Since the abrupt downturn in the economy in 2008, the number of acquisitions in the security alarm industry dealer segment has declined materially. The level of activity is estimated to be down in excess of 30 percent. Recent indicators and research done by SECURITY SALES & INTEGRATION however, indicate the stage may be set for a reversal of this trend. (Editor’s Note: An announcement at press time that Tyco Int’l was acquiring Broadview Security, formerly Brink’s Home Security, further supports this premise.)
Generally, a decline in deal activity is not good, as an orderly market for alarm companies and their assets is an important element in the overall flow of capital into the industry (which is necessary to sustain growth). The fewer transactions, the less confidence one can have in valuation and liquidity indicators. This is particularly important to the thousands of owners that have substantial portions of their net worth tied up in their alarm company’s stock, and the many lenders that have loans against their assets.
Let’s take a closer look at what appears to be reason for optimism on the acquisitions horizon.
A Wealth of Wallflowers
Conventional wisdom suggests declines in mergers and acquisitions (M&A) activity is reflective of a scarcity of buyers seeking transactions, and/or the money to support them. To an extent this would be true, particularly in late 2008 and early 2009, when most everybody was in a hunkering down mode and conserving cash, and the credit markets were a complete disaster. Getting any deal done during that time frame was tough.
However, provided one excludes the market for the purchase of the very largest of alarm companies, the overall number of buyers and the committed capital available does not appear to have materially changed — or at least not changed enough to fully explain the declines.
In order to better understand the drivers of the market, one must remember “it takes two to tango.” That is, what is happening on the sell side is as important as the buy side. To extend the dance analogy, the number of couples on the floor is often not governed so much by the number of people attending, but rather on how many of them like the song that is playing. In the recent market, it appears sellers didn’t like what they were hearing, with the “song” being the price and terms available.
Buyers changed their views on matters of valuation to a greater extent than sellers, with the result that the “bid” and the “ask” widened and was less frequently resolved. This increased spread is likely the primary culprit in the downturn, not the drying up of demand (as has been the case in prior lower value markets).
Reconciling Risk and Opportunity
The decision to do a deal is complicated for both buyer and seller. While broadly speaking the near-term economics are well established, the long term assumptions are the ones that tend to matter most, and at the same time are inherently the hardest to make. Both sides are effectively seeking to quantify the present value of the future.
The market remains active if both sides perceive the future to be roughly the same. That is, any given potential buyer and seller can sit down and broadly agree on the future performance range of the seller’s company, and handicap the risks and the opportunities. Naturally, the seller will tend to have a more optimistic leaning relative to the range of possibilities. The gap is then typically bridged by the buyer giving up some of the value associated with their lower cost of capital, consolidation savings, or strategic benefits … or, the seller giving up some of their future benefits for the certainty of a transaction.
The relatively abrupt downturn in the economy and the upheaval in the capital markets changed three critical factors in the equation: 1) the cost of capital increased;2) attrition rates increased; and 3) the creation of new alarm subscribers declined. Each resulted in a lower present value of the future. This is exacerbated by proximity to a time of significant economic upheaval, which reminds everyone of the inherent uncertainty of the future, and the need to price in the risk of being wrong in one’s projections.
Buyers were forced to accept this reality, and quickly adjusted their calculus; particularly those that had paid high prices for acquisitions in prior years justified by (among other things) assumptions regarding the three critical factors outlined above, which were proving to be incorrect.