Small-cap companies with a low return on equity and stable cash flow are in high demand by private equity investors.
In the second quarter of 2006, private equity investors raised $47 billion — the largest quarterly amount in six years, according to a report by Merrill Lynch small-cap strategists Satya Pradhuman, Georgiana Fung, and Denise Saunders.
A lot of that new private equity money now is chasing inexpensive companies with a low return on equity, which general partners view as an opportunity to buy the entire company or some business segments and improve performance. Valuations for such companies continued to be high, even as their numbers increased. The small-cap companies with the characteristics that private equity investors find most attractive tend to be in the technology, consumer cyclicals, and business services sectors. Meanwhile, the proportion of large-cap stocks with low return on equity dropped to a level not seen in almost six years.
Some of the companies that fit the common profiles of acquisition candidates by private equity firms are Spherion Corp., Amtel Corp., Quantum Corp., Sycamore Networks, Saks Inc., and American Greetings Corp., among others (see table).
“We believe that opportunities can still be found in smaller cap equities in the public market and that the capital markets will continue to facilitate these deals,” the report’s authors state. The capital markets continue to support even marginal borrowers, the report notes.
Indeed, the authors say, most measures of credit show that funding continues to be cheap and easy to come by. The high-yield bond market totaled $76 billion in issuances this year through the second quarter. Of that amount, $22 billion financed mergers and acquisitions. At the same time, a survey of senior bank officers conducted by the Federal Reserve shows that bank lending standards remain quite loose.
While most companies and their private equity or venture capital investors continue to hope for an initial public offering, the Merrill Lynch report concludes that appetite for risk in the public stock markets has declined from its peak in April. That leads the authors to conclude that there will be few venture-backed IPOs this year.
However, small companies with fast growth can expect to benefit from the acceleration in mergers and acquisitions, the report notes. “It is our contention that buoyant capital access, economic cyclicality, and attractive corporate valuations, which we term the 3C’s of consolidation, are a recipe for M&A,” the authors wrote.
|Likely Private Equity Acquisition Targets|
|American Axle & Mnfring|
|AM American Greetings|
|Source: Merrill Lynch|