In the M&A environment of the past two years, not only is deal volume down, but so is conviction around specific deals, according to Keystone Capital Managing Director Bill Sommerschield, who spoke at last year's Chicago Smart Business Dealmakers Conference. There's a real divergence, he says, between A-quality assets and everything else.
"As you think about valuation, world-class businesses that have continued to grow, are high cash generative, diverse in their customer base, etc., those deals are still getting done," Sommerschield says. "Valuations may have come down a little bit, but they're not coming down significantly. And those are printing. I think when you look at B to C assets that in 2021 would have sold at a discount to the premium assets, there's a bigger spread. Those deals just aren't getting done. And so, there's a lot of what we would call a hung deal. There's a lot of businesses that have gotten to market that have had to retrench because the investor demand isn't there. And that's in large part because of what you're seeing on the debt side."
He says there's less appetite from money center to provide debt, and less of it, but the fees are inexpensive. On the private lending side, they have more expensive fees but they're willing to offer significant amounts of debt. That's leaving buyers with a choice.
"So, you have to make that trade off of, Do you want to have cheap debt that you sleep really well at night with and that you don't have to really worry about your ability to service but you don't get as much of it so you have to put more equity in?" he says. "Or do you want to take more debt so your equity check goes down, but you're paying a heck of a lot more for it?"
So, in this financial environment, he says the fundamentals of a target's story matter a lot more.
"First and foremost is cash generation and consistent history of that," Sommerschield says. "It's single point of failures that everybody's trying to avoid. So, customer concentration is really challenging and those are very, very hard to get financed in this environment."
Further, he says businesses that don't have deep investment in SG&A, don't have a built-out infrastructure or a business development team and are too reliant on reputation to generate business are challenging to finance with debt because there isn't a regimented approach to bringing in new business.
In industries such as infrastructure and engineering there can be multi-year backlogs that are easy to finance because the revenue is locked in. In professional services businesses that have shown a history of having multi-year, strategic, C-suite and board-level relationships with clients, where, despite not having signature on paper, strategy is being set with the executive team prior to the year, they can talk to that team to get confidence before closing on a deal.
"All of those things just around stability, diversification, et cetera, are key because if you have a 30 percent client and, it might not be anything you're doing wrong as a business, but something specific to that client happens and they have to shut off the spigot, that's catastrophic not only for you, it's catastrophic for the equity, it's very catastrophic for the debt, too," he says.
He expects higher interest rates will be around for quite some time, so purchase multiples have to come down.
"I think there is going to be a reckoning," Sommerschield says. "If you look at the prices people were paying in 2021, the levels that that got to, the multiples of EBITDA visa vie three years prior for the same business, was kind of astronomical and unsustainable. So, it's going to take some time. You're going to have to see some reckoning with some people that paid really high prices for high growth businesses. Growth might come down now that prices are going to come down, even if growth had stayed there, and then you compound, we're not willing to pay as much for something that is growing less in the first place, I think you're going to see a reckoning there. Prices have to come down because those returns have to improve. Otherwise, people are going to allocate their capital differently."
He expects that over the next few years, sellers are going to have to get their arms around the idea that prices paid for companies won't be what they were in 2021 and 2022. That, he says, is going to bring returns back up.
"There's still a couple trillion dollars sitting in people's pockets, and they're incentivized to put it out," he says. "Where that goes will be interesting. But I do think you're going to have to see a reckoning there to some degree."
