2021 was a record-breaking year for mergers and acquisitions activity for companies in the middle and lower-middle market. Overall deal volume surpassed records set in 2019, and valuations increased steadily throughout the year. By November, valuation research firm GF Data reported that valuations were at the highest point in the data provider's 16-year history, an average of 7.6x EBITDA across all sectors in the middle market, up from 6.8x EBITDA for the same period last year.
Several factors contributed to buyers’ interest in acquisitions and the increase in valuations:
· Pent up demand from 2020. Sales of all businesses came to a screeching halt in March 2020 with the onset of COVID. M&A activity did not fully pick up until the fourth quarter of 2020, and many buyers who might otherwise have bought companies in 2020 postponed pulling the trigger until 2021.
· Private equity activity. Private equity buyers were especially active in 2021, investing over $800 billion and completing 64% more transactions in 2021 than the previous record-breaking year of 2019.
· High levels of liquidity and low interest rates. With banks and other lenders ready to provide capital at low interest rates, buyers of all types have had easy access to low-cost financing for acquisitions.
· Strong equity markets. The S&P 500 finished up 27% in 2021. When financial markets are strong, buyers feel optimistic and have more cash available to fund acquisitions. And when equities seem expensive and bond yields are low, many sophisticated investors seek higher returns in alternative investments such as private equity -- providing more capital to private equity funds to use for more acquisitions.
· Fear of tax increases. In the middle of the year, many accountants and financial advisors predicted a tax hike that would take effect in 2022. Although that didn’t happen, some sellers did decide to sell in 2021 in order to take advantage of both a strong market and potentially lower tax rates.
With rising interest rates on the horizon, many would-be acquirers recognize the cost of acquisitions may increase over time, which drives a desire to buy now rather than later.
What do we expect for 2022?
We believe that ongoing buyer demand will sustain M&A activity through 2022. Many strategic buyers who spent a good portion of 2021 dealing with tactical and short-term challenges brought on by COVID are now at a point where they can refocus on long-term strategic plans including acquisitions. And private equity firms still have $600 billion of "dry-powder" or cash in their funds available to continue their spending sprees. Companies which have successfully weathered the changes brought on by COVID will continue to be in high demand.
Continued interest in smaller transactions. Over the past several years there has been a steady increase in acquisitions of lower-middle market companies from both large strategic buyers and private equity buyers. In the consumer sector, buyers recognize the need to acquire small, nimble companies who have been able to tap into changing consumer preferences and purchasing behavior. And private equity firms are always on the hunt for smaller "add-on" transactions that provide synergies with their existing portfolio companies and offer significant upside potential. Around 30 to 35% of acquisitions by private equity funds are typically for add-ons, and when overall private equity transaction volume increases, add-on activity increases too.
Challenges. Factors that could put pressure on valuations or slow the pace of M&A moving forward include inflation, supply chain challenges, increased labor costs, and, most recently, global financial uncertainty due to the conflict in Ukraine. Inflation concerns will likely drive the Fed to increase interest rates, which in turn may slow valuation growth. Supply chain challenges and increasing labor costs can also slow sales growth or reduce margins for both buyers and sellers, and can create situations where a buyer needs to right-size their own business before making acquisitions. The potential for increasing energy costs due partly to the Ukraine crisis could also further impact a supply chain still reeling from COVID.
We expect valuations to stay strong through 2022. However, as the current excess capital is invested or as other economic factors come into play, smaller companies in the lower-middle market will see any valuation declines first. Weaker companies within a competitive set will also feel the pinch earlier. We're keeping a close eye on valuations to track trends this year.
Ultimately valuations will hit a ceiling, where only the most well funded buyers can afford to invest, while other buyers recognize the challenges of generating a positive return on investment at high prices, and opt out of deals.
What should an entrepreneur do?
The best way to sell your business is with an organized, professional process, that highlights the unique factors of your business and reaches qualified buyers who are well suited to acquire your business. However, selling your business when buyers are very motivated and willing to pay a premium will maximize valuation and can also provide leverage on deal points such as structure, non-competes, and indemnification.
In today's market, if you and your business are ready for an exit, buyers are highly receptive to conversations.
We are always open to discussing the market for your business, sharing information on valuations, and providing any insight or suggestions to help you make the best decisions for your business and personal situation. Please feel free to schedule a call with us here, or drop us an email.