After a robust start to the year, the pace of M&A deal making slowed in the third quarter 2022. Year to date, the total number of announced M&A deals is down 16% compared to the record-breaking number of deals that were closed in the same period last year.¹ However, lower middle market valuation multiples have stayed steady so far.
With some variances by sector, we expect M&A activity in 2022 to end on par with or slightly below pre-pandemic deal volume of 2018 and 2019.
The dip in lower middle-market deal volume is not unexpected, given the current slowdown in the economy and the record-breaking deal volume we saw in 2021. With rising interest rates and concerns regarding future consumer demand, most acquirers are more cautious now than last year. At the same time, fewer businesses are being placed on the market.
Despite the drop compared to last year, overall deal volume is still relatively healthy, and businesses continue to sell.
No impact yet on valuation multiples. Average valuation multiples for all lower middle market companies valued at $250M or less were flat at 7.4x EBITDA in 2Q but rose to 7.5x EBITDA in 3Q. Average valuations for smaller companies valued between $10M and $25M also increased from 6.1 to 6.3x EBITDA in 2Q.
Here are points to consider regarding the current M&A environment and the outlook for 2023 and beyond:
The long-term outlook for lower middle market-market M&A remains very strong. The rush to complete deals we saw at the end of 2021 has slowed. However, we continue to see steady buyer demand in the short-term, and the long-term outlook for the sale of middle market companies is excellent.
Private equity firms need acquisitions to fuel growth. Private equity is a $5 trillion industry that needs to find, buy, build and then sell companies to make money. Private equity buyers are particularly interested in smaller add-on transactions which complement their larger platform deals. With a collective $900 billion in available capital, private equity buyers will continue to be the driver of lower middle market acquisitions, holding up value and raising the bar for strategic buyers who also want to make acquisitions to drive growth.
Rising interest rates will impact M&A. When buyers need to finance an acquisition, higher interest rates impact their return on investment. Banks and other lenders are also getting picky about which deals they will finance. The somewhat-good news for lower middle market companies is that while search funds, independent sponsors and other small buyers will feel the pinch of rising rates, there are many larger, well-funded buyers who do not need to borrow to acquire a smaller company.
Move to quality deals. Whenever there is uncertainty regarding the future economic environment, acquirers tend to be more selective. They continue to buy great companies where there is a good fit, but pass on opportunities with more risk. Companies in the top quartiles in their category, with good branding, strong margins and a clear story regarding future growth will likely stay in high demand and receive multiple offers. On the flip side, companies that are underperforming compared to their peers, are not profitable or have other major challenges will find deals harder to close. Many businesses fall somewhere in the middle, and deciding when to sell requires balancing the current and future performance of the business, the overall economic environment, and the personal goals of the entrepreneur. (This move to quality is also likely why we’re currently not seeing a dip in valuations, as the best performing companies are being sold, while companies that might previously have pulled down the average multiples are off the market.)
Fewer companies available for sale. Smart buyers with a long-term focus are continuing to look for quality companies. However, the overall economic environment means many businesses are struggling to grow or even meet last year’s EBITDA. Entrepreneurs usually want to sell when income is on an upswing, so there are fewer businesses on the market, and buyers have to look harder to find them.
Correlation with equity markets. M&A activity in the lower middle market is often correlated with equity market performance. A strong stock market creates a sense of optimism and confidence, and helps drive interest in acquisitions. Last year, the S&P 500 ended the year up 27%. This year, it's down 19% as of early November. If the Federal Reserve is successful in efforts to counter inflation and the economy rebounds next year, M&A deal volume will likely be back off to the races with another round of pent-up demand driving more deals. But if inflation persists, employment weakens and the economy takes a serious downturn, we can expect fewer completed deals next year.
Despite the current headwinds, the longer-term outlook for lower middle-market M&A remains strong. While deals may take longer to close compared to last year, quality businesses will continue to sell for attractive valuations.
Expect M&A deal volume to rebound very quickly as economic news improves -- so plan now. In March 2020, the M&A market tanked, but rebounded by year end and drove a record-setting year in 2021. Companies sold on the early side of this big wave of M&A were ready for a sale before demand grew. Bear in mind it takes time to get your business on the market. If you are thinking of an exit in the future, this may be the perfect time to prepare your business for sale, understand valuations and the sales process, select an investment banker, and be ready to exit just as your business performance swings back and deal volume peaks.
Recent experience shows that lower middle market M&A bounces back very quickly after a slowdown, as private equity buyers look to quickly catch up on missed opportunities.
If you’re thinking of an exit next year, please call us now. There are many drivers that impact whether any business may sell, and if so, for how much. We are always open to confidentially discussing the market for your business, sharing information on valuations, and providing a candid no-pressure assessment and suggestions to help you make the best decisions for your business and personal situation.
¹ Per Capital IQ data for all deal sizes. Cap IQ does not capture all transactions, especially in smaller, privately held deal sizes, so deal volume should be viewed as directional rather than as a guide to the total market.