We are about to publish our 4th annual Consulting Mergers and Acquisitions report looking back at how the market performed over the last year and it will come as no surprise to you to discover that the numbers with respect to deal values and volumes reflect a low point in the current economic cycle. However as we stand here in April 2010 you are probably more intrigued by what we think will happen to the market moving on as you plan and execute your exit or growth strategy, organically or inorganically.

If you want our analysis read on, or if you just want the conclusions go to the bottom!

Each year, along with our retrospective market analysis, we have attempted to predict the future and if we say so ourselves, been pretty close! For example, in 2009 we predicted that valuations in the form of revenue multiples (the best indicator of market sentiment from available data) would reach a low point of 0.9 and we were proven right when that happened in the 4rd quarter. The last time we saw valuations as low as that was in 2004. Compare that to the top of the last economic cycle in 2006 when 1.6 was eminently achievable for a quality firm!  So what is in store for 2010 and beyond?

We foresee two main market changes:

• A modest recovery in M&A volumes and values driven by big firm growth imperatives
• Deal structures with less up-front cash driven by the need for buyers to de-risk acquisitions

On the face of it herein lies a stand-off – we expect more demand but don’t expect prudent buyers to dip so deeply into their pockets, on the other hand why should sellers short-change the value of the investment they have built into their firms, or lock themselves into long earn-outs? However from what we have seen so far in 2010 there is we believe a win/win here. Before I describe where the forces for recovery are coming from and what a modern win/win consulting M&A deal will probably look like moving on, we need to understand the backdrop away from which the market is evolving.

2009 was a difficult year for the consulting industry

2009 was undoubtedly a very challenging and difficult year for the consulting industry.  After the collapse of Lehman Brothers in the autumn of 2008 many consulting businesses saw new orders dry up, particularly those companies exposed directly to the financial services, property, retail and other cyclical industries.  As they entered Q1 and Q2 of 2009 existing projects drew to an end and revenues began to fall. If we look at an index of revenue for the quoted US consulting businesses, these fell during the year by nearly 8% from their ‘pre-credit crunch’ levels. Similarly, an analysis completed by Equiteq on SME sized UK consulting businesses showed an average 10% fall in revenues.

Index of US Quoted Consulting Business Revenues (100= Q3 2008)
 

Clearly there is still uncertainty in the economic environment and some significant risks.  A number of European countries are in an extremely weak financial state, the levels of government debt are at worryingly high levels, thus creating the threat to reduced public sector spend on consulting. The banks are not readily lending and private equity remains subdued, removing one of the sources of cheap credit that supported the boom in the consulting M&A market we saw 3 to 4 years ago.

So the last 2 years has been tough for most Consulting firms. With client demand dropping by 10% shareholders and Partners in Consulting firms have seen share values and bonuses reduce. Not surprisingly they are keen to see this trend reverse! Indeed the ‘big four’ have publicly stated ambitious growth objectives. Attacking client markets and service lines with greater growth potential than others clearly makes sense. Acquisition is one strategy that could drive growth.

Forces for recovery in the consulting M&A market

We see three main drivers:

• Consulting industry consolidation
• Investment of cash flow
• Supply and demand

Consulting industry consolidation: There remain compelling reasons for a number of buyer groups to enter the consulting market and / or develop their existing practices.  Over the longer term, consulting offers substantial profit growth opportunities and unique opportunities for positioning other service lines. Examples

• Outsourcing groups – leverage offshore
• Facilities management groups – new service lines with higher Gross Margins
• Engineering groups – Global project opportunities
• Major accounting practices (eg. the “Big Four”) have made public statements that they seek to achieve substantial growth in their consulting practices, including through pro-active acquisitions (a change to their previous position). This has been substantiated by many recent deals.

Investment of Cash Flow: While banks might not be lending, they are also not providing returns on deposited cash.  Cash rich corporations in the business services market are therefore looking to invest with better financial returns, and choosing consulting businesses as a way to achieve a greater mix of high-margin business.

Supply and Demand: prices at recent levels have clearly attracted potential buyers in to the marketplace, where, often, they find that the best managed and unique consultancies in the most appealing spaces are under heavy demand. Examples include:-

• Environmental Consulting firms
• Regulatory Consulting firms – both financial and sustainability
• Operations Consulting firms – in particular cost reduction or profit improvement
  

Achieving a ‘win-win’ deal in 2010

The main question for buyers is how to acquire in the current uncertain environment without undue exposure to forecast risk. For sellers, the issue is all about price. With current price multiples at 60% of the peak of the last economic cycle, seller shareholders don’t wish to lock-in a price on the firm that doesn’t reflect it’s intrinsic value. Traditionally the use of earn-outs has been the main way that buyers have de-risked their purchase. Whilst earn-outs have been seen in a negative light by sellers, in today’s environment they represent the key to a ‘win-win’ deal.

The problem today is the size of the gap between the sellers view of the value of their firm and the price that buyers wish to pay. The buyer’s price today includes very pessimistic assumptions about growth. The seller remembers the ‘double digit’ profit multiples achieved in 2006/7 when firms were growing at record rates and is unsurprisingly reluctant to sell at a significant discount to these prices.

Even though a seller may have experienced a small decline in sales revenues in 2009, the sales pipeline could be looking more healthy today. In the past few months Equiteq has negotiated deals that de-risk the purchase for buyers yet provide double-digit EBIT multiples for sellers. A combination of some cash at close and an uncapped earn-out linked to the delivery of Gross Margin would appear to meet the apparent conflicting requirements of minimum purchase risk for buyers and maximum price potential for sellers.

In this environment, extending the period of the earn-out benefits both buyers and sellers, maximising the price delivered for seller shareholders and ensuring the acquisition delivers growth over the medium term. There are synergy and integration issues to be addressed with this approach and no doubt this won’t suit all buyers and sellers but it does represent a solution when the price gap appears to be insurmountable and that is likely to be a feature of many deal opportunities in 2010.
 
Conclusions
  
So what’s our forecast for 2010 and beyond?

Given the economic environment and trade levels in consulting, it is not surprising that 2009 saw very subdued M&A activity in the consulting market. On the other hand, while at the macroeconomic level the situation is weak, there are a number of forces that indicate a recovery of the market, not least because the ‘big four’ all want to put a year of shrinkage behind them and use their war chests to grow.

As a prospective buyer, 2010 should continue to be a good time to acquire with competitive multiples compared to long term averages and potentially some ‘first mover’ advantage by acquiring ahead of a wave of buyers who are waiting for greater certainty before entering the market.
 
Those sellers who have service offerings that are additive to the buyer in terms of product extension/expansion or sellers who can bring to buyers access to new clients/markets/geographies, coupled with strong management and good financial performance will complete deals at premium multiples. However, sellers should expect no more than 50% of a ‘good deal’ in upfront cash payment, and the remainder in a 2 to 3 year earn-out.

And finally what about multiples? With the forces described above, along with other indicators, we are forecasting that 2010 average revenue multiples will be in a range of 1.15 to 1.25. In fact from the 0.9 low point in 4Q 2009, in 2010 so far the average revenue multiple is 1.16.
 
So if you are intending to sell, or planning for that eventuality, now would be a good time to benchmark your firm and optimise it for maximum value within your exit horizon, and as you no doubt expect, we are here to help you on all counts if you wish!

I spend my working days at Equiteq deal-making with buyers and sellers so here's my synopsis of what I'm seeing on the ground as the worst (fingers crossed!) of the recession seems to be behind us. The headline is that after a big pause in acquisition programmes caused by economic uncertainty buyer interest and activity is resuming, however there is a substantial mismatch in valuation expectations between buyers and sellers!

Buyers seem to have concluded that the world is not coming to an end and embargoes on acquisition activity are being lifted because the need for growth has not gone away. My barometer for this uplift in activity is that my calls are now being taken and discussions are constructive! However a lot of the interest is what I would describe as speculative. Buyers are coming in with 'low ball' offers and massive earn-out conditions with little up-front cash in the deal structure. Why? Because they're more risk averse and believe that market conditions are in their favour. The bigger firms on the acquiring side of the fence have problems of their own, their valuations have taken a dive and many quoted consulting companies have share prices at rock-bottom levels. This on its own is an argument used in driving down the offers made to sellers. The issue of raising finance has also not gone away and this is also hampering deals.

If you're on the selling side of the fence, acquirers are looking for quality and are much more focused on finding firms with great strategic fit, unique propositions and those that will be transformational in nature. There is a lot of overhead in an acquisition and unless its a strategic buy with transformational prospects the deal may not be worth the effort for the buyer. So if you're a firm with these qualities AND you've performed well during the recession, then you will be a prime target. Therein lies the dilemma, the buyer wants you at a bargain price, but you're not going to sell yourself short and why should you!

Result - Mexican stand-offs and lots more dancing around handbags to try and reach a deal!

However the market has been in a big freeze and this mismatch in expectations is all part of the thawing process. Activity levels ARE picking up, smart buyers who want to be first movers are leading the pace and a number of sectors are in demand, particularly Energy, Environmental and some parts of Financial Services. I'm certainly encouraged by the increased temperature of my telephone handset!

1. Company Scale. Your firm struggles to win lucrative contracts with key clients because your scale does not compare with larger competitors and you pose a greater risk. You need to acquire to achieve the scale necessary to attract the kind of clients that sign the bigger deals.
   
   
2. Shareholder Pressure. You may be a plc with pressure from investors to grow shareholder value, but your organic growth options cannot deliver. Acquiring a private firm on a profit multiple less than your own traded multiple will achieve growth faster and add instant value for your shareholders.
   
   
3. Global Extension. Your target clients are increasingly global and you don’t have the international profile necessary to compete. Acquiring a company to build a global presence, or achieve a local culture fit, will expand your firm’s capabilities to attract and service clients in your chosen markets.
   
   
4. Sector Extension. You have a strong track record in one industry sector, your service is transferable into other sectors, but you know that cost of entry is going to be high. Acquiring a similar firm with an existing track record and a client list in other sectors will accelerate your entry into new industries. .
   
   
5. Service Extension. You have excellent skills in your domain, but there is a demand for services adjacent to yours and you don’t have the skills to service it. By acquiring another consulting firm with the competencies you require, you are able to increase your footprint in the combined client list and develop new business elsewhere. .

1. Pure Investment Potential. You are a wealthy investor who needs to achieve a better return on capital and you’re looking for a cash generative business with healthy profits. Service businesses like consulting firms, if well run, have a reputation for delivering high margins and good cash flow. This presents an opportunity to spread the risk and improve the return from your portfolio.
   
   
2. Leveraged buy-out. You are a private equity firm with an obligation to provide an outstanding investment return to your fund providers. A private consulting firm, with founders that are ready to retire and a good management team who are ready for the next stage of growth, presents a good investment opportunity. Buy out the owners for cash, but provide most of that cash through loans against the business. The founders are happy, the firm grows, pays off its debt and both the private equity firm and management team will benefit.
   
   
3. Distress Sale or Turn Around. You make your living by finding firms that are under performing but have the potential to do much better. You find a mature consulting company with a poor order book and a worn out management team, ready to sell at a significant discount to the potential market value of the firm. You acquire the firm, turn it around, and sell it on a year or two later for a significant capital gain.