It happened quickly: we began noticing rising prices on essential goods earlier in the year with food and energy prices inching up. They were driven higher by geopolitical disruptions in early spring. Business owners have been struggling with labor shortages and supply chain challenges for most of the last year.
Faced with a Consumer Price Index that reached a 40-year high, the Federal Reserve took aggressive action in March and expectations are that they could raise rates to 3% by 2023, a significant hike given that 2022 began at a 0% interest rate. Investor concern can be seen in the downward performance of the public security markets such as the S&P 500, Nasdaq and the Dow Jones Industrial Average as inflation and rising interest rates remain a top concern.
What does this mean for owners thinking about selling their companies? How will these macroeconomic factors affect the valuations of companies, especially those that have managed to create significant value despite the challenges of 2008, the pandemic and recent supply chain and labor problems?
While these macro factors will have an impact, we think there are important considerations that warrant optimism especially in the lower end of the middle market (private companies with $25 million to $150 million in revenues) where deal activity will continue to be driven by two factors: first, the need for firms to achieve growth, both organically and through acquisition, and the opportunity that smaller companies offer investors to achieve this growth. Second, the amount of investment capital that needs to be put to work by investors.
An important characteristic of the middle-market deal activity broadly is that volume is not exclusively driven by public listings. Analysts at PitchBook said that sponsor-to-sponsor transactions and corporate acquisitions in the middle-market actually set new median deal-size records in the first quarter indicating that demand for businesses with strong earnings and revenue growth will remain robust. If investors have a strong exit valuation, they can be more bullish on their initial valuations. For sellers, it also means that retaining equity after a transaction can still lead to a meaningful second liquidity event.
One of the key reasons is that smaller companies are known to bring strong returns to acquirers and their investors. Whether the headwinds abate in the second half of this year or continue to blow, the opportunity to accelerate growth in smaller privately held companies by investing capital and achieving operational efficiencies will continue. This makes smaller companies attractive investments and supports higher valuations. This is especially true of companies that provide business-essential services such as ERP optimization, operation-critical components or maintenance and repair of operation-critical facilities.
Another factor is driven by investors. Private equity firms—who shepherded much of the deal volume in 2021 and 2022—are currently sitting on $949 billion. These firms have been responding to the need of investors—both institutional and private—to commit their investment capital to strategies outside the public markets. Even if fundraising slows in the second half of the year, “dry-powder” capital from prior years will continue to fuel M&A activity.
Well-financed buyers and strong sellers will dominate deal activity. While the cost of financing is increasing–which means debt coverage ratios and debt-to-equity ratios in deals will become more conservative favoring less leverage–this will affect weaker buyers and sellers. Valuations may feel some downward pressure by the end of the year but buyers with strong balance sheets will continue to be active, and valuable, well-run companies in search of a buyer will be actively pursued.
If you have built a good company and managed it well, you should remain optimistic about this year, even if the headlines have been grim. There is a tremendous amount of capital on the sidelines, and investors want to put it to work.
And since the lower middle-market is known to generate value for smart investors who are investing in long-term growth, M&A activity will continue, albeit with some new challenges.