Depressed oil prices made 2015 a challenging year for U.S. energy services and equipment business owners, and the outlook for this year is no different.
Today, energy services and equipment business owners want to know two things: when will merger and acquisition activity rebound and how can I ensure my company has a compelling valuation once the market improves?
Many industry experts believe the price of oil won’t go much lower and, as a result, that M&A activity should pick up in the second half of 2016. However, the businesses that will best maximize their value are those that take proactive steps now, including selling a stake in their firm in return for a crucial capital infusion.
Low oil prices mean more companies are feeling the pressure to sell assets as a lifeline to survival but valuation multiples have dropped precipitously, making such sales far less attractive. Whereas in 2014, many equipment and services companies could justify record valuations, enterprise value to EBITDA multiples have dropped significantly over the past year. As a result, a common refrain today from senior management is this is no time to sell. Rather, they want to wait until the industry turns around and commodity prices increase.
However, while valuations are not at 2014 levels, much like trying to time the stock market, it would be a mistake to try to time the cycle perfectly. Instead, it makes sound strategic sense for many companies to accept outside capital now, not merely to survive but to go on the offensive while your competition plays defense.
A huge challenge to getting deals done today is the blunt emotional reaction of many owners when they hear the current sticker price of the business they worked so hard to build. Many owners feel shortchanged and even angry when they discover what a stake in their business is worth today despite their years of sweat equity.
However, if an owner picks the correct partner and sells a majority share of his or her company, a 30 percent stake can be worth more in the long run than retaining full control of a firm that never received a capital infusion.
Once an owner agrees in principle to sell a stake, getting to the right deal is challenging. Many buyers don’t think it is fair to value businesses based on elevated 2014 valuations, while owners won’t agree to a value based on depressed 2015 or 2016 performance.
Instead, deals increasingly employ an average of company performance over the highs and lows of the market cycle. In addition, many deals assign a portion of the firm’s value to an “earn out” clause that allows the selling party to earn a portion of the total valuation based on agreed performance hurdles.
There are many reasons to consider selling an ownership stake for outside capital. Such an infusion can provide the deep pockets needed to level the playing field with larger competitors. It can help finance acquisitions, boost market share, help battle larger competitors that will use tough market conditions to drop prices to weaken smaller firms, and fortify balance sheets.
In addition, owners can expect another opportunity to cash out their investment alongside a partner, when they can realize maximum value for their company. After all, private equity investors typically want to cash out three to five years after making an investment and will use that time to work with management in an effort to maximize value.
While traditional bank debt across the energy landscape is harder to come by today, private equity capital is available in spades for high quality companies. At the end of 2015, the amount of private equity capital available for investment stood at $696 billion, according to private equity research firm Preqin. The challenge is convincing a buyer that your company is worth more than your competitors. When getting a capital infusion in a depressed market, top line valuations are less relevant than knowing you got a fair deal compared to your competitors.
Once owners get over the emotional wrench of selling a stake in their firm, finding the right financial partner is paramount. Owners must have a thorough understanding of an investors’ time horizon and involvement with the business. Do you want a passive partner that will provide capital and leave you to operate the business or could you benefit from a partner that will bring significant operational and strategic insight alongside their investment? Honest, effective communication is key to striking the right deal with the right partner.
While many U.S. energy services and equipment businesses are struggling to survive, proactive business owners can still successfully grow their firms in ways that will significantly boost long-term value. That may involve the difficult decision to sell a stake in your company during a down cycle, but sometimes becoming an industry leader or maintaining your position as a market leader requires finding the right partner to ensure your company stays on the right path.
Stuart Brown is Managing Director and head of Energy Equipment and Services at MHT MidSpan, an investment bank headquartered in Dallas.
Photo courtesy of MHT MidSpan