Lower Middle-Market M&A Likely to Stay Hot in 2022

Strong, innovative technology and healthcare IT companies are in high demand and can command high valuations

Economic uncertainty has been one of the enduring themes of the COVID-19 pandemic. But businesses worldwide are betting on recovery, showing their optimism by acquiring other companies at an impressive rate.

Last year was an M&A blockbuster, with more than $5 trillion changing hands in deals that spanned numerous sectors and involved companies of all sizes. And with CEOs reporting they plan to keep up the pursuit of growth in 2022, few expect the feverish pace of M&A to slow down.

Low interest rates – however long they last – and investment capital sitting on the sidelines are two of the tailwinds propelling buyers, including private equity, toward M&A deals. And a potential increase in capital gains taxes means many sellers are open to selling earlier than expected.

But even if this year features another frenzy of dealmaking, that doesn’t mean every prospective sale will eventually close or that every seller will achieve a double-digit EBITDA multiple.

The Year Ahead

While the M&A dollar figures were enormous in 2021, lower middle-market companies were major players in last year’s deals. Companies of all sizes in technology, transportation and logistics, facilities maintenance, niche manufacturing and healthcare services attracted significant buyer interest.

Although a number of blockbuster deals contributed to record high volumes, there remains a significant supply and demand imbalance in the lower middle-market that is driving up the price of strong companies – those with strong recurring revenue, management teams and margins – in the hottest sectors. According to private M&A data provider GF Data®, the average valuation of private M&A transactions for companies with a total enterprise value of $10 million to $25 million in 2021 was 6.2x adjusted EBITDA.

This trend for lower middle-market companies in a strong position is expected to continue this year, with healthcare IT, cybersecurity, cloud computing enabled by artificial intelligence and machine learning, facilities management, and niche manufacturing still very much in focus for large acquirers.

PE firms – which are expected raise massive stockpiles of capital in 2022 that push deal volume past 2021 levels – are keen for add-ons, which let them mitigate risk by backing known businesses. The money PE firms are raising and their enthusiasm for add-ons spells more opportunity for lower middle-market companies.

The Pandemic’s Effect on Dealmaking

The COVID-19 pandemic brought changes to the way we live, work, and shop, accelerating changes already afoot and increasing the pace of digitization. Buyers want to keep up with the changes and will continue to do that by acquiring companies that can give them new capabilities.

But buyers are growing more particular about what they acquire, and there is increasing focus today on innovative technology companies, especially those using artificial intelligence, machine learning, IT, and cybersecurity to serve today’s businesses and consumers.

Buyers are also increasingly considering “human capital” as they devise price tags for deals. A strong management team and a highly skilled workforce, especially in the field of IT, are growing to be as attractive for buyers as a company’s business fundamentals. Human capital, in fact, could begin driving more acquisitions in 2022.

Will 2022 Remain a Seller’s Market?

Corporate fundamentals remain strong as the new year gets underway, interest rates remain historically low and corporations and investors have stores of dry powder for acquisitions.

Buyers are looking for innovative products and services to meet evolving customer needs, and ways to mitigate costs as wages rise and supply constraints continue to plague the economy.

Taken together, it means 2022 will very likely be a continuation of the seller’s market we saw last year, if not an acceleration of it. That is, at least, for companies with strong recurring revenue, management teams and margins.

But macroeconomic conditions can always change, and indeed there are clouds on the horizon this year. Inflation and a looming increase to the capital gains tax will likely weigh on investors’ minds and affect their decisions. We will likely see the first of several interest-rate increases in March, which could cut into the country’s economic growth and acquirers’ ability to pay top dollar for mergers and acquisitions.

Other factors that could impact the M&A outlook in 2022 include new COVID-19 variants, higher-than-expected inflation, stock market volatility, continued supply chain issues, armed conflict in other parts of the world, and a potential slowdown of China’s economy.

We continue to monitor the macroeconomic environment, including the potential tax implications of the Build Back Better Act on lower middle-market companies. That said, we expect another strong year of M&A activity for companies between $25 million and $150 million in revenues.