KEY ARTICLE TAKEAWAYS
- 2021 Private Equity M&A Recap
- 2022 Deal Activity, Lender Environment and Outlook
2021: A Record Year
2021 private equity deal activity was record-breaking by nearly every metric. Especially pronounced was the surging volume in the second half of the year. U.S. private equity deals surpassed $1 trillion for the first time ever and marked a whopping 83% dollar-value growth rate over 2020. Additionally, deal quantity was up 61%.
This growth can be largely attributed to a confluence of several factors:
- A proportion of deals delayed in 2020 due to the pandemic
- Other deals being expedited ahead of 2022 for tax purposes
- Many sellers seeking to take advantage of historically high valuations
- Buyers capitalizing on inexpensive debt
The chart below illustrates the influx of deal activity during the 2021 period.
Source: PitchBook Data
2022 Outlook: Tapping the Brakes
With deal volume and valuations accelerating at such a breakneck pace in 2021, the market was positioned for a natural slowdown. In addition to an organic slowing in Q1 2022, concerns over macroeconomic and geopolitical conditions have tempered some investors’ willingness to stretch past certain multiple thresholds or overlook particular risk factors in a target investment, as they factor in how a potential recession could impact their ROI.
With that said, our conversations with private equity groups indicate that the pendulum is still far from swinging from a seller’s to buyer’s market. Most middle market private equity groups we have spoken with are currently preparing their next fund and are expecting to close in 2022 or early 2023.
Additionally, 2022 forecasts are for high levels of fundraising among mega-funds seeking $5 billion or more. Despite market volatility, there is an excess of dry powder available, which points to continued competition for high-quality deals.
Deal Prospects: Quantity Over Quality
In our conversations with institutional investors, the consensus is that while deal volume in 2022 has remained healthy, picking up after a slow January, there has been a discernable drop-off in deal quality. A multitude of factors, in particular the following, have likely contributed to the decline.
Impact of Proposed Capital Gains Tax Hikes
Entrepreneurs with more attractive businesses – those likely to drive the highest multiples – would have felt heightened dollar-for-dollar impact from proposed capital gains tax hikes, which would have increased the rate from 20% to 39.6% for anyone earning more than $1 million per year. This figure did not include the 3.8% Obamacare surtax or state capital gains tax, which would have brought the total rate to over 50% in some states. Although the Biden Administration’s push to reform the tax structure was ultimately unsuccessful in 2021, entrepreneurs prepared to get ahead of the impact.
Of course, the sellers who would have seen the most significant take-home effect would have been those selling for the highest enterprise values. For example, the seller of a $200 million business would have owed nearly $40 million in additional taxes. As such, it’s no surprise that many owners of highly valued businesses were eager to sell ahead of the proposed change.
COVID-19 Impacts Varied by Industry
Generally speaking, many industries that were most negatively impacted by COVID are not traditionally the sectors generating the highest valuation multiples – consumer or commercial field services, manufacturing, foodservice, transportation & warehousing, mining, and brick & mortar retail are some examples of industries that were disrupted most by the pandemic due to supply chain bottlenecks and government-recommended isolation guidelines. Many sellers in these industries likely opted to wait for a trailing-twelve-month period of normalized financials after the height of the pandemic before going to market, leading to a currently higher than usual supply of deals in these sectors.
Conversely, many businesses in industries that command the highest valuations were neutrally or positively impacted by the pandemic. These sectors include e-commerce, technology services, and well-positioned B2B services.
Deal Flow Summary
The takeaway from many private equity groups in 2022 is that A+ assets will continue to command historically high valuations due to scarcity, while deals in less attractive markets may see valuations creep down as market volatility draws a more skeptical eye from investors and lenders leery of more recession-susceptible assets.
Lenders Still Active (For Now)
Given the uncertainty in the market due to hyperinflation, rising interest rates, the war in Ukraine, and extended supply chain issues, lender activity will be an important area to watch in gauging the strength of the M&A market.
At this point, most investors we have spoken with indicate their lenders remain active and enthusiastic to provide financing at healthy multiples, especially for high-quality deals that are likely to weather a recession. Given the tightening liquidity environment triggered by the Fed’s commitment to temper rising inflation, however, it is possible that we will see less leverage-dependent private equity firms and corporate buyers win a higher percentage of deals in the coming years than we have when debt was historically cheap.
It is interesting to note that rising interest rates have not always had a compression effect on the deal market. For example, when interest rates rose between 2016 and 2019, both deal volume and value rose.
Another trend that has grown significantly among middle market private equity investors is opting for private debt facilities versus lending through the syndicated loan market. While this has been the case in the lower middle market for some time, many larger private equity groups have recently begun to follow suit. Private debt facilities are generally easier to secure during times of market volatility and are not subject to leveraged lending guidelines, so the current environment could accelerate this trend.
After a blazing 2021, deal flow started the year of slowly, but has since ramped up. Despite the current macro-environment of uncertainty, the private equity market remains flush with dry powder and lenders continue to stand ready to support leveraged buyouts, at least for now.
Our conversations with investors signal little reduction in the premiums being paid for top-tier assets, although riskier assets are likely to see less enthusiasm until we weather the storm of current volatility.
If the past few years have taught us anything, it’s that things can change in a hurry, but at the moment, investor sentiment indicates that we are still very much in the midst of a seller’s market.
Bobby Motch | Head of Sponsor Coverage | Class VI Securities, LLC
As head of Sponsor Coverage, Bobby is responsible for managing financial and strategic sponsor engagement, developing sponsor-related content, and managing Class VI’s Buyer CoPilot program. Prior to his role as Head of Sponsor Coverage, Bobby was responsible for executing and closing transactions and supporting Class VI clients through financial analysis, modeling, market outreach, industry research, and valuations.
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