Introduction
BMI has seen robust business acquisition activity from buyers and sellers in 2023, even though economic trends and credit availability remain uncertain. Our takeaway from all the data is the positives outweigh the negatives. While there are headwinds, the overall trend is one of strengthening.
Companies Holding Steady
Company financials reflect a stable economic environment, with revenues mostly holding steady, albeit with some mild pullbacks compared to the booming period of 2021-22. While supply issues have largely subsided, certain businesses still face shipment challenges. On the positive side, costs have stabilized and, in some cases, even decreased. Large corporate earnings reflect the same….as 79% of reporting companies beat Q1 expectations (FACTSET).
Resilience in the Face of Recession Predictions
Most economists continue to predict the possibility of a recession, but their certainty is declining as the economy shows resilience. Bank of America came out on August 2 revising their forecast from a mild recession to slow growth and a “soft landing,” echoing the Federal Reserve’s economists’ predictions. Despite these positive signs, buyers remain cautious and concerned when they observe even slight declines in revenue. They seek reassurance that such declines do not indicate a downward trend but rather typical fluctuations in a stable revenue environment.
Impact of Rising Interest Rates and Credit Availability
One area of concern revolves around rising interest rates and their potential impact on office real estate. There are worries that this could lead to reductions in bank credit availability, including for M&A deals. Although this remains a developing story, its full impact may not be felt in the mainstream for months.
The good news is that interest rate increases seem to be nearing their end, providing some certainty for planning purposes. The question now is how long rates will stay elevated before beginning to decline. On another front, new capital rules for banks were announced on July 27. These rules will require more banks to hold more capital, potentially resulting in less credit availability. This could have its biggest impact in the lower middle market, where business acquisition deals are usually too large for SBA backing, and it falls to midsize banks to supply the capital. However, the FDIC reports most midsize banks have sufficient capital to meet the new rules, although undoubtedly, there will be some impact.
M&A Deals: A Changing Landscape
Private equity deals have seen significant changes since 2022. Debt as a percentage of enterprise value has declined from 50.8% to 43%, indicating a more conservative approach and more expensive debt capital. Private credit, which has played a crucial role in supporting the market since big banks withdrew, remains robust. Additionally, big banks have started providing credit on LBOs (leveraged buyouts). But, the market is not monolithic as GF Data reports debt ratios on deals $10-$100 million debt to EBITDA ratios at historically high levels while the $100- $500 million ratios are well below prior years.
According to Pitchbook’s Q2 US North American M&A Breakdown report (Chart 1), the M&A market has maintained pre-COVID-19 levels of deal activity, which were considered strong years before the 2020 to 2022 frenzy set the bar high. While overall Private Equity deal activity is on par with 2022 and surpasses any year before 2021, deals in the over $1 billion category have reached their lowest level since 2016(Chart 2), reflecting the challenges of financing larger deals and the resiliency of the middle market. 2023 annualized deal activity could reach 17,500, which is on pace to be a very good year for deal volume, however, deal values are down with all this, indicating smaller deals are where the action is.
PE Deal Activity – Over $1 Billion – including 6 months 2023(Pitchbook):
Deal Values Hold with Upside
M&A valuations across the broader market, as reported by Pitchbook are on par with 2022, but when you look at subsets of data such as GFData’s lower middle market stats for companies with EBITDA between $3 and $5 million, you see valuations at or above historical averages (Chart 3). Of course, 2023 data is preliminary and a relatively small sample, but at this point, whether we look at BMI’s experience or published research data, we see a strong market on valuations.
Vibrancy in the Lower Middle Market
Activity in the lower middle market, including companies with $5 to $100 million in revenue, remains strong. The number of owners testing the market has increased, while buyer interest has not waned from the heated pace seen in recent years. As a result, valuations in this segment have remained relatively steady. In contrast, larger deal sizes have experienced a notable decrease in valuations, ranging from 10% to 20%.
Private equity firms, anticipating weaker returns when selling portfolio companies, are currently holding onto these assets instead of selling them, leading to increased demand for non-backed privately held companies in the lower middle market.
Conclusion
The Q2 M&A Middle Market portrays a resilient landscape. Despite concerns about a potential recession, the economy has shown remarkable strength. The stabilization of costs and interest rates has provided a sense of certainty for businesses planning their strategies. The private equity sector has experienced notable shifts, with lower debt levels bolstered by significant cash reserves helping sustain deal activity. The lower middle market remains vibrant, attracting significant interest from both buyers and sellers, leading to stable valuations in this segment. What happens next seems positive but is certainly unclear. For now, the market looks good.
David Olson
Senior M&A Advisor
BMI Mergers & Acquisitions
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