M&A market conditions are changing. After setting a record pace throughout 2021 and much of 2022, activity declined in the face of inflation and climbing interest rates, according to PitchBook’s Annual U.S. PE Breakdown.
Private equity deals sank nearly 20 percent for the year, PitchBook reported, even though it remains above the quarterly pace seen in late 2020 and 2021. But macro trends might not reflect the reality buyers and sellers are seeing in their home markets.
“Today’s M&A environment is becoming more segmented,” says John W. Lewis II, founding member of Metz Lewis Brodman Must O’Keefe LLC. “Everything we read is that M&A activity is slowing down, which is coming from larger news organizations tracking the large-deal M&A space, including publicly traded companies. However, with Metz Lewis occupying the lower to middle-market space, we are seeing a consistent level of M&A activity with what has been occurring over the last 10 years, with plenty of capital seeking acquisitions, and still a healthy number of companies considering a sale in 2023.”
Sellers, Lewis says, have gone through three years of COVID, followed by an overheated economy, supply chain shortages, a wild election cycle, and war in eastern Europe, to name of few. The last three years require each seller to script a narrative as to how its earnings were impacted, positively or negatively, by recent disruptions.
“Sellers need to be better than ever at explaining their story to buyers,” he says.
And while there’s some hesitation among buyers because of macro conditions, buyers in large part are still active.
“I have definitely been told that some of the larger family offices are ‘sitting out’ investments right now until there is more certainty in the economy,” Lewis says. “But for the most part, the fear of a recession has not really dried up the well for acquisitive capital.”
Deals for strong, fundamentally sound companies will continue to get done, especially given the amount of dry powder waiting to be deployed, says Jonathan Dane, founder and CIO at Defiant Capital Group. But all the headwinds from 2022 remain today and distressed activity is picking up.
“Some sellers who didn’t take advantage of elevated valuations over the past two years are starting to move back to the sidelines, especially as valuations compress,” Dane says.
Joshua Lefcowitz, a Valuation & Litigation Support Services partner at Cohen & Co., says the U.S. market is heading into a period where good businesses are still very attractive, but businesses that have been struggling are unlikely to find a buyer.
“Many of these businesses have been propped up by Paycheck Protection Program and/or Employee Retention Credit funding, and are starting to be exposed,” Lefcowitz says. “Further, there seems to be anecdotal evidence that there is more willingness to see businesses go into bankruptcy and other alternative restructuring options.”
Obstacles and opportunities
While there are certainly challenges, Nick Conti, Senior Associate at 3 Rivers Capital, describes the M&A environment as competitive.
“We are seeing larger private equity firms coming down market to make platform investments in spaces where there are opportunities to create value by changing the revenue model from one-time sales to contracted recurring revenue,” Conti says.
Sellers still expect high valuations on the multiples of EBITDA and on the proforma EBITDA adjustments and historical performance, says John Erkert, CFO at industrial products firm IPEG Inc. Pricing is still going well for sellers and they are receiving good multiples and terms. However, buyers and their funding sources are getting more cautious and financing is getting challenging, which then impacts sellers.
Dane says the valuation disconnect between buyers and sellers is an obstacle to getting deals done. While this is starting to come in, sellers are still looking for valuations based on outsized growth the previous two years.
With the Secured Overnight Financing Rate well over 4 percent and another hike likely this year, the cost of financing is a significant headwind to many deals reaching return targets.
Rama Subba Rao Mithipati, CFO at Aquatech International, says sellers are benefiting from a relatively strong macro-economic environment in the U.S. relative to the rest of the world, while buyers may feel a sense of relief about the strong indicators that there will be a relatively mild recession and soft landing from quantitative tightening. But higher interest rates and what he calls “a high decibel pitch about an impending recession” are creating a generally challenging macro-economic environment.
Early-stage sellers with fast growth and a very clear breakeven in the near-term horizon are in a strong position, says Patrick Colletti, founder and
advisor at Net Health.
“Breakeven is a major plus and high-growth companies with earnings are golden,” Colletti says. “For larger sellers, a good margin profile plus evidence of a defensible pipeline that will weather the next two-plus years is a winning combination.”
Properly leveraged buyers with patience are in the catbird seat right now, he says. However, diligencing a target’s pipeline in the midst of the market’s uncertainty is complex work.
“Evidencing why future consumers need the target’s product or service in the medium term remains a top obstacle,” he says. “Financing is more difficult, but with strong diligence, a good balance sheet, and a legitimate synergy rationale, it’s achievable.”
Charles A. Oshurak, a partner at Cohen & Co., adds that while businesses are seeing numerous, different and in some situation’s unprecedented operational and economic challenges, this is putting the intelligent and savvy investor in the situation to possibly acquire and add immediate value to businesses in the market.
View from the early stage
For entrepreneurs at the early stages of business, business fundamentals trump aspirational metrics in the current economic environment, says Meredith Meyer Grelli, assistant professor of entrepreneurship and entrepreneur in residence at the Carnegie Mellon University’s Tepper School of Business.
“Entrepreneurs need to show a clear and speedy path to profitability,” Grelli says. “They need to be supremely capital efficient as funding opportunities slim down in the face of ever-rising interest rates.”
Ven P. Raju, president and CEO of Innovation Works Inc. and managing director of Riverfront Ventures, says over the course of the last 10 years, there have been significant global capital inflows into alternative asset classes, including venture, contributing to increases in deal volumes, deal sizes and valuations.
“Even if the macroeconomic pressures persist, it’s not necessarily all bad for investors, as valuation and valuation expectations are calibrating to more ‘rational’ levels, therein creating opportunities to invest and making it more investor friendly,” Raju says.
Ashley Gilmore Reid, founder and CEO of Wellist, says cash-efficient businesses and established entrepreneurs with good momentum and investor networks will manage through today’s economic challenges.
“Unfortunately, a tight market generally hurts more diverse founders, and up and comers, who may not have the same access,” she says, noting that 72 percent of venture capital funding went to all-male founding teams in 2022. “That’s a problem for everyone.”
Dror Yaron, principal at Ethics .Coach, says the startup ecosystem still seems to mostly support one path for entrepreneurship: get VC funding, scale fast, exit. To meet growing demand, Yaron says a new set of resources and support organizations is emerging to guide entrepreneurs in alternative business paths and models, and to help them develop purposeful, socially responsible, and values-driven companies.
“De-risking financial, reputational and unintended social harms will require developing a new set of tools and a culture shift,” Yaron says. “This type of change can be hard to bootstrap. Fortunately, a new sector is emerging to support this rethinking.”
And with the percentage of Black founders and all-women founded companies each hovering below 2 percent, who gets funded continues to be a challenge: he says it is still the case that race and gender have the most significant impact on an entrepreneur’s ability to get funding.
Deals will get done
Moderating inflation, the strong labor market, relatively stable oil prices, and continuing progress of supply chain onshoring all will have an impact on the U.S. GDP growth rate in 2023 and will determine the M&A environment, says Rama Subba Rao. For him, all are signals pointing towards a strong finish to the deal year.
For Lewis, the supply chain and customer impacts of inflation are diligence issues for buyers, as inflation affects sustainable profitability of the target. And higher interest rates affect the borrowing cost of a leveraged transaction, which is beginning to chip away at deal pricing. Still, he expects that nothing will significantly dampen M&A activity in 2023.
“The same fundamentals continue to apply, and deals will continue to get done,” he says. ●