Welcome

We are happy to provide you with another edition of M&A Spotlight. The spring weather has arrived here in the Mid-Atlantic, and as we start seeing signs of life in nature, the economy is also beginning to show signs of a long-awaited rebound. Along with these changes in the economic cycle, will come market forces that all middle market businesses need to monitor and address. Our article in this edition of the M&A Spotlight is written with those trends in mind.

We are especially grateful to our clients and referral sources as it is because of these strong relationships that we are able to advise so many companies in their business transactions.

As always, our SC&H Capital team is prepared to invest time getting to know your business. For more information on our services or to schedule a complimentary advisory session, please call me at (410) 785-8049.

Best Regards,
Christopher Helmrath, Managing Director

Bank On It

By Christopher Helmrath, Managing Director, SC&H Capital

The cost of borrowing will increase and contribute to the downward pressure on valuations in the middle market.

The statement above is based on a series of factors that, combined, create increased pressure on lending institutions. These factors include a looming downturn in commercial real estate loan markets; increased capital regulations on the banking system; and the pending rise in interest rates, which will be required to stave off inflation. These factors will place increased pressure on the use of funds which will result in downward pressure on the supply of funds available in the market. As the supply of money tightens, and the cost of capital increases, valuations in the middle market will decrease.

By some estimates, there is approximately $38 billion in commercial real estate debt that is set to mature in the next 12-24 months, with a concentration of the current debt residing in small to medium-sized banks. When many of these loans were originally made, capitalization rates were in the 5-6% range but are now in the 8-10% range. This change, coupled with decreasing net operating income levels due to higher vacancies and lease re-negotiations, have pushed market values lower. According to Elizabeth Warren, Chair of the Congressional Oversight Panel created to oversee the implementation of the Emergency Economic Stabilization Act, these lower market values will result in underwater loans totaling at least 50% of the entire commercial real estate debt market. At the same time, there is simply not enough absorption within the current lending markets to support this level of debt overhang given the lack of activity in the syndication market. In a recent interview with CNBC, Treasury Secretary Timothy Geithner stated, "Commercial real estate will still be a problem for the country and we are working through that process and it is going to be hard to manage through that process. It is going to put a lot of pressure on small banks across the country that got themselves too exposed to commercial real estate."

Tier 1 and Tier 2 capital ratios for banks are also increasing. The new standard for capitalization – 8% for Tier 1 and 12% for Tier 2 – represents an increase of approximately 33% over previous levels. Banks are thus required to retain 33% more capital that previously had been used for investment purposes. According to the Wall Street Journal and a recent Federal Deposit Insurance Corporation quarterly report, top tier banks, which participate in the majority of lending in middle market M&A deals, are recovering faster than the majority of the industry. However, these banks continue to register grim milestones:

• 2009 resulted in the largest decline in total loans in 67 years.
• The number of U.S. banks at risk of failing hit a 16 year high.
• 5.4% ($391.3 billion) of all loans and leases were at least three months past due - the highest level recorded in the 26 years this data has been collected.

Banks will be closely examining their loan loss reserves and this will place even more pressure on required capital levels.

As most banks are publicly owned, there remains market pressure for share values and profits, as well as expectations for dividend increases. With increased demands on bank capital, where will the money come from? The answer is from customers – both borrowers and depositors. Banks will need to charge more for the risk being taken and the services being provided. Banks are already more selective in extending credit than they were several years ago. This selectivity along with widening margins will result in some form of higher borrowing costs.

Federal Reserve Chairman Ben Bernanke is being watched closely to see when the Fed will begin to tighten the money supply. In 2008, the Fed reduced short term rates to almost zero. As the economy worsened, the Fed began printing money - a step that would lead to inflation if not managed. By all accounts today, Mr. Bernanke is plotting out an eventual exit from the easy-money policies that the Fed fashioned to combat the economic malaise of the past 24 months. Regardless of how Mr. Bernanke and the Federal Reserve Governors handle the issue, the result will be higher interest rates in the future.

Combining all three of these factors will have a distinct effect on the middle market. Regardless of whether these effects are directly seen in how deals are structured or financed, there is no doubt that we will see downward pressure on valuations.

For more information about Strategic Planning, contact Christopher Helmrath: 703-287-5991 or chelmrath@scandh.com.

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