The economic tailwinds of 2021 and most of 2022 have been replaced by headwinds, creating a more challenging M&A landscape, says Jeffrey Bechtel, Regional Market Executive and President of Cleveland Region, First National Bank.
"In addition to rising interest rates and volatility in the economy, companies are facing increasing labor costs and lingering supply chain issues," Bechtel says. "Companies also may find themselves with fewer options for deal financing as lenders tighten credit availability, making it more important than ever to have a relationship with a lender you trust. These factors are contributing to an overall slowdown in M&A activity."
According to PitchBook's 2022 Annual Global M&A report, released in January, global M&A activity this past year remained resilient despite the macroeconomic headwinds. While M&A value declined 13.7 percent to $4.7 trillion compared with 2021, it was strong relative to historic levels and marked its second-best year.
North American M&A stumbled in 2022, ending the year with some 18,576 deals for a combined value of $2.2 trillion, according to the report. Deal value dropped 21.6 percent from the record-setting activity seen in 2021, but deal count and value on the continent remained above the average realized between 2017 and 2019, which PitchBook says, similar to the global picture, illustrates that deal activity is correcting to historic levels.
This year, market uncertainty continues to be the fly in M&A's ointment. Bechtel says M&A deals generally run smoothest when outcomes are predictable or there are prior examples of success to follow. However, current conditions are more prohibitive to creating a sense of certainty, something he says is likely to continue for companies pursuing M&A activity, especially as they consider growth projections based on performance in the first half of 2023.
Several area dealmakers chimed in on how they see the current market; how buyers, sellers and entrepreneurs are faring; and their expectations for how the remainder of the deal year plays out. Here's what they have to say.
Business unusual
"Tough" is how Sanjay Singh, Chairman and CEO of Mace Security International Inc., would characterize the current deal environment.
"Opportunities are limited because of the higher cost of capital," Singh says.
Walnut Ridge CEO and Managing Partner Mike Moran sees a confluence of factors that have created what he calls a cautious market.
"Sellers are working through sticky inflation, recessionary pressures and optimizing the workforce to future demand in a post-pandemic environment," Moran says. "Buyers, for their part, are working through this same inflation, uncertainty in the capital markets, higher costs of borrowing and a less competitive market for debt financing, and less clarity on near-term demand in certain sectors."
Cheryl Strom, partner, origination, at The Riverside Company, says today's M&A market is not “business as usual” compared to first half 2022.
"Sellers who are trying to find the peak of the market, particularly for large companies, are holding off right now," Strom says. "But the world keeps turning. Prompts such as retirement, succession, owners wishing to make a significant change in their lives, or in need of capital and resources for growth, continue to develop each day. These generate continued transaction activity in the smaller end of the middle market."
Similarly, Tucker Ellis LLP Partner Jayne E. Juvan says every economy presents opportunities for M&A.
"While the volume and value of transactions is down right now for both strategics and sponsors, this environment presents a welcome opportunity for buyers who have dry powder they can deploy to seize on deals at lower valuations," she says. "In today’s environment, we’re seeing disciplined investing, a flight to quality, and more balanced economic terms, all of which bode well for success in transactions."
For entrepreneurs, Stephen McHale, CEO of UnifyWork, says today's environment is challenging.
"We hit quite an inflection point — almost disruption — going into the pandemic," McHale says. "The financial markets were heated; things were going well. Then, COVID hit and we had to bridge through it. Technology was the bastion and we saw a lot of first-time venture capital groups supporting tech startups. There was an influx of capital and VC firms were seeking entrepreneurs. Unfortunately, we’re now seeing a lot of failures, and venture capital firms are scrutinizing opportunities more closely; it will be more challenging for entrepreneurs to get funding."
Dealmakers such as Singh are keeping their eye on a bevy of economic factors as they gauge the deal market. For Singh, that means watching consumer sales, unemployment claims, yield curve, durable goods orders, the stock market, manufacturing orders, building permits, the GDP growth rate, interest and inflation rate, and government debt to GDP.
For Juvan, there's also reason to be aware of the health and stability of the banking system, as she says it's creating pressure on M&A.
"CEOs and boards need to be confident to be willing to pull the trigger and complete deals," she says. "When institutions such as Silicon Valley Bank — the 16th largest bank in the U.S. — fail, that generates worry that can cause delays or paralyze decision-makers."
While Juvan says it's fortunate the Treasury and Federal Reserve approved actions to protect uninsured depositors, thereby limiting systemic risk that might have otherwise followed the collapse, these events can cause decisionmakers to think twice before taking on the risk of doing a deal.
Sellers' market tempers
Moran says sellers are benefitting from the large amount of capital, raised by private equity funds, that needs to be deployed and the relatively strong trading multiples of public companies.
"Consolidation is likely to be driven by acquirers needing to better position themselves to get through an uncertain market," Moran says. "The focus will be on finding opportunities for cost synergies, improving competitive moats, solidifying distribution channels and gaining advantages of scale as costs rise."
Pushing against those positive attributes is the more expensive and less available debt. Lenders, Moran says, are acting more conservatively on leverage levels and are more conservative on what they will accept for projected performance.
Juvan sees the overwhelming acceptance of representations and warranties insurance as something that's allowing sellers to walk away with more cash at closing and limit their post-closing indemnity risk.
"While there may be fewer no-recourse deals given the macro-economic environment, sellers are not bearing risk or escrowing funds for indemnity claims to the extent that they were before representations and warranties insurance became as prevalent as it is today," Juvan says.
However, she says many sellers are challenged by their failure to reset valuation expectations and still desire to sell their companies at pandemic-era pricing and terms.
According to Strom, sellers who have established a business model with repetitive revenue, rather than one-time projects, are meeting with continued demand by today’s investors.
"Sellers who spent time preparing for a transaction by having a deep management bench, lots of data, defensible financials and attractive facilities, will 'show well,'" Strom says. "Buyers are more cautious, so a compelling value proposition and strong case for future demand is more important than ever."
At the early-stage end of the deal spectrum, McHale says the capital markets are looking for experienced entrepreneurs with a track record for success.
"They’re leaning in more and providing more resources and connections to these entrepreneurs — that’s what’s really important," McHale says. "It’s great for those that have a model that makes sense and attracts smart capital that will help them."
However, entrepreneurs' challenge is getting funded.
"The closing of Silicon Valley Bank was jarring — it’s going to make people nervous for a while to fund startups and entrepreneurs," McHale says. "Because of that, entrepreneurs will need to be very disciplined about their spend. The capital you raise could be your last, so you need to get to a model to break even as soon as you can. If investors can see a growth trajectory, coupled with a discipline on spend, you’ll be rewarded."
Dust settles for buyers
In these less-certain economic times, Strom says buyers who have rich experience and a track record in their desired industry are more confident.
"Even better, buyers who have an existing company, or platform, with capital to make add-on acquisitions, face a much wider range of acquisition opportunities," Strom says. "For example, a buyer can absorb a large customer concentration if that business will fit into an existing portfolio company to diversify that risk."
Juvan says buyers with access to capital may see less competition for deals given the interest rate environment. And sellers are also more willing to provide financing or agree to contingent consideration such as earnouts to bridge valuation gaps.
Because the market is less predictable today following a long period of growth and the impact of the pandemic, Moran says smaller companies are seeing clouds on the horizon for near-term growth.
"Many companies, especially those that are lower middle-market, absorbed more inflation in costs than they were able to pass along in pricing, so margins are stressed.," he says. "Private company owners may not be willing to do the belt tightening to weather a recession and are tired from what they had to do to navigate the pandemic."
Also, he adds that buyers may become more near-term internally focused to make the operational adjustments needed to address the market environment and less willing to be strategically bold in acquisitions.
Investors, McHale says, are benefiting from less noise.
"There are fewer companies out there willing and capable of meriting funding," McHale says. "Things are slowing down a bit, so there’s not as much volume coming at investors. Yet, the quality of volume is going up, so there are a lot of nice opportunities for investors.
As the market is slowing a bit, the challenge for investors will be to hold up the portfolio companies they’re already in.
"Investors need to recalibrate their models and revalue their portfolios, which is challenging," McHale says. "It’s hard to raise capital and funds if you’re trading down values for the companies in your portfolio."
Fear and fit
When it comes to obstacles that threaten deals, Singh says confidence levels in the investment thesis may be lower than expected because of the economic slowdown and rising cost of borrowing.
Along those same lines, Moran says fear and liquidity are considerable barriers to deals these days.
"Many buyers are building up cash reserves and paying down debt to provide future flexibility," Moran says. "This combination of moves has the potential to weaken demand for acquisitions near-term but could signal mid- to longer-term improved ability for acquisitions."
For companies at the larger end of the middle market, Strom says the pullback in the debt market is a constraint.
"This is more pronounced for sellers that must sell now and do not match up with a strategic buyer," Strom says. "For companies that fit as strategic add-on acquisitions, there are more options when the strategic buyers to not need outside debt to finance their transaction."
Looking ahead, Moran says he believes that the year has the potential to end strong once rates and inflationary pressures stabilize.
Strom expects private equity funds are going to overweight on add-on activities this year and will also be successful being creative and purposeful making new, stand-alone platform acquisitions but at lower frequencies.
"Those firms that are well funded and with large portfolios will remain quite active meeting the needs of small business owners seeking liquidity or ownership changes not driven by the market but by natural forces as owners age and seek change, and whose companies fit nicely as add-on acquisitions," Strom says.
