The deal conditions aren’t as favorable as in years past, according to dealmakers we spoke with, as both buyers and sellers contend with capital constraints that have contributed to deeper deal scrutiny that’s extending transaction timelines. High-quality companies can find buyers willing and able to pay, but it’s more critical now than in previous years for buyers to both have a solid plan to get an investment return and to nail the post-deal integration.
Dealmakers such Mike Arguelles, a partner at Stonehenge Partners, find the M&A market mixed. He says deal volume in the sub $10 million EBITDA range remains steady as sellers in this segment tend to be driven more by life events. But larger deals have been slower and more impacted by the higher interest rate environment as leverage multiples have contracted. As a result, businesses backed by private equity sponsors have largely sat on the sideline to time a better market and a higher valuation.
“From a quality perspective, given that there are fewer deals and PE firms still have ample dry powder, we have seen good deals get great multiples — sometimes one to two times higher than a year ago — as firms continue to put money to work,” Arguelles says. “Deals that tend to have more complexity have taken longer to close or are not getting done.”
Chris W. Michael, a partner at Ice Miller, says increasing volatility and cost of capital have created headwinds for many, but there remains an unprecedented amount of private capital —and pressure to deploy it — available to high-performing assets.
“As a result, M&A is highly segmented not only by industry but amongst peers as well,” Michael says. “This creates a wide range of transaction structures that are being employed to meet the needs of the particular deal.”
Brent Crawford, principal at Crawford Hoying, says it’s a very challenging market right now, especially for any pre-revenue or cash flow negative businesses, something that’s being further exacerbated by continued interest rate increases.
“Valuations have plummeted dramatically over the past 18 months and we are not seeing a rebound in the near term,” Crawford says.
Several area dealmakers talked to Smart Business about how they see the current M&A market; how buyers, sellers and entrepreneurs are faring; and their expectations for how the remainder of the deal year plays out. Here’s what they have to say.
The deal environment
Key macroeconomic issues influencing deals, according to Reese Fields, founder of Columbus Area Family Exchange, include interest rate fluctuations, inflationary pressures and potential policy changes.
“These elements can impact financing costs, deal valuations and overall investor sentiment, influencing M&A activity through the end of this year and into early next year,” Fields says.
Leslie S. Johnson, a partner at Ice Miller, says one macro factor affecting deals is tight financing markets. That has created a deal environment in which the process is taking longer and outcomes are uncertain.
“Traditional funding sources may no longer be available to everyone, so buyers need to be purposeful in securing capital,” Johnson says. “Sellers are seeing a greater level of scrutiny from buyers and their funding sources, so they need to be prepared for that in this market by optimizing their business before it goes to market.”
Paige McCarthy, vice president at Trailhead Brothers, says that one of the key issues to continue monitoring is the
Trailhead Brothers
stability of the banking industry.
“We have already seen a lot of disruption this year due to the issues with SVB and Signature banks, which seriously impacted the venture capital industry,” McCarthy says. “Then we just recently had Moody’s downgrade several more small to mid-sized banks. Not only do these changes have the potential to change the behavior of smaller banks and how they lend, but they could also impact consumer confidence, changing investor behavior and limiting M&A activity.”
Seller perspective
Still, despite macro concerns, Arguelles says sellers who have a strong business in a non-cyclical industry, good historic cash flows and a clear differentiator within their respective industry continue to see very healthy multiples being offered to buy their business, arguably better than a year ago given overall lack of supply.
Crawford agrees, saying deals are typically happening for companies with strong margins and profits.
“There is a lot of money on the sidelines but that money smells blood in the water and can afford to be selective in investments and acquisitions,” Crawford says.
Similarly, Michael says high-performing “class A” sellers are still commanding high multiples across a variety of industries, and industry consolidation is providing additional opportunities for sellers.
Sellers are, however, operating within a less favorable environment — both deal and economic — than a few years back. As McCarthy says, sellers in many industries are facing margin challenges as prices for materials are coming down post-COVID and they are hoping to avoid passing on all savings to their customers. Additionally, the “Great Resignation” and resulting increases in labor rates have also put margin pressure on many businesses as they are paying more for the same labor and output.
“As a result of some of the unprecedented events and dislocations of the past few years — e.g. COVID, inflation, labor challenges, government stimulus, etc. — all industries and businesses have been impacted to some extent,” Arguelles says. “Given this, buyers likely feel as if they are being asked to defend growth and related sustainability of revenue and cash flows.”
Fields says sellers may encounter challenges related to due diligence scrutiny, as buyers focus on risk assessment and potential liabilities. Market volatility and regulatory hurdles can also impact deal certainty.
Michael sees increasing costs and scrutiny from buyers driving purchase prices down or deferring portions of purchase price to contingent, uncertain future events. He says more sellers in the market are also creating a shift in the supply/demand curve.
Buyer perspective
Buyers who are able to capitalize on some of the market dislocation through creative and flexible structures by thinking somewhat differently about deals — for instance, through preferred or minority structures — can make great partnerships and investments at solid valuations, Arguelles says. Given some of the challenges and uncertainty in the market, more than ever as a buyer it is important to have a clear value-add plan about how to grow businesses after acquisition.
“It is a buyer’s market right now and the tight financing market has decreased the competition,” Johnson says. “There are fewer buyers to compete for the same deals, and valuations have dropped dramatically.”
Michael adds that buyers are able to be highly selective given the increasingly more abundant number of sellers as the middle market ages. Increased due diligence and leverage are allowing buyers to save on purchase price, and many are able to shift transaction value into future arrangements reducing cash needs up front.
While the deal environment may be seen as favoring buyers, McCarthy says many buyers are faced with the difficult task of figuring out real growth for companies that experienced lumpy earnings due to COVID.
“Additionally, much of the growth companies are recording is related to price increases from cost of goods sold that they are passing onto customers,” McCarthy says. “This can also skew the real picture of long-term growth and profitability for buyers.”
Arguelles says, in the past 20 years, this is arguably one of the most difficult times to underwrite deals and evaluate new investments. That means determining sustainability of margins and cash flows is key.
Buyers also face competition for attractive companies, Fields says, leading to potential bidding wars and inflated valuations.
“Integrating acquired companies effectively and managing post-merger synergies remain critical challenges as well,” Fields says.
A (mostly) positive outlook
As overall deal conditions tighten, Michael says deals are becoming more fact-specific.
“Marginal differences in organization, management, or structure may be fatal to a potential transaction,” Michael says. “A growing divide between seller and buyer expectations is also challenging in this dynamic environment.”
Arguelles adds that the quantity of information, level of scrutiny, diligence and documentation have all continued to prolong overall deal processes in all phases of a transaction.
Sellers also are having to accept lower valuations than they might expect, Crawford says.
“With capital very expensive, they face trying to raise capital at much higher costs or sell at a valuation significantly lower than 18-24 months ago,” Crawford says.
Despite the challenges, Fields says barring any unforeseen economic shifts, he anticipates a continued brisk pace of M&A activity in Columbus.
“As the year progresses, I expect an emphasis on strategic partnerships and cross-industry collaborations, contributing to a diverse range of successful deals,” Fields says.
Crawford says the Federal Reserve’s monetary policy is working its way through the system right now and he anticipates things will become even more challenging through the end of the year. He doesn’t expect any significant improvement until the second quarter of 2024.
Johnson says the second half of 2023 should see some improvement based on signs of progress in the market conditions. And anticipated future rate cuts could bring financing rates down and jumpstart M&A activity in late 2023 and first quarter of 2024.
View from the early stages
When it comes to early stage businesses, Andrea O’Carroll, managing director, corporate partnerships at Rev1 Ventures, says her outlook is optimistic for companies that start with a strong foundation and proven target market fit.
“Amid industry-wide volatility and cooling investments, the startup ecosystem in Columbus and the Midwest has continued to grow,” O’Carroll says.
She says where she’s seen the most success in this region is with entrepreneurs who offer enterprise technology and research institution spinouts. But there is one common denominator when it comes to success.
“All successful startups, no matter their industry focus, solve significant problems with innovative solutions,” O’Carroll says.
Brian Zuercher, general partner at 1870 Ventures, says the state of entrepreneurism today can be characterized as
highly accessible, especially for digital solutions.
“It is easier and less expensive than ever to start a business or offer a product or service,” Zuercher says. “However, the low barrier to entry has resulted in a crowded field, making it challenging for entrepreneurs to stand out and demonstrate a scalable and investable business model. Gaining traction, retaining customers and proving a sustainable value proposition are crucial and difficult aspects for success.”
O’Carroll says the entrepreneurial and startup ecosystem, especially in Columbus, has never been more connected. Leveraging those connections opens doors and leads to potential customers, investors and future team members.
“Entrepreneurs who are focused on solving the problem they’ve identified, typically deploying innovative technologies as part of that solution, tend to be the most successful when they lean into their networks and resources,” O’Carroll says.
However, the biggest challenge O’Carroll says entrepreneurs face is the uncertainty the market can bring, and how that impacts funding and a company’s ability to continue innovating, hiring and growing.
“While we had several strong years in a row where many startups had record funding, it has cooled, so entrepreneurs have to make sure their business model is solid and that they have strong pitches that secure the funds they need,” O’Carroll says.
“Entrepreneurs, especially those in the early stages, tend to have the hardest time securing funds because there’s a real gap in capital, which we and other early stage investors are seeking to close.”
Zuercher agrees that a significant challenge for entrepreneurs is the lingering effect of the recent era of abundant capital.
“Investors have become more cautious with their money, and entrepreneurs now face higher scrutiny when seeking funding for their ventures,” Zuercher says.
Investors, on the other hand, currently enjoy the benefit of better starting valuations in some markets, Zuercher says. Moreover, the adoption of new technologies by businesses presents opportunities for invested capital to be utilized more efficiently, leading to value-creating activities.
However, depending on the composition of their portfolios, some investors may have dipped further into reserves than anticipated due to changing market conditions.
“Deciding when to invest and coming off the sidelines before others can be challenging, especially in uncertain sectors,” Zuercher says.
Zuercher sees a growing emphasis on fundamentals in investment decisions. This trend translates to longer due diligence periods and higher standards for valuation and check sizes. Investors are also leveraging AI to source information and conduct due diligence more efficiently, which is shaping the funding process, particularly in certain markets.
The rest of the year, Zuercher says, is expected to bring exciting prospects for entrepreneurs who demonstrate strong talent and promising business deals.
“With the continued emergence of new technologies, we can anticipate a surge in innovative solutions and technologies being introduced to the market,” Zuercher says. “As a result, both entrepreneurs and investors are likely to see promising opportunities in the coming months.”
O’Carroll says it’s still an exciting time for entrepreneurs and investors, despite the recent volatility in the market.
“With entrepreneurs continuing to generate innovative ideas, we expect a rapid rise in technologies, platforms, products and solutions that address specific real-world challenges,” O’Carroll says. “We’re optimistic that 2023 will end on a high note and set the tone for 2024.” ●
