Following the money: Schmidt, Barnes and Christhilf talk deals, valuations and taxes
YARMOUTH, Maine—A number of big deals happened in 2012: the split-up of Tyco, the acquisition of Vivint and the creation of Securadyne, to name a few. As the end of the year approached, Security Systems News conducted a virtual roundtable with industry experts about the deals that went down and those that did not. How did valuations compare to 2011, and were buyers’ and sellers’ expectations matching up?
Weighing in on these topics were Will Schmidt, managing director of CapitalSource; Michael Barnes, a partner in the consulting and advisory firm Barnes Associates, which specializes in the security alarm industry and co-sponsors the annual Barnes Buchanan Conference; and Stuart M. Christhilf, principal at Pamlico Capital.
SSN:What was the most interesting deal of 2012? Why?
Schmidt:Vivint being acquired by Blackstone was the most interesting deal of the year because it demonstrated again that there continues to be a strong appetite from the private equity community for security alarm companies. Furthermore, this transaction continues to raise the bar on the size of companies that private equity targets within the industry and the amount of capital they are willing to invest.
Barnes:I think the most interesting deal in 2012 is the spinout of ADT’s residential and small-business unit from Tyco. First, it takes ADT out from under a conglomerate and offers investors a pure-play investment with the 800-pound gorilla of the industry. Second, it detached ADT residential from its large commercial operations, which remained with Tyco. This runs contrary to conventional wisdom, which has historically asserted large operating synergies associated with the combination. The thought is that the new ADT will be a leaner, more focused player. Lastly, it changes a critical reference point within the industry. Now the largest player is clearly a residential-market-oriented company, rather than just a subset of the entire industry. Combine this with the recent recapitalizations of Vivint and Monitronics, both of whom are similarly focused, plus the entry of several very large MSOs and cable companies, and things look very interesting in the residential-market side of the industry.
Christhilf:There were a number of interesting deals in 2012, including bigger headline-grabbing deals on the residential alarm side, such as Blackstone’s purchase of Vivint, and buyouts of smaller, growing interactive service providers, such as BV’s purchase of DTT or TCV’s purchase of Alarm.com. You are seeing significant focus on providers of innovative new security/building automation services that are improving the return on investment and value proposition to the end customer right now. For us, given our focus on the systems integration space with Securadyne, we thought KRG’s recent purchase of Convergint was extremely interesting. It demonstrated a strong interest on the part of the financial community, in the form of both private equity firms and lenders, [and] in platform-grade commercial systems integration. M&A in this end of the market has been dominated by strategics over the past number of years, and you really haven’t seen a systems integration deal of this scale that was so widely pursued by financial players in some time.
SSN: Can you make some generalizations about valuations this year for alarm companies and systems integration companies? Up or down from 2011?
Schmidt:Valuations continue to remain strong. Based upon the transactions we have participated in during the year, it appears that there has been a modest upward trend in prices for the best-performing account bases in 2012. The market does remain disciplined, so sellers cannot assume that they will automatically realize the same sale multiples. The market is generally efficient, with the top-performing businesses being rewarded with the highest valuation multiples.
Barnes:Generally, market values for alarm companies strengthened in 2012. We are right in the middle of finishing up our surveying and analysis for our upcoming conference in February, so the full extent of the firming in values is not exactly clear. While overall averages will be up, we are seeing a widening spread between the highs and the lows. That is, the market is getting increasingly efficient, with a strong bias toward companies that have [achieved] and can achieve systematic growth above the overall industry rate.
Christhilf:It is always hard to make generalizations about valuation trends, as data is incomplete and different segments of the market can be trending differently. But overall, our experience in the middle market would suggest that alarm monitoring valuations driven by RMR, EBITDA and SSCF multiples remained elevated at roughly the same levels in 2012 as they were in 2011, and that systems integration multiples of EBITDA were also relatively stable year over year. Despite macro pressures and other headwinds, valuation levels (as well as lending levels) have been strong, as the security sector can be somewhat recession-resistant and is benefiting from favorable trends around local and national security concerns, advancing technology, increased service offerings to market, [and] growing regulatory-driven demand.
SSN:A lot of deals happened in 2012, but several quality companies were "shopped around" but not acquired. How would you characterize expectations for valuations among systems integration company owners and alarm company owners? Are the expectations generally in line with what buyers/lenders are willing to pay?
Schmidt:While there is talk of a couple of companies being “shopped around” and not trading, we see this as indicative of the strength and stability of the operating platforms and not necessarily a large bid-ask spread. Most disciplined sellers evaluate any sale offer against the risk and return of continuing to own and operate the business. Given the strong and stable operating performance, friendly capital markets and limited attractive alternatives to redeploy capital, in some cases continuing to own and operate the business was more attractive than selling.
Barnes:A number of companies looked for buyers in 2012 but did not consummate a deal. This is not unusual in a strong, changing market with overall high average valuations. Every day that a business owner doesn’t sell at the market price, he (or she) is effectively buying the company at that price. With rising valuations and a potentially changing future, the hold/sell gap has narrowed and more owners are contemplating a sale. But, as I mentioned earlier, the market is more choosy and it often takes a sale process to define the value and allow the owner specific clarity on the issue. Sometimes, the value ends up below expectations and the company will not trade.
Christhilf:There were certainly a few notable deals in 2012 that suffered from sellers’ expectations exceeding those of buyers’, and we currently view valuations as relatively high across our sectors of focus, although that is not necessarily a new phenomenon. When selling a business, you often see sellers attempt to get value for growing pipeline activity, expectations of reducing attrition, investments made previously in sales efforts, or various other adjustments or future activities that are not being fully reflected in the current financials and that can create significant differences of opinion on what is “fair value” for that business. Particularly in the uncertain times we lived through in 2012 and will continue to live in during 2013, it can be hard for buyers, who will often view those future value-drivers with greater skepticism, to pay sellers their view of “full value” today. And sellers that are invested in quality assets that are performing in this space today often have the luxury of waiting until they execute and grow into their targeted valuation in the future.
SSN:There was a lot of talk in 2012 about the potential benefits of getting deals done before Jan. 1, 2013 because of possible tax increases. What's going to bring sellers and buyers to the table in the new year?
Schmidt:While the tax changes have certainly created a sense of urgency in the second half of 2012, we believe that tax strategy is only a small factor in the overall decision that drives a transaction. Despite 2013 being unlikely to benefit from tax-motivated selling, we believe that there will be a carry-over of transactions that did not get completed in late 2012 that will still occur in early 2013. Furthermore, the consolidation economics of the industry remain intact and there is no reason to expect that the market won’t revert back to the normal measured pace of strategic acquisition. Also, technology continues to make a big impact on the residential and commercial markets, so we would expect to see strategic fill-in acquisitions as industry participants look to round out their product sets.
Barnes:The prospect of change will be the primary catalyst that will bring buyers and sellers together in 2013. New business models, applications, technologies and competitors are a given. What now also appears to be a given is higher tax rates. Ultimately, it is the net after-tax yield that is important to business owners in the hold/sell analysis discussed previously, so the prospect of an abrupt change downward in net realizable value can create a strong incentive, particularly for those who were likely to seek to sell in the near term anyway. Sadly, I think we are in for a number of future years where rates will likely go up and create specific short-term incentives and distortions in the market. Interestingly, the security alarm industry is particularly sensitive to changes in tax rates. A combination of operating dynamic and accounting treatment typically results in very little of the value created by most alarm companies being taxed in the period in which it was created. … All of this untaxed value, however, comes to light in a sale event, which makes owners very sensitive to the prevailing rates at the time of the transaction.
Christhilf:While tax concerns clearly drove increased M&A activity in 2012 like they did in 2010, we saw a lot of middle-market deals also driven by other factors: Sellers who had been sidelined for two to three years in the recession looking to gain liquidity; new security technologies and technology-enabled services that had been early-stage and often unprofitable starting to show greater promise; and both strategic and financial buyers leveraging their strong cash balances and receptive financing partners to support targeted M&A strategies. We see these specific drivers, as well as the higher-level trends of an increasing focus on security concerns locally and nationally and the growing convergence of logical and physical security, continuing to support deal activity in 2013. So, if you assume that the world doesn’t spin off of its axis due to the fiscal cliff, European debt crises, geo-political issues or other calamities, and that we have a slow, plodding recovery, I think you will see sellers looking to monetize their investments at continued favorable valuations and interested buyers looking to play in what continues to be an attractive sector.