SMEs having their cake...?

When two major institutions like Morgan Stanley and PricewaterhouseCoopers predict that the merger and acquisition (M&A) boom will continue for the rest of this year, and probably into 2008, their research has clearly focused on global and national corporations. However, Wilf Altman discovers that it is not only major firms that are driving the boom

A diversity of small and medium-sized businesses (SMEs) across the board are becoming increasingly involved in record levels of M&As, management buy-outs (MBOs) and management buy-ins (MBIs). Mostly these are private deals often driven by accountancy firms' corporate finance specialists: mid-tier firms, as distinct from international practices active in giant deals. Typical transaction values in the SME market range from £250,000 to £5m or more. Deals from £10m to £100m tend to be advised by M&A boutiques.

More mid-tier accountancy practices with dedicated corporate finance units are acting as advisers not only to vendors, purchasers and investors, but also to the owners of SMEs interested in retirement sales, to fund an acquisition or negotiate a sale. In many cases, parts of larger businesses which no longer make a good fit are sold in an MBO or MBI.

The current trend of highly leveraged deals looks set to continue in Shear's view, with lenders keen to back acquisitions where most, if not all, of the money is borrowed and a large element unsecured. This means that there are plenty of buyers out there with ready access to funds. Add to this the fact that vendors of a company usually only pay an effective tax rate of 10% (assuming they have held their shares for more than two years in a trading company), which suggests it is actually a good time to sell.

Paul Storer, corporate finance partner at Price Bailey in Cambridge, says: 'We are busier than we have ever been, with enough work to take us well into next year. The main types of work are buying and selling companies, advising on MBOs and MBIs, raising finance for deals and providing consultancy. More owner/managers are thinking of selling due to increasing regulatory pressures and the impact of the China boom. Tax issues - capital gains tax, income tax, national insurance, stamp duty and corporation tax - clearly play a significant role in most transactions. Financing the deals is often a key issue.'

When Pearson Education announced plans to sell its £3.75m turnover educational software division, managers wasted no time in talking to professional advisers about the possibility of buying the business, and Price Bailey was selected. The key aspects of a deal were to secure an affordable price, raising the purchase price and working capital.

In another case, Storer assisted with the business plan and negotiations for venture capital and investor funding of £620,000, besides advising on taxation, legal and structural issues relating to a trade sale.

Price Bailey also advised a young contract cleaning company, Shine Group in Bishops Stortford, with a turnover of £700,000, which wanted to buy another, larger rival turning over £1.8m. Shine Group found 35% of the purchase price, which was matched by the bank, and the rest was based on future profits. Since the deal was finalised two years ago, and integration of the two companies has worked well, group sales have increased by 20% and operations have expanded beyond Hertfordshire into Essex and Cambridgeshire. But as the company's managing director, Stuart Felstead, points out: 'Unless you already have experience of expansion, you need professional advice on valuation, negotiating and raising finance.'

Some M&As never achieve their aims, a consequence, according to Storer, of too much initial enthusiasm and a tendency to overpay for the business. Where this is the case a reduction in price should be negotiated later. Another reason why some acquisitions fail is because too little time is spent on planning the post-acquisition integration.

'The due diligence process,' in Shear's view, 'should be used to further evaluate the strengths, weaknesses, risks and opportunities of the target business and form part of future business planning. This can make the due diligence process very cost effective in not only confirming that a particular acquisition is sound, but also in helping to achieve value growth post-acquisition.'

Apart from retirement sales, Shear predicts more acquisitions where SMEs want to buy out competitors, diversify into new areas or new markets, or increase market share.

Simon Blake, corporate finance partner at Haslers in Loughton, Essex, attributes wider interest in M&As in the SME sector to an 'increasing entrepreneurial spirit', partly encouraged by the current capital gains tax taper relief legislation, and the aim to provide an exit for the founding shareholders by passing ownership to managers in an MBO or MBI, rather than counting on their children to take over the business.

The private equity and venture capital approach has encouraged entrepreneurs to look at their exit from the business and to measure its life in terms of years rather than decades. The goal is almost entirely set on maximising personal shareholder value.

Blake's team, which advises vendors, purchasers, investors and SMEs seeking seed capital, working capital and advice on selling or growing their business, sees 'the SME corporate finance market becoming increasingly self-perpetuating with serial entrepreneurs and vendors reinvesting their proceeds, partly for tax planning purposes, in new ventures, either on their own or as business angels. Frequently, we are asked by vendors to introduce them to new investment opportunities, involving both cash and skills.'

Are M&As in the SME market sector good for the economy? 'Yes,' says Storer. 'Young companies have to move on and grow - and that's good for owners, employees and for the economy. But bigger is not always better. Bigness mustn't get out of hand, or it will have the Monopolies Commission on its neck.'

M&As can help smaller businesses to grow faster than they would relying on organic growth. MBIs and MBOs can offer challenging new opportunities for able managers. Many small companies with a distinctive brand have been swallowed up by larger concerns and often flourished. The downside is that, in too many cases, once promising brands ultimately face extinction because in later life they have lacked the tender loving care of their original owners.

Wilf Altman is a business journalist.