Today’s M&A market is dynamic, says Ice Miller LLP Business Group and M&A Partner Chris Michael, although recently, it’s characterized by a cautious optimism.
“Deals are still being conducted and closed at a significant pace, but purchasers are exercising increasing caution and digging deeper into the due diligence process,” Michael says. “The environment seems to be changing on an almost monthly basis.”
Tradepost Partners Founder and CEO Jordan B. Hansell says that while liberal access to cheap credit and equity capital-seeking deals have made for continued robustness in M&A, macroeconomic factors have had a softening effect.
Dealmakers interviewed for this story see continued strength in the M&A market overall but note that the Federal Reserve’s interest rate increases, geopolitical issues, the ongoing pandemic, supply chain disruptions, inflation, volatility in the public markets, labor issues and consumer spending are drags on the previous year’s momentum. That negative pressure can be seen in the volume of transactions; according to PitchBook’s Q2 2022 Global M&A Report, approximately 4,571 deals closed in North America during the second quarter, a decline of 30.2 percent from Q4 2021.
Still, while the pace of overall deal flow has slowed across the country as uncertainty affects the markets, GBQ Partners LLC Managing Director Darci Congrove says that, from her seat in a firm focused on the middle-market, she’’ still seeing a high volume of M&A activity in the second half of 2022.
Momentum still favors sellers
Many business owners are coming off record performances over the last year or two, says Hansell. To the extent they can convince buyers that
these trends will continue, or at least not be materially damaged in the medium term, they are in strong positions to sell. Increasingly expensive capital, however, is reducing the buyer pool, which results in less demand — a dynamic that places many potential sellers in a relatively weaker position.
Interestingly, sellers who don’t have to exit the business are in a positive standing, says former CEO of Updox Mike Morgan.
“The fundamentals of playing in a big market, good product market fit and strong execution with a path to profitability are starting to be valued higher again,” Morgan says. “And those companies will still be able to sell at very fair
Ice Miller LLP Business Group Vice Chair and Partner Tom Pampush says sellers who were forced to take earnouts following the COVID downturn are generally seeing those being paid. And sellers that have shown results that resemble their pre-2020 trajectories are having success eliminating or reducing contingent aspects of the purchase price.
Michael says there is still a lot of transaction momentum that favors sellers as funds continue to be under pressure to deploy dry powder and lots of motivated buyers remain in the marketplace. Multiples are still high, as well, so sellers can command significant enterprise values, although as buyers begin digging deeper into due diligence, sellers are having difficulty extracting the level of value that many were seeing in the second half of 2021. Also, with significant shifts in the labor force and decreased consumer spending, many sellers are experiencing flat or declining earnings.
Buyers face issues with misalignment
M&A activity for the purpose of re-shoring or creating a more stable supplier network gives buyers more control of their overall business cycle, Congrove says. But higher borrowing costs and declines in corporate stock values create concerns about managing the balance sheet. That means, she says, that there’s less room for error in decision-making.
More difficulty obtaining capital, particularly from the debt markets, is likely to put pressure on buyers’ ability to offer competitive pricing and to close transactions, Hansell says. But, as valuations in many industries hurtle toward an inflection point, it could create opportunities.
“To the extent potential sellers have borrowed over the last few years, and interest rates are rising, buyers may find some sellers who are in distress, providing additional opportunities for value purchases,” Hansell says.
Michael says that the time it takes to close a deal seems to be lengthening and buyers are exercising increasing restraint and diligence. The resulting effect is that buyers are reverting to pre-pandemic levels of due diligence and, in some respects, bargaining authority. However, buyers are experiencing difficulty in aligning seller expectations, which are often inflated coming off of 2021, compared to seller and market realities.
“Terms that buyers may have glossed over or lived with in 2021 are no longer being accepted, whereby sellers are trying to cling to these waning expectations,” Michael says.
Morgan sees a similar issue.
“The chasm between sellers’ and buyers’ expectations is as big as I have ever seen it,” Morgan says. “The misalignment of value expectations is the biggest obstacle in getting deals done in the current environment. There has always been a gap between buyers and sellers, but it is becoming so big that it makes it difficult to get deals closed.”
Another compounding issue, according to Ice Miller Business Group and M&A Partner Leslie Johnson, is that there are fewer deals available for buyers in 2022 compared to 2021.
“The anticipated tax changes in 2021, and the increased activity last year from a slow 2020 due to COVID, drove more deal activity in 2021, which means there are fewer sellers and deals available to buyers in 2022,” Johnson says.
On the early stage side, SureImpact Founder, President and CEO Sheri Chaney Jones says despite the macro turbulence, there are still
opportunities for entrepreneurs to raise money, build successful companies and reach a successful exit. The past decade, she says, has created a strong ecosystem of angel investors and venture capital, many of whom are focused on investing in traditionally underrepresented founders, such as entrepreneurs in the Midwest, women and entrepreneurs of color. That, in turn, has opened the door to many innovative companies.
Jones, however, is closely watching her prospects’ confidence about the future economy.
“Consumer confidence might slow their spending and/or delay them from making a decision,” Jones says. “This may impact early stage startups, as the sales cycle might take longer, which may mean they will need a longer runway to hit projected milestones.”
Ohio Innovation Fund Principal Faith Voinovich says she’s monitoring the performance of IPOs, as well as funding at the earliest stages, given potential liquidity challenges. That’s because volatile public markets can spell challenges for the earliest-stage startups, which are more dependent on high-net-worth and angel money. Fundraise timing can also become more challenging when investors are either pushed to support their existing portfolio companies with reserved capital, rather than pursuing new investments, or take a pause on evaluating new investments due to the market uncertainty — something she’s seeing with many later-stage funds.
Still, she says entrepreneurs in the Midwest today are much better positioned for funding than they were a decade ago, thanks in part to venture funds beginning to pay closer attention to the Midwest. Ohio entrepreneurs are also benefiting in many ways from both the boomerang effect of Midwesterners who spent time developing their startup skills on the coasts, then decided to move back to their home states during the pandemic, as well as the shift to remote work, which has allowed many startups to pursue hybrid work structures, significantly expanding their pool of talent.
There’s a negative component, though, to the additional talent access that remote and hybrid structures have provided, and that’s the compensation piece.
“The Midwest enjoys a relatively low cost of living, and salaries are commensurate with that. Recruit a new, awesome product person who’s based in Saratoga, California, and all of a sudden that salary needs to be at least 50 percent higher in order to be competitive,” Voinovich says. “Financial modeling and projections need to take these higher costs into account, which can have significant inputs on cash flow and burn rate.”
Jones says there are additional reasons that early stage entrepreneurs are facing significant challenges finding highly skilled talent.
“Well-funded startups have driven up salaries of talent,” Jones says. “Early stage entrepreneurs have difficulty matching these rates while managing runway. Without the ability to attract and retain talent, it slows down the entrepreneur’s ability to achieve milestones.”
Voinovich says there are great startups being founded and scaled in the Midwest, and investors who are active in the region have the chance to get to know startup founders and teams in a more robust diligence process. However, more mega-funds are looking to expand earlier in the funding cycle, which Voinovich says has led to overinflated valuations and excess money being pumped into very early stage companies. This, she says, can create scenarios in which dedicated early stage funds providing more strategic capital are outbid by “dumb money,” which can create challenges for company scaling and decrease the chance of success, especially for first-time founders.
“While bringing on a lot of capital at a super-high valuation can be a good fit for some companies, it’s historically been detrimental for Midwestern startups that are encouraged to spend, spend, spend prior to really understanding how that spending is driving value — for themselves and common shareholders, as well as for investors, which leads to challenging conversations around down-rounds or out-of-the-money exits for common shareholders,” Voinovich says.
Jones says more investors are seeking companies that have the potential to be the next unicorn and have a path to a billion-dollar exit. This affects the fundraising process for entrepreneurs because they need to spend significant time identifying a path to this type of exit to be attractive to investors. It also means companies that will likely have high-value exits need to do significantly more investor research to figure out if investors are a good fit and worth the time it takes to build a relationship with them.
Obstacles and predictions
Fear, borrowing capacity and overstretched advisers and dealmakers are all obstacles to getting deals done in this environment, Congrove says. She expects a slowdown from 2021 but still a strong M&A environment, especially with private equity buyers.
Deals for companies that have built solid businesses will continue to happen at good valuations, Morgan says. But there will also be many companies that have raised a lot of money, yet still haven’t figured out how to profitably scale.
“To survive, they will either need to cut dramatically and weather the economy, or choose to sell at a discounted rate, creating value opportunities for buyers,” Morgan says.
The general feeling of uncertainty, particularly among the debt and equity capital sources, could be the most significant obstacle to dealmaking, Hansell says. He expects that will lead to deals being repriced, which reduces the odds of closing. While deals already in progress will close, the pipeline of transactions will begin to slow, resulting in a downward trend in deal activity through the rest of this year and into the next.
Michael says flat and declining earnings make alignment difficult in this environment. Also, with buyer approaches seemingly reverting to pre-pandemic practices, increased buyer diligence, focus and negotiation have made most deals anything but routine.
“While I expect transaction volume to remain robust throughout the remainder of 2022, it likely will be more akin to 2019 levels, and less than experienced at the end of 2020 and 2021,” Michael says. “If private equity continues to drive transactions at a similar percentage as it has over the last 18 months, then we can expect a slightly higher volume, but this will be difficult with the economic headwinds that are present.”●