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What a Difference a Year Can Make

Fed Rate Hikes & the Deal Landscape

With inflation running rampant, the Fed has worked fervently to slow an overheated economy. Interest rates were raised six times by November 2022, including four consecutive 0.75% hikes. As a result, debt has become much more expensive for M&A market buyers relying on financing to execute deals.

A domino effect is having far-reaching impacts on the deal landscape. Buyers are not able to utilize cheap debt, and lenders have become more selective on deals and leverage multiples. Average EBITDA multiples have consequently dropped in comparison to last year’s frenzied M&A period.

Both deal volume and valuation have declined for a third straight quarter, down from Q4 2021 historic highs. Worth noting, however, simply because deal activity has fallen does not indicate a departure from historically normal activity. As illustrated in the chart below, Q3 estimated deal value is consistent with 2017 to 2019 averages, and deal count came in higher than the average for the same period.

It will be interesting to monitor how far M&A activity continues to drop off in the wake of additional Fed interest rate hikes.

On the other side, sellers and their advisors have become more stringent with buyer selection. Large strategic buyers with strong balance sheets and well-funded private equity groups have gained favor. Conversely, search funds and highly leveraged private equity buyers have become less desirable choices for many sellers, given the heightened risk of financing or capital raises falling through.

Flight to Quality

An interesting dynamic is emerging, driven by economic volatility and a decline in higher quality deals, as compared with last year’s high dry powder private equity environment. One might assume that a receding tide would sink all ships, but we are still hearing from buyers that the limited availability of high-quality deals is causing a race to the top for many bidders looking to protect themselves with high quality assets as we enter a potential recession.

On the other hand, lower quality deals in recession-vulnerable sectors are either seeing lower valuations or facing greater challenges on the way to closing. One private equity professional we spoke with estimated that they had suffered more busted transactions in the last three quarters than over the past five years, excepting the pandemic’s early days.

Many buyers and lenders are nervous to commit capital to businesses in recession-susceptible businesses, such as discretionary goods and products and services related to new construction. Moreover, high-growth industries, such as consumer products, software, and healthcare, which saw jumps in M&A valuations over the past couple years, are beginning to come back to earth. Valuations are falling in line with industry counterparts in the public markets, where depressed trading multiples have limited many strategic acquirers’ ability to pay the multiples common in 2021.

What About Structure?

Deal structure has also seen a significant shift as a result of the economic downturn. As you might imagine, lenders have raised the cost of capital substantially in lockstep with climbing federal funds rates. Impacts extend beyond the dipping valuations we highlighted above. Many buyers have also had to take on a higher proportion of equity to fund deals.

Moreover, many deals in high-growth sectors have seen more structured compensation, specifically performance-based earnouts, so that investors can cover the downside in the event of an extended recession. Increased interest rates and a less competitive deal environment in certain industries have led to some sellers to take on sellers’ notes as a form of transaction compensation.

Many of our private equity contacts have also indicated that due diligence standards have changed markedly since last year. After several years in which the market favored sellers, deal terms have returned closer to the middle. Expedited diligence and exclusivity periods are giving way to longer terms.

Buyers are now applying more skepticism to seller projections and earnings adjustments. In some cases, they are extending diligence further to ensure adjustments are converted to cash and projections are tracking.

Many private equity groups have pointed to their challenges in determining what they consider to be true normalized earnings, given the unique business elements of the last couple of years, both positive and negative. As a result, they are relying heavily on buy-side quality of earnings reports and ramping up financial diligence.

Conclusion

M&A deal flow remains solid relative to historical standards, although it may be difficult to view the environment through such a lens after 2021’s frenzied conditions.

The private market will, of course, continue to be informed by the macroeconomic environment, but the fundamentals—including demographic effects of retiring Baby Boomers and the $1.2 trillion in private equity dry powder awaiting deployment—point to continued interest from buyers and sellers in 2023.

AUTHORED BY:

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.

The views expressed represent the opinion of Class VI Partners. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness.  While Class VI Partners believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and the Class VI Partners view as of the time of these statements.

Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Testimonial may not be representative of the experience of other customers. Testimonials are no guarantee of future performance or success. Testimonials are NOT paid testimonials.

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