Market overview

Sub-prime woes have crept into the overall global credit market, exposing the systematic under-pricing of risk contributed to the bull market of 2006 and 2007. After closing at a record high of 14,000 on July, 19^th the Dow lost 8.3% in one month sliding to 12,845 at close on August 16^th.  The broader S&P 500 experienced a similar slide, dropping 9.1% from 1,553 to 1,411 in the same time frame. The question on all investors’ minds is whether this was a bottom for the much needed market correction or the beginning of a bear market. Since mid-August markets have remained volatile and as of yet no definitive answers to this question are forthcoming.

On the inflation watch, core consumer prices rose by just 0.1 percent in July, a smaller advance than June’s 0.2 percent rise. This small rise was primarily driven by a 1 percent decrease in energy prices, largely counteracting any small increases in food (+0.3%), shelter (+0.2%) and medical care prices (0.6%). Core inflation, which excludes often volatile energy and food costs, rose a modest 0.2 percent in the same time frame. The Producer Price Index rose by 0.6 percent in July, following a 0.2 percent decrease in June. The increase was led primarily by energy prices, which rose 2.5 percent.

Despite the tame inflation readings, many investors are hoping for the Federal Reserve to cut the Federal Fund rate from their current level of 5.25 percent given the heightened fear in the credit markets. The Federal Reserve has kept rates steady for the past year, while the European Central Bank is expected increase its benchmark rate to 4.25 percent in September after keeping it at 4 percent in the August meeting.

The Federal Reserve has made multiple high profile repurchase agreements over the past few weeks, injecting temporary liquidity into the market. On August 17th, the Federal Reserve cut the discount rate by half a point to 5.75 percent.  This is largely a symbolic move, as this rate provides funds to large banks rather than commercial and consumer borrowers. The Fed has not gone as far as indicating an (intra meeting) cut of the federal funds rate, which would be perceived as a strong signal that they are looking to bail out the stock markets. However, The Federal Reserve confirmed that they are not ignoring the markets, as the Federal Open Market Committee stated “financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth.”

Deal overview

Given the tightening credit markets, private equity firm are having a harder time finding the type of debt financing that has fuelled much of the buy-out wave over the last few years. An example of a large player repositioning itself for the new financial climate is Blackstone, which recently announced that it will be targeting the middle-market.  Most likely the Company will target the upper end of this market, up to $1 billion in transaction size.  With private equity players temporarily retrenching or realigning their strategies, a resurgence of strategic buyers may be in the making.  

The technology M&A market has been strong, echoing the strong performance of technology companies in the pubic markets. Following strong Q2-07 results, Hewlett-Packard announced its intent to acquire Neoware and Opsware in July. Neoware shareholders will receive $16.25 per share for a TEV of $214 million. Opsware shareholders will receive $14.25 for an enterprise value of $1.6 billion.  Additionally, Google announced three acquisitions in July: Image America, Grand Central Communications, and Postini.  The first two of these deals both closed, with the Postini deal expected to close in the third quarter for a TEV of $625 million.

With the markets as jittery as they are, it is helpful to take a broader historical perspective. One way to view the economic cycle is to look at public market valuations, which reflect both current performance and expectations about the future. The exhibit shows the range of revenue multiples over the last 10 years for Companies included in the Russell 2000 index across Mirus’s key coverage segments .

As expected, peak valuations across segments correspond to the 1999-2000 timeframe, while the lowest valuations mostly occurred in late 2002 and early 2003. As of August 22^nd, all three segments were still above the historical median. Business Service companies were trading at a premium of 17% relative to the historical median, while Industrial Products were at 11% and Software was at a 5% premium over the median.

Overall, current valuations do not appear excessive in a historical context. The market may continue to "correct", but just moderate further adjustments would get valuation in line with historical medians.