The current M&A market has been in the doldrums since the beginning of 2023. The circumstances contributing to the state of the market have not occurred for some time and not at the same time — the hangover from a pandemic, relatively high interest rates, a presidential election year, geopolitical risk and government intrusion into the market. These factors and the uncertainty they engender will continue to depress activity until there is more clarity.
Admittedly, the M&A market just a few years ago was incredibly active, and some would say overheated. Concerns about rising taxes in a Biden administration, low interest rates and an ever-growing private equity supply of capital drove those conditions in 2021and 2022 — very busy years in M&A. This likely pulled the M&A calendar forward from 2023 into 2022.
Then, the Federal Reserve, to combat inflation caused by government spending during and after the pandemic, was forced to significantly raise rates. This and mixed economic signals have shifted the narrative from how many rate cuts could there be to whether there will there be any at all.
Less discussed but also important has been the Fed’s involvement in the economy that began in 2008, which was never fully unwound but accelerated in 2020 to combat warranted concerns about the pandemic. Until the Fed has fully unwound its purchases of treasuries and mortgage-backed securities, it is more difficult to gauge the true health of the economy.
Combined with geopolitical risk stemming from Ukraine, the Middle East and China, as well as an election year in which the two major-party presidential candidates have very different views of the world, there is a great deal of uncertainty, which is making decisions about where and when to deploy capital more difficult. This includes private equity funds and traditional banks.
The current market is positive, however, for subordinated debt lenders who are able to take on more risk and move up the capital structure normally filled with traditional banks. Further, the prime rate used as a benchmark for lending is at 8.5 percent, compared to the 11 to12 percent that is typical for subordinated debt interest rates. That’s not much different, but borrowers like the flexibility offered by subordinated debt compared to traditional bank debt.
Having a separate and important impact on M&A in the post-pandemic world is the lack of trust and general divisiveness in the wider business community. I am referring to the “gotcha politics” now used by accounting and law firms to attract private equity clients as a way to show their M&A mettle, and then private equity capitalizes on these professionals’ “findings,” stating that they are unable to make decisions that might be different in any degree from the reports the firms provide. These private equity investors are, in a way, communicating that there is lack of trust in their own organizations — they’re unable to have their own judgment, or they are hiding behind their service professionals to elicit leverage in negotiations.
On the seller side, there is a similar situation where the professional standards are at a relative low point with regard to the typical adjustments process associated with underwriting normalized earnings, and a general lack of disclosure or misdirection on how the business is being presented.
This lack of trust translates into longer sales cycles, divisive discussions, deals not closing and stunted future partnerships. This is as much of the issue as the malaise of the M&A market. Rather than enjoying an important event for buyer, seller and management team, it is becoming more of a win-lose atmosphere that ultimately has no winners.
Jeffrey Kadlic is Founding Partner of Evolution Capital Partners
