why are they doing that? Because it’s so cheap. If you can get 30-year money for 3.5% or something similar — wow! We’ll never see that again the rest of our lives, so they are doing that now.”

For smaller business acquisitions, Peregrine does not believe the low interest rate environment matters as much as access to capital. Until recently, banks have been lending money to smaller businesses only if they had money. He acknowledges that regulatory pressure has something to do with it, but “it’s almost as though it had to be a risk-free loan for them,” he added.

If the early returns are any indication, this could be changing. “I wouldn’t doubt it,” says Peregrine, who is involved in a residential development project known as The Vineyard at Cambridge. “We have a $4 million or $5 million project altogether, and we plan to borrow 75% of that. We don’t have a real good feel for what’s out there, other than people have said this bank or that bank is looking to make loans. In other words, they are sitting on money. 

“It costs them almost zero to borrow from the Fed, about 2.5% for overnight funds, and now they are looking at building their loan portfolios.”

Sunny money

Before the economy went south, the prime rate was much higher and it wasn’t unusual to see interest rates north of 6%, in some cases up to 10%, for commercial loans. “The funny thing is, we still lent money then,” Marron recalls. “People still did business and transactions still happened. People still utilized small business lending because those needs were still present. Even if we are in a rising rate environment, business still has to happen.” 

For the time being, it’s likely to happen with short-term lending. Knowing that the Fed has signaled its intent to start raising interest rates in 2015, many banks don’t want to get caught making long-term loans at fixed rates. As a result, they are more willing to make loans with terms of three years or less rather than loans with terms of five years in order to avoid getting caught behind the rate curve.

If the deal is right with a credit-worthy customer, they will extend to five years, but three years is a standard term for business loans, and rates will be adjusted to whatever the market rate is after three years. “You have to plan for what could happen after three years,” Marron says. “That potential buyer really has to understand their projections and certainly have realistic projections for that business to succeed.”

Wisconsin banks made roughly $11 billion in commercial and industrial loans in the fourth quarter of 2013, according to data provided by the Federal Deposit Insurance Corp. Rose Oswald Poels, president and CEO of the Wisconsin Bankers Association, noted that data provided by the FDIC has shown a continual, albeit small, upward trend in lending for the past few quarters. 

It’s also clear that bankers put more stock in low interest rates than business owners. “Anecdotally, the WBA has heard that lending for the first few months [of 2014] is trending up as well, although it’s difficult to accurately gauge quantity of lending at this point,” she noted. “The rate environment continues to be favorable, so now is a great time for entrepreneurs of any age to approach a bank for a loan.” 

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