Time to make a deal? What's driving the volume and prices of companies sold?

WHILE THE CURRENT television game show "Deal or No Deal" allows contestants to make a deal just by guessing which briefcase holds the most money, deal-making for Indiana businesses is a little more difficult as out-of-state money comes in with increasingly tempting offers of higher prices.

According to data from Thompson Financial, the state's 2006 deals have been dominated by companies outside Indiana buying Hoosier assets, such as the acquisitions of Guidant, White Lodging Service and Berry Plastics. Other sales of Indiana companies include Windrose Medical Properties, Aearo Technologies, Marsh Supermarkets, Suros Surgical Systems and such financial institutions as Waterfield Mortgage, First National Bank and Trust and Irwin Financial.

The notable exception was Eli Lilly's recent $2.2 billion acquisition of ICOS, the Seattle-based biotech firm with which Lilly has a joint venture to manufacture and sell the erectile-dysfunction drug Cialis. Otherwise, beyond such deals as Duke Realty buying a Virginia property company and Legends Gaming buying the Isle of Capri Casino in Louisiana, there were few Indiana purchasers.

However, the number of deals for small to medium-sized Indiana businesses is increasing and the prices for those companies continues to climb.

"Merger and acquisition activity for 2006 continued at a torrid pace," says David Millard, vice chair of business development for the law firm of Barnes Thornburg. "We've averaged 200 deals each of the last two years and look to exceed that pace in 2006. This represents the fourth straight year of increased activity."

Millard says additional liquidity in the market is fueling the current boom and increasing prices. "For the most part, this liquidity comes from private equity funds and hedge funds, which continue to raise money at record rates," he says. "These funds have become large and well-funded enough to compete aggressively with strategic buyers for businesses willing to sell. With capital gains rates the lowest in history and the generous availability of bank debt, we have almost a perfect storm for sellers, which is resulting in high sale prices."

Indeed, the private equity sector across the United States is set to break records in fund-raising in 2006, with 147 funds collecting a combined $96.4 billion on the first half of the year alone. According to a report by Dow Jones & Co., buyouts are accounting for the bulk of the deals.

As investor dollars flow into private equity, however, the pressure to find good opportunities increases. And while the large amount of leverage involved has some investors concerned about the impact of such heavy debt on investment returns, Millard expects the deal-making to continue in the next year.

"This trend looks to continue into 2007," he says. "While there has been talk of a looming credit crunch, we haven't seen much evidence of it. Although the capital gains tax rate may increase in 2010, that is a long way off. The political and economic uncertainty of an election year may impact 2008, but probably not 2007."

Millard notes that merger and acquisition cycles typically run four to six years and we are in the fourth year of the current cycle right now.

While predicting the future is difficult in any type of market, it may be helpful to consider the past decade when looking at the coming years, says Glenn Scolnik, president and CEO of Hammond, Kennedy Whitney & Co., a private equity firm in Indianapolis.

Scolnik notes that the 1990s started with a recession, followed by an expansion with increased deals that pushed up valuations until another recession arrived. He sees a similar pattern in the current market with a lot of capital chasing deals and paying increasingly higher prices for companies, especially those at the higher end of the market.

"The bigger the private equity fund, the harder it is to find reasonably priced deals," he explains. "So they are forced to bid up values so they can deploy committed capital. This is what is driving a lot of the market."

Dave Schmitt, a partner at BKD, also says he expects the number of deals to continue. In fact, he notes a trend where business owners are selling their companies twice.

Schmitt explains that business owners who sell their companies are increasingly retaining a percentage of ownership for a period of three to five years before selling the remainder of their interest. That ownership is usually a minority position of 15 to 20 percent since the new owners want to have a controlling interest.

"It's good for both sides because it allows a transition and allows the owner to diversify, but also keeps talent in the company and allows it to grow," Schmitt says.

He notes that keeping an owner in place for a few years can also provide growth opportunities for the company that may have been restricted due to a lack of funding. In such cases, the new investors in the company and the experience of the previous owner can make a good partnership and increase the value of the business. After a few years of such an arrangement, a second sale takes place where the original owner's remaining interest is purchased.

Schmitt says there is a lot of demand for medium-sized manufacturing firms that have a simple product that would be hard to make elsewhere. Venture firms are looking for profitable businesses that they understand and are difficult to replace, he says.

And since there is a limited number of such companies and often little incentive for owners to give up their reliable profits, prices are climbing. Those higher prices are reflected in increased multiples of EBITA (earnings before interest, taxes and amortization) with prices that can range from five to eight times those amounts rather than a more traditional three to four times. "If you are going to sell, it's a good time to think about it," Schmitt says.

However, Schmitt also cautions buyers not to pay too much for potential acquisitions. One potential mistake is to value the company in terms of what it is worth with the addition of a buyer's resources. "You have to be ever so careful not to pay for what you are bringing to the business," he cautions.

Bob Welch of City Securities has also noted the increase in prices and says they tend to vary according to the type of business being purchased. "If you break it down a little bit further, I would say that in 2006 you have seen a general decline in multiples for companies in more cyclical industries, while it has continued to accelerate for most other, non-cyclical industries," he says.

Welch says most health care-related companies have continued to grow very quickly and have reaped high multiples when they are sold. On the other hand, he explains that many heavy industrial companies have seen their relative prices decline, as uncertainty in the economy and particularly in the automotive industry continues to weigh heavily on near-term prospects for growth and stability

"Leverage is what drives most multiples," Welch says. "If the lenders are apprehensive about a company or an industry, they will lend less aggressively into the cash flow of the company and therefore the company will have a smaller multiple."

Welch also agrees that private equity money continues to be a factor in the number and size of deals and the higher prices. "Generally, private equity and lenders are willing to get more aggressive for companies that are of a certain size and exhibit high growth, strong cash-flow margins and strong management teams," he says. "We continue to look for very positive pipelines in 2007 after near-record levels in 2006."

One area that has not seen much activity is the use of initial public offerings as a way to sell stock to the general public. "The IPO window remains largely closed across the country. The same is true in Indiana," explains Millard. "The Sarbanes Oxley regulations and other similar actions have had a chilling effect on this market. At the end of the day, to secure liquidity for their shareholders, many companies now choose to sell rather than go public."