Inflation, a rise in interest rates, and global unrest and uncertainty represent some serious headwinds for the economy right now. But the consensus, from my sources in the M&A world is that dealmaking for the lower middle market has not faltered and will not falter going into the next year.
Granted there has been a decrease in the pace of M&A activity when you compare 2022 to 2021, but that’s not a far comparison, as last year we saw record-breaking deal-making thanks to pent-up demand for deals as we emerged from the pandemic.
As PricewaterhouseCoopers put it in their Deals 2022 midyear outlook report:
“Just like a car that slows from 100 mph to 60 mph is still moving fast, so was the first half of 2022. The 2021 deal volume was not a sustainable annual average, and that context is important.”
There are several factors contributing to this continued run of impressive M&A activity.
There is a massive amount of capital out there, with $800B to $900B in dry powder available to be exercised by PE firms and Strategic Buyers.
Prices are leveling off. Unlike in 2021, with its frenzied rush of acquisitions, there are not as many Buyers pursuing a given target. That means more reasonable pricing for Buyers. Fewer bidding wars.
There has been extra scrutiny focused on publicly-held companies, with the federal and some state governments taking closer looks at so-called megadeals in terms of antitrust issues. But this is not an issue for privately held like the majority of lower middle market firms.
Rising interest rates, inflationary pressure, and consumer spending variability are impacting transactions – but not stopping them.
Supply chain issues have actually caused many companies to react by acquiring suppliers, cutting out the middle-man to source materials directly. For example, in consumer goods, companies are acquiring distribution centers so they have control over that part of their supply chain at least.
While volatility does inhibit IPO volume, PricewaterCoopers maintains in their report that “alternative sources of capital or transactions may be more likely, including PE suitors.”
You also have to look to owners and founders of lower middle market companies. Many feel cornered by these ongoing macroeconomic trends. They feel like we’re headed to a similar fate as 2008/09, and they don’t want to be caught up in that cycle as a protracted recession could prevent them exiting for three to five years. So they have an incentive to get a deal done in the next 12 months.
This is particularly the case in places like California and New York locations. These folks want sell, retire (or move on to other ventures), and they’re ready to escape to places with lower taxes and lower cost of living.
These Sellers willing to take a discount if they can get out sooner rather than letter.
It’s also worth noting that conditions that you would think would slow down deal-making…are actually doing the opposite. As the Deals 2022 midyear outlook report notes:
“Some of the same forces creating market uncertainty – the lingering pandemic and geopolitical turmoil – also are driving dealmaking imperatives. Whether a company needs to transform its capabilities, supply chains or go-to-market approach, the market is impatient and one of the fastest ways to accelerate transformation is through M&A.”
Certain market sectors are doing particularly well in these times.
Technology companies are sitting pretty, buoyed by very favorable market fundamentals. Businesses need to keep pace with innovation and the ongoing worldwide digital transformation. There is always some new tech needed to stay competitive.
And that means M&A deals for companies offering software, cloud solutions, analytics, and cybersecurity will continue at full steam.
In the consumer goods market, they are faced with the fact that some people are not buying as much due to inflation. However, we have a strong market, which means plenty of people spending money out there.
And industrial and manufacturing companies are also streamlining in the face of supply chain issues. With recent experience, they are getting better at making contingency plans for future supply chain interference, which means commodity shortages are less of an issue. Plus, they are increasingly turning to onshore manufacturing.
All this said, deal-makers must be cautious. There are a lot of unknowns out there. The situation is volatile and changing constantly. But I contend that it will be more expensive – in terms of lost opportunity – to hunker down instead of continuing to move forward on deals. But deal-makers do have to work smarter in this climate.
As Cascadia Capital put it in Summer 2022 Quarterly Newsletter:
“Though the astronomic prices are gone, buyer scrutiny is more intense than ever. We have entered a ‘show me’ world where buyers are demanding concrete proof. They need to see it before believing it; once they do see it, they are willing to value and pay for it.”
One way to eliminate Buyer and Seller risk in an M&A deal – especially now but in any market conditions – is with Representations and Warranty (R&W) insurance. This product is tailormade to facilitate fast acquisitions too.
Transfers risk of breaches of any Seller Reps and Warranties to the insurance company.
It protects Buyers if a post-closing breach occurs. They won’t be subject to covering that loss entirely themselves or having to pursue the Seller for a clawback.
When this coverage is made part of the deal early on, there is no need for the intense negotiations over reps and warranties because, if there is a breach, the insurer pays the damages.
This speeds up the process – not to mention saves on legal fees, about 20% savings on the negotiations part of the deal.
The target company keeps more money in their pocket rather than in escrow. This is especially compelling for owners and founders seeking a quick exit.
Buyers savvy enough to offer the idea of R&W at the opening of negotiations, routinely finds the target company will gladly pay for the coverage.
As a boutique broker with long-time experience with R&W insurance, I’m happy to chat with you about how this unique coverage could be part of your next deal.
Please contact me, Patrick Stroth, for more information on TLPE and other M&A insurance options.