The Financial Markets: A Mixed Midyear Report

The following post was authored by Cheresh Casinelli and Derek Dowsett, partners at the accounting firm of Moss Adams

So far 2010 appears to be one of the more interesting financial years in recent memory. It’s certainly not as glum as 2009, but it’s not as ebullient as the pre-meltdown era either.

In terms of merger and acquisition activity, the strategic market is the most active. In terms of the source and nature of deals, we’re seeing dispositions from many large companies that are attempting to get their financial houses in order. On the buy side, many businesses are trying to grow their revenue bases through acquisitions. There are also a number of strategic business partners that are coming together in more formal ways; these moves are an effort by smaller players to partner rather than going it alone in these uncertain times. Finally, there’s lots of roll-up activity and lots of smaller deals (less than $50 million) being closed.

It’s true that 2009 was virtually moribund, so year-over-year figures look great so far in 2010. But even beyond simply comparing against low numbers, the first quarter of this year we saw a significant pickup in the transaction market overall.

That’s one aspect of the market today. The other is less positive. There are many companies that are simply in dire straits. They need money to stay in business, and so they’re eager—at times anxious—to do a deal, especially given the tight credit markets, which have squeezed liquidity. Targets now have new, realistic expectations about purchase prices. They know they’re not going to see ten times EBITDA, and they’re willing to accept four to six times EBITDA instead. For their part, buyers are looking at targets as real opportunities. They see real values, and they want to act and acquire.

There are other factors at play too. The recent unraveling in Europe, for example, has penetrated the IPO market, which may not open up in the way people anticipated. Many IPOs have already delivered diminished profitability versus forecast, and these deals aren’t going up 20–40 percent. They’re staying flat. That’s why we believe venture capitalists and private equity firms will start to become flexible in terms of exit strategies for their companies; the high-valuation IPO may no longer be the answer it once was.

Now is also probably the right time to put the overall stock market in perspective. The brutal truth is that it’s been flat for a decade. IPOs don’t drive the economy, but they’re definitely affected by it, and we continue to see that reflected in deal activity and valuations.

We do see growth opportunities, however, and they can—and should—be leveraged in the second half of the year.

In technology, for example, there are several good behind-the-scenes plays. One we like is back-office support and systems in the mortgage industry. The health care sector employs technology in the same way, and the data-management part of the business should expand, given the dynamic reorganization we expect to see in this industry.

Online gaming and social networks that are add-ons to other products and make the user experience more interesting are also going to be bright spots for the remainder of 2010 and into 2011.

When it comes to software, we’re watching Internet-based software as a service (popularly known as SaaS). This new business model has proved itself and is now moving to a more mature growth phase.

Biotechnology is less robust. We see lots of deals forming in the future—but not today.

People use the word recovery loosely. But what does it really mean? Given the mixed data, it’s difficult to call 2010 a year of economic recovery. The economy does appear to be firming, but the labor markets remain in disarray. The financial markets appear to have settled down, although they can still plunge without notice. And while the transaction markets appear to have some momentum, M&A activity is often defensive and IPOs are often underwhelming.

As a result, while 2010 may be a much better year than 2009, it’s not the kind of year that makes investors and deal makers truly happy to be in the game.