The low interest rate, high growth, and lofty valuation environment has made most business owners look Buffet-like and most investment bankers appear to be Wall Street geniuses. The fact of the matter is that free flowing cash and artificially low interest rates can cover up a lot of inadequacies on both fronts.
Weak businesses have been able to survive but are no longer able to push through price increases as their materials, transportation, and labor costs have risen. Businesses that have been hanging on with old equipment and products without continuing to invest in development looked fine before but are starting to show signs of wear. Management teams with limited depth have been able to appear competent. Many of these companies, the "underperformers" are reaching a point of distress, and when this happens, bargain-seeking buyers begin to circle.
Private equity has paid top dollar for acquisitions for the last 4 or 5 years, and the thought is they can finally sit back and wait for valuations to begin to drop off as these "underperformers" are forced to come to market. In fact, Mergers & Acquisitions Magazine reported that,
"Private equity investments have slowed down significantly so far in 2022. While there is still plenty of capital going around, firms are being more selective with a possible global recession looming over the market. Dealmakers are looking to wait out the market in hopes of a further decline in valuations."
The issue with looking at the M&A universe in this way is that it completely ignores the fact that there are other deal makers.
Strategic buyers, who in the past have been outbid by private equity firms fueled with cheap debt in leveraged buyouts are sitting pretty with cash-laden balance sheets and models that don't require debt to finance acquisitions.
Private equity firms use debt disproportionately more than strategic buyers when making acquisitions, and as interest rates rise, their ability to pay up for a business and deliver returns to investors is limited. In addition, because of the limited time period private equity has to deliver that promised return, an economy with slower growth projections means that valuations must decrease.
Strategic buyers, on the other hand, have been accumulating cash and use much less debt for acquisitions in general. An increase in interest rates will make financing purchases more expensive for everyone, but not to the same extent as the financial buyers, whose LBO models need a combination of high levels of debt and rapid growth to generate the returns promised to investors. And that's the second advantage of the strategic buyer; they have the benefit of a longer time horizon in which to deliver returns to their investors as a result of acquisitions. They don't need to model massive growth over 3 or 5 years to justify a purchase that makes sense for the long-term vision of the company.
If a strategic buyer wants to expand a geography or add a product line, there may be some bargains available in the market for the first time in a while. Strategic buyers will have the ability to operationally and importantly – to mathematically outbid the private equity suitors. My message to all the growth-minded companies out there – be ready to act. If you have learned anything from the last cycle, you know that moving quickly and efficiently is the name of the game. This is where corporate buyers lost the edge in the last cycle of acquisitions – especially in the middle market – they just weren't as prepared as the financial buyers. Identifying the right opportunities, having the right team in place, and acting decisively on undervalued assets will create opportunities in this interesting cycle.