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Posted: January 16, 2012

The flight to quality

It's a sign of the economic times

David Tolson

Many buyers or investors are still searching for quality opportunities. The recession has highlighted both weak and strong companies. The identification of good investments, from a buyer's perspective, has taken more time and diligence.

In addition, there have been a lot of struggling companies looking to sell which has tilted the supply and demand curves in favor of buyers. In essence, investors, out of necessity, have the requirement to be more diligent in their assessments of opportunities. This is generally good news for good, quality businesses, as those types of companies are garnering more attention in this market.

So what exactly is a flight to quality? Generally, it's the notion of investors moving away from risk towards safer investments. Such is the case with mergers, acquisitions and investments in today's economy.

What defines a "quality" investment is arbitrary. An investment firm initially thought our client was a great fit, then decided to pass. The investor used eight criteria to evaluate the opportunity, and our client hit only seven.

What really drove the decision to pass may never be known. In the fast and loose times of 2006 and 2007, most investment firms would look at something like this and put a deal together. Today, however, buyers and investors are still risk averse and looking for the perfect fit.

Through 2011, most investment bankers and deal attorneys saw virtually the same thing: an inordinate amount of analysis being done before Letter of Intent, and then extensive amounts of due diligence post LOI in an effort to find "perfect." This highlights the fact that buyers are taking their time to really understand a business, its operations, its organizational structure, and the fundamental value drivers in the business before they'll commit to investment or acquisition.

Perhaps another reflection of this flight to quality is the response of private equity. Many private equity groups today are only looking at deals that are directly in the wheelhouse. This may be due in part to some private equity funds getting low on funds to invest but the data states the contrary. Most investment bankers believe that there is in excess of $1 trillion dollars in cash from private equity that is ready for investment.

Strategic investors are reflecting this risk avoidance as well. For ten consecutive quarters, public companies have been hoarding cash. Estimates right now put the amount of cash on public company balance sheets at close to $2 trillion. Why so much cash? Quality. The value of a cash position today (for corporations) is higher than the value of investment either within their company or in acquisitions. Financial returns become less important in an environment when cash is truly king. Let's face it, in this market, cash is certainly king, and will most likely continue to be the monarch of this economy.
Let me be clear; I am not saying that the markets are terrible. Nor am I saying that those interested in selling shouldn't consider doing so now (per Chris' earlier article - anyone need a haircut?). As reported by Thomson Reuters, deal volume (measured in dollars) in U.S. Small Cap M&A was up 3.5percent in the 3rd quarter of 2011, over the same period in 2010. This is a good sign. The actual number of deals was virtually flat for that period. The high tech sector represented the largest share of market activity in this segment, which usually acts as a leading indicator to economic resurgence (let's hope that's right).

What does all of this mean? First, we will see more deals done in 2012 than in 2011. As the economy continues to rebound, we expect to see increases in both volume and the number of small cap deals. This also coincides with the significant amount of cash that private equity has to invest and that public companies have on their balance sheets. Investors (strategic and private equity) require confidence to pull the trigger on the more than $3 trillion worth of investable dollars sitting in the markets. As they get more confident, they will start to be less conservative in their assessments and release some of the capital in the form of investment and acquisitions that leverage said optimism.
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David Tolson is Managing Director of CapitalValue Advisors, LLC. Since 1992 David has worked in small and middle market based businesses in operations, sales, and marketing, and has extensive experience in appraisals and mergers and acquisition. He is widely regarded as an expert in middle market private company valuation. He has conducted numerous seminars, taught senior level university courses in organizational management, and been featured as a special speaker at the graduate level on strategic planning and acquisition strategies at both Colorado State University and the University of Colorado. Additionally, he is the co-author, along with Chris Younger, of the book Harvest: The Definitive Guide To Selling Your Company.

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