We have all seen the data about M&A valuations decreasing and deal volume falling in the second half of 2022. Unfortunately, data as of April, 2023 shows a continued decline in both volume and valuations across the board for almost all sectors and sizes of transactions.
Factset’s US Merger Metrics showed that the number of transactions with enterprise value between $10 million and $50 million fell 43% and between $50 million and $100 million fell 44%, with valuations off about the same levels for each group. The smallest transactions - those between $10 million and $25 million of enterprise value are seeing the smallest decline in volume and value - with only an approximate 30% drop in both categories.
The lower middle market rarely sees the stratospheric valuations you read about in the newspapers but it also doesn’t get the low radical swings.
The middle market, and the lower middle market, specifically, tends to have forces that differ from the broader, larger transaction ecosystem.
Forces that drive the middle market tend to involve entrepreneurs and lifestyle decisions in combination with economics.
Why do we see any difference in the numbers?
You might be saying to yourself, "the economy is the economy - why would we see any difference in attitudes and valuations based on the size of a transaction?"
In reality, different forces are at work in times of flux. With these recent interest rate hikes, we are seeing private equity take a step back and re-examine some of the more traditional models and transaction structures.
Early 2023 Saw Fewer Big Deals
A reduction in "go-private" transactions
A material percentage of the large transactions over the last five years have been fueled by go-private transactions, particularly in the software industry – which was often seen as undervalued in the public market. According to Institutional Investor, during the first half of 2022, the value of take-private deals announced or closed by buyout funds was $96 billion versus $118 billion for the entire year 2021. These transactions relied heavily on large amounts of debt. When debt became more expensive with interest rate increases, these deals no longer made as much sense and became difficult to accomplish.
Fewer debt/dividend recapitalizations
These transactions involve a company adding debt to its balance sheet to allow owners or employees of a company to take money out as a dividend or for growth - add debt and create cash. It essentially moves risk from equity/owners to debt holders (banks). When debt was cheap, this was a very low-cost way to take money out of a business. In fact, until 2022, many investment banks were running around with their private equity friends only doing dividend recaps. Check out this article from the New York Times. Private Equity firms used dividend recaps to juice returns in larger deals prior to a sale or an IPO.
However, when debt becomes more expensive and the economy becomes wishy-washy, this is a lot less lucrative and banks become unwilling to hold business risk.
So Where is Everyone Spending Their Time?
Because I work full-time in the lower middle market, I can tell you unequivocally that the market has moved downstream. We are seeing buyers who would never look at deals in our transaction ranges, sniff around. We are, unfortunately, also seeing investment banks that normally spend their time in the rarified air of large IPOs and dividend recaps, all of a sudden sniffing around the middle market. Why might this be?
More add-on of smaller tuck-ins to existing platforms
If private equity isn’t completing the mega-transactions anymore because of the amount of debt they require, what are they spending their time on? Tuck-in acquisitions.
These are purchases of smaller companies that fit with the investment strategy of a company that they already have. The goal is to make the portfolio company larger so that the PE firm can have a bigger asset to sell when/if the economy turns around to take advantage of multiple expansion, operating synergies, and broaden the portfolio company’s capabilities and resources.
The trick to these tuck-ins is that they often have no minimum size requirements – meaning a PE firm that told investors that they weren’t going to buy anything less than $7 million in EBITDA generally has the flexibility to buy tuck-in or add on acquisitions at any size. The smaller deals are not usually valued at the extremes and do not require the same amounts of debt to be completed. Sometimes they are so small a private equity or strategic buyer can get them done with all equity or cash – with the hopes of financing them later, when debt becomes cheaper.
Smaller, founder-owned deals are not entirely driven by ROI
The other market dynamic at play is that founder-owners and private sellers certainly consider economics when selling their business, but they have other factors that they might be weighing.
Founder-owners, for instance, might be selling for retirement reasons, or because they have had a health scare. The time to sell the business is now and they want to get the highest valuation when they go to market, but they do not have the luxury of waiting out an entire cycle like a professional seller might.
Private equity and strategic sellers have a bit more leeway to wait for the exact right moment to sell (or when they believe to be the exact right moment - there rarely is an exact right moment).
As a result, we are seeing transactions happening in the lower middle market founder-owned space. If these transactions are quality businesses, the valuations are still quite good because the number of bidders looking at them is greater than we have seen in a while due to all the buyers moving downstream.
We are still seeing activity in the lower middle market as deal makers find ways to be creative with private credit and additional equity to get these smaller transactions done. This happens, in part, because of the nearly one trillion of unspent capital sitting in private equity coffers waiting to be deployed. Transactions will slow, and they may shift from larger to smaller, but they cannot stop. If you happen to have a nice, mid-sized company that is ready to go to market, this may be an interesting time to consider selling.