Overall M&A Market Commentary
Is there a reason for optimism in the current M&A market? After the COVID pandemic subsided, the sub $300 million company value M&A market surged in late 2021 and into early 2022 before first declining, and then stagnating at activity levels last seen during the depths of the pandemic. The causes for the tepid deal market are many. Inflation seems to be a major factor, while a more intense regulatory environment and business uncertainty were also contributing. Investment bankers tend to be eternal optimists by nature and disposition, but that disposition has been tested over the last couple of years.
The middle-market M&A activity levels reached a low point in 1Q23 and moved slightly higher but not much above the lowest activity levels observed in 2023. The data for 2Q24 shows that both the dollar value and the number of middle-market M&A deals remain at the low levels observed in 2023 and preliminary data for 3Q24 show more of the same. The economy is performing reasonably well so this lack of M&A activity is surprising. Furthermore, private equity (“PE”) funds and strategic buyers have ample resources and a desire to make acquisitions, and the business owner population is starting to “age out.” All these factors seem to suggest there should be a more robust deal market. There are emerging signs that positive changes in the M&A market are yet to come.
The current M&A market activity is being sustained by add-ons to PE portfolio companies and acquisitions by strategic acquirors. These deals, while important to the market, because of their smaller size, have lower risk profiles for the acquiror and require less debt capital to complete the transaction. While the average deal size in the M&A market has risen slightly in 2024, until we see a large increase in this measure, we will not see greater growth in PE platform activity.
The U.S. economy has been very resilient. Second quarter GDP was 2.8% exceeding expectations in part because of growth in business investment, strong consumer spending and a boost in business inventories. Government spending also contributed to GDP growth. At 6.3%, the United States has one of the highest budget deficit to GDP ratios in the world, roughly twice the global individual country average. With deficits this high the ability for the U.S. Government to “juice” future GDP will be limited, so it is incumbent on our country leaders to grow the actual economy. The M&A market once it picks up can play a major role in that growth.
The Fed made a 50-basis point reduction in the benchmark Fed funds rate in September 2024. While widely anticipated this reduction is likely to be the first of many additional rate cuts later in 2024 and into 2025. The Fed has indicated that it will be data driven, so the size and number of future cuts will evolve as changes occur in the economy. These rate cuts will reduce the costs of capital for acquisitions and potentially help escalate activity in the M&A market.
According to the August 2024 National Federation of Independent Businesses Small Business Economic Trends survey, 24% of business owners suggested that inflation is the most important business problem they face. While the annual rate of inflation growth has declined to 2.5%, prices are still cumulatively up over 20% since 2021. Inflation has caused problems in the business and consumer sectors. According to S&P Global, during the first eight months of 2024 US bankruptcy filings have reached the highest levels since 2020 and the second highest levels since 2010. Inflation and higher interest rates have taken their toll and are cited as major factors in these filings.
Dun & Bradstreet’s Global Business Optimism Insights report indicated that U.S. businesses recorded a 9% rise in optimism in the third quarter. This optimism was prompted by falling inflation and the expectation that there will be further interest rate cuts. There is an improving economic environment that is dealing with still declining but persistent inflation and an uncertain political environment. The current market presents owners with a significant opportunity to consider selling their businesses.
Private equity (“PE”) firms have abundant, time limited investment capital to put to work. Strategic buyers are well capitalized and still looking for growth opportunities. The demand for deals outstrips the number of willing sellers with good quality companies. This is a flight to quality market where buyers have a keen interest in high-quality acquisition opportunities. In this environment well-prepared companies with sound business fundamentals will command broad buyer interest.
Due to the extended period over which private company M&A market data is collected, there is a one-quarter lag in our information. As a result, the market commentary reflected below is generally limited to the data through 2Q24. Any 3Q24 data included in this edition to expand trend lines is still preliminary and will be reviewed in detail in the next quarterly newsletter.
M&A Market Activity
Since the COVID deal market “recovery” years of 2021 and 2022, middle-market M&A activity has stalled at low activity levels measured by both the number and annual dollar value of deals. The deal activity in 2023 and so far in 2024 has remained near the low levels experienced at the absolute bottom of the M&A market during the 2020 pandemic. Further, our preliminary 3Q24 data shows a continuing deterioration and even lower levels of 3Q24 activity.
Even with a relatively strong U.S. economy, business optimism is tepid, induced in part by stubborn inflation, elevated interest rates, increased regulatory scrutiny and political uncertainty. The Fed’s efforts to reduce the rate of inflation growth by slowing business activity has succeeded but input prices of raw materials and outside services used by businesses are still more than 20% higher than they were 3 to 4 years ago. These increased costs have negatively impacted corporate earnings and business owner psyche. Business owner optimism is important when these owners consider taking on the risks associated with acquisitions. Optimism is also important to business sellers as well to attract buyers of businesses. Until business optimism improves, the M&A market activity is likely to move sideways.
There is a potentially significant factor that may serve to offset the current lack of business owner optimism. PE funds have an abundant supply of uncommitted capital to make acquisitions. This capital, coupled with the prospect of a lower interest rate environment, may lead to greater demand from the PE funds for new deal activity and an increase in M&A activity. According to GF Data, a PE deal market database and analysis firm, PE deal activity in the first half of 2024 was on track to surpass the activity in both 2023 and 2022. They project that full year 2024, based on the year-to-date data, will surpass 2023 by at least 20%.
If business optimism improves (remember we have an election in November) and the number of business sellers increases, there is a ready demand for new deals.
- In 2Q24, $26.0 billion in middle-market deals were recorded, up slightly from the value recorded in 1Q24 and in quarter-over-quarter comparisons, 2Q24 deal value was up 4.0% compared to 1Q24.
- The number of middle-market deals closed in 2Q24 was approximately the same as the number of deals closed in 1Q24. Similarly, in 1H24, deal volume was flat when compared to 1H23.
- The average middle-market deal size of $52.0 million in 2Q24 was slightly larger than the average $50.0 million deal size closed in 1Q24 and a little larger than the average deal size of $51.0 million recorded in all of 2023. The trend in the current M&A market continues to be toward smaller deals and add-ons to existing companies because of the lower business risk profile of add-ons and the easier path to attract financing for smaller deals.
PE exit information reflects a somewhat different pattern than the overall M&A market. While the 2Q24 overall M&A market was flat, in contrast the dollar value of PE exit activity in 2Q24 increased dramatically. PE exit activity in 2Q24 measured by dollar value was up 102.8% from 1Q24, while the number of PE exits was down 25.3% for the same period. The ramp in deal activity dollar value during 2024 shows that PE sellers took advantage of the scarcity of deals and sold the more marketable, larger portfolio companies (implied by more dollar value and a lower deal tally) to realize gains and harvest cash in their portfolios. It should be noted that this was the highest PE quarterly exit value since the first quarter of 2022.
The PE funds are the “professional buyers and sellers” of businesses. PE funds strategically pursue both the buying and selling of portfolio companies both at the portfolio company level, when the asset is most saleable and at the fund management level when the fund needs a realization to return capital to their investors. PE funds generally have limited time frames over which they must invest their committed capital and “harvest” these investments to return cash to the funds’ limited partners. Typically, these time frames are 10 to 12 years and creates realization urgency in PE fund management. According to Tim Clarke, Pitchbook’s lead PE analyst, there are more than 11,000 PE portfolio companies in PE funds. “The number of companies in PE’s inventory is very high and you need to get the exits pace up to whittle down the supply of older companies.” This could be only the beginning of the PE fund realization cycle because of this large overhang of portfolio companies in PE funds. Yet another factor that is pointing to a likely pick up in deal activity.
Even with lower M&A market activity and more cautious buyers, both strategic and financial buyers continue to look for deals in the M&A market. Still elevated borrowing costs and perceived business uncertainty are causing buyers across the spectrum to be more decerning in making acquisitions. But, as pointed out earlier, there is growing evidence that the M&A market could be improving shortly. Sellers with quality companies and good financial performance are receiving strong buyer attention. Business sellers will be able to achieve appropriate enterprise valuations if they are prepared to manage a competitive sales process and can withstand more rigorous due diligence scrutiny.
Middle Market Deal Valuations
Our annual valuation data seems to indicate that 2023 may have been a low water mark for M&A deal valuations. The 2Q24 valuation information shows a continuation of the valuation recovery first observed in 1Q24. The $10 million to $25 million and the $50 million to $100 million segments set new five-year valuation peaks with the middle size category coming in just below the 5 year average. As stated in previous editions of the Prairie Middle Market Perspectives (“PMMPs”), it appears that only high quality, clean deals are closing in the current market. As a result, we believe the valuation statistics may be skewed higher because they represent the highest quality companies with the highest valuations.
- Deal valuation multiples for the sub-$25.0 million category in 2Q24 came in at 6.6x, above the long run average of 6.1x for this size category and establishing a new 5-year market peak for this size category.
- Deal valuation multiples for the large middle-market, the above $50.0 million category, came in at 9.0x in 2Q24, well above the long-run average for this size category and setting a new 5-year peak for this size category.
- Finally, the 2Q24 valuations in the $25.0 to $50.0 million, middle segment were recorded at 6.8x, just slightly below the five-year average of 7.0x.
PE funds have abundant committed capital and strategic buyers continue to cautiously seek growth through acquisitions. The reduced volume of M&A activity has produced a smaller pool of new deals, leaving the demand for quality acquisitions unsatisfied. This supply-demand imbalance provides sellers with an opportunity to maximize their valuations. However, in this cautious market, only the better-quality companies can push for higher valuations. Market uncertainty and conservative financing markets have forced buyers to be more measured in making offers for all but the best acquisition opportunities. Sellers have started to recognize the change in market dynamic and have lowered their valuation expectations and are starting to enter the market in greater numbers.
Private Equity versus Strategic Valuations
Strategic acquirors are major factors in the M&A market, comprising almost two thirds of all deals that have closed during the last decade. PE portfolio companies that make add-on acquisitions are grouped in the strategic category because these companies have many of the same characteristics as other strategic acquirors. Synergistic cost savings, access to new customers and other revenue enhancement opportunities provide strategic buyers with the ability, but not the need, to pay more than the typical financial buyer. Since 2020, the size of the strategic premium has declined almost to zero but that reversed starting in 2023. Strategic valuations began to climb in 2023 while PE valuations were flat. This resulted in a return to the strategic premium we saw before the pandemic.
- As noted in previous PMMPs, strategic buyers are very active in middle-market M&A. In the post pandemic years of 2021 and 2022, strategic buyers, on average, paid little strategic premium over the PEs for their acquisitions. But that trend reversed in 2023, where strategic valuations jumped to 8.5x above the 5-year trend level of 8.3x.
- Over the last five years, EBITDA multiples paid by PE buyers have remained in a range centered around 7.3x. The full year 2023 valuation data indicates that PEs are currently paying slightly more than the long-term trend level for new deals.
- Our historical M&A valuation data shows strategic buyers tend to pay a premium compared to PE firms’ valuations. The 2023, 1Q24 and 2Q24 data shows that the strategic premium of almost 1.5x EBITDA has returned.
- Prairie estimates that, for deals below $50.0 million, middle market valuations are between one and two multiples of EBITDA lower than the levels reflected in the chart below.
Middle Market Leveraged Buy Out Capitalizations
In 2023, the economy showed resilience but there was low confidence in long run economic conditions coupled with troubles in the commercial bank sector and an anticipated recession which produced a tepid lending environment and more conservative capital structures. This started to change in 2024, as the U.S. economy continued to show resilience, the equity markets set new records and the Fed, believing inflation has been tamed, started to reduce interest rates causing recession fears to subside. However, even with these positive developments in the first half of 2024, the bank lending markets remained conservative.
Commercial bank lenders still have a “risk-off” credit appetite but are aggressively pursuing more credit worthy borrowers and forcing the lesser quality lending opportunities to other lenders. Fortunately, the private credit markets (including business development corporations, asset-based lenders and other lending-oriented private credit funds) are picking up the slack. These private credit lenders are moving to a more “risk- on” lending profile and providing slightly more aggressive lending terms for lesser quality issuers. While private credit and ABLs are becoming more active in the market, their loans are more expensive and have a greater debt service cost. The growing private credit participation in the current lending market is leading to improved overall debt availability and forcing more aggressive lending terms and, in some cases, lower credit spreads across the lending market. Even with better terms the maximum debt component of a deal is around 50.0% of a typical leveraged capital structure which remains conservative.
The Fed’s first reduction in interest rates occurred in September and expected additional reductions later in 2024 and 2025 will shift borrowing costs lower. These lower borrowing costs may lead to better issuer debt service coverage and could lead to more debt in a typical capital structure.
Mezzanine funds are active in leveraged transactions. This capital has a high interest rate that can stress a company’s cash flow. Mezzanine is increasingly a critical component of a middle-market buyout capital structure when senior debt capital is harder to find. Interest-only and payment-in-kind (“PIK”) structures still dominate the markets, but in the current environment, the use of equity co-investment structures help match mezzanine returns with deal risk profile structures.
Overall Comment on the Financing Markets
With refinancing and new loan activity increasing rapidly the financing market appears to have turned a corner in mid-2024. Lending activity for the last couple of years was muted because of the Fed’s activities in fighting inflation, including increasing interest rates to slow down the economy. These factors led to less investment in capital equipment and other assets to grow many middle market businesses which in turn lead to less loan demand. Over the same period, these higher interest rates combined with business uncertainty and heavier government regulation stifled the M&A market further, reducing the demand for new loans. There is a growing feeling in 2024 that the Fed will orchestrate a soft landing and avoid a recession, and this belief has buoyed the lending markets.
After raising interest rates 11 times, and 525 to 550 basis points, between March 2022 and July 2023, and then pausing for almost 14 months, the Fed made its first interest rate decrease in September 2024. The 50-basis point reduction was long anticipated and signaled the Fed believed that inflation, while not completely defeated, is now more manageable. Fed Chairman Powell said after the rate cut meeting, “We know it is time to recalibrate our policy to something that’s more appropriate given the progress on inflation. We’re not saying, ‘mission accomplished’ … but I have to say, though, we’re encouraged by the progress that we have made.” The market took this as a very positive turn. As interest rates move lower, there will be a positive effect on the M&A market which should lead to further increases in new loans.
Lower interest rates will decrease financing costs and increase potential debt capacity in new deals which could support M&A valuations and lead to more loan demand. As pointed out earlier in this report, 2024 valuations have moved slightly higher across the size spectrum, but could see even larger increases as more interest rate reductions are made.
The commercial bank lenders are still pursuing higher quality lending situations and more relationship-oriented deals. On average, deal capital structures are still conservative with about 50% equity in new deals and overall debt leverage inside 4x EBITDA. The private credit market, an alternative to bank loans, is growing and will continue to expand and change the lending market over time. While segments of the lending markets have moved toward a more “risk-on” attitude, this is still a market where quality matters. More challenging deal situations and poorer quality borrowers will find little interest from lenders in this market. The private debt funds are stepping up to the more challenged borrowers, but the steep cost of capital demanded for these deals makes closing poorer quality deals difficult.
Preparation is key in any market, but even more important in the current M&A environment. All borrowers should have thoughtful business plans that show lenders how the company will react to inflation, lower margins, changes to revenues and other business issues including changes in interest rates. Lenders want to be repaid, so borrowers must detail how they will make that happen. With proper preparation, good quality, credit-worthy issues will be able to attract capital. Borrowers will have to be prepared for an extended financing process and potentially more conservative and expensive capital structures.
Total U.S. Middle Market Loan Issuance
- U.S. Leveraged Loan issuance in 2023 dropped to $737.3 billion just barely exceeding the trough in volume of loans recorded in the pandemic year of 2020. The decline in leveraged loan issuance reversed dramatically through 3Q24 increasing to $1,126.5 billion, and full year 2024 widely expected to exceed the COVID post high point achieved in 2021.
- Recessionary fears declined in 2024, and the interest rate environment has stabilized leading to more aggressive behavior by lenders on borrowing terms and credit spreads. The Fed’s initial cut to interest rates in September is leading borrowers to become more comfortable with the current interest rate environment, which in turn has increased their demand for new credit to fund growth, capital expenditures and M&A activity. As a result, deal flow in the credit markets has started to return to more normal levels.
- Bank lenders continued to focus on relationship banking, corporate borrowers’ lines of credit and areas where they have a competitive advantage, such as operating business needs (including payroll and checking accounts). Due to the current economic environment, banks are cautious in making new loans and are very selective in new leveraged transactions. Private credit funds have taken up the slack but even this sector is focused on better quality loan situations.
Interest Rate Environment
And so, it begins. In the September 2024 Fed Open Market Committee meeting, the Fed made its decision to make its first cut to its benchmark rate. They chose not to cut by 25 but instead a more robust 50 basis points. This was the first rate cut after seven consecutive meetings where the Fed decided to leave rates unchanged. After that cut, many Fed watchers were predicting a couple more rate reductions this year, but then the September inflation report was released.
The September Consumer Price Inflation (CPI) report was a little hotter than expected and showed an increase in monthly prices of 0.2% and an annual inflation rate of 2.3%. Both measures were 0.1% higher than expected. Inflation is a stubborn thing, and once released into the system is difficult to control. Earlier in 2024, it was believed that the Fed would cut interest rates as many as six times this year. Now, it seems that the Fed might cut rates one or two times before year end.
The interest rate environment has finally normalized in 3Q24. The slope of the yield curve in normal times is usually upward sloping, reflecting normal inflation expectations. The 2-year to 10-year Treasury differential was a positive 79 basis points at the end of 2021. However, due to the Fed’s inflation fighting action in raising short term rates, the yield curve 2-year to 10-year differential moved negative in mid-2022 and has remained negative since that time. Usually, a negative 2-year to 10-year differential is a signal of an impending recession, but because of the Fed manipulation of short-term rates that predictive signal was spoiled. At the end of 3Q24, the 2-year to 10-year differential was a positive 15 basis points, only slightly upward sloping but indicative of a more normal interest rate environment.
Middle Market Debt Multiples
- Average total debt leverage in middle-market deals moved lower in 2023 to 3.6x, down from the 3.9x average in 2022. As mentioned earlier, rising interest rates and business uncertainty led to lower debt leverage multiples in 2023. Our 2Q24 data shows that leverage moved a little higher to 3.7x but remains conservative relative to 2022.
- Mezzanine capital continues to play a key role in leveraged capital structures. While mezzanine is more expensive capital than senior debt, its return structure matches the risk profile of companies operating in the current uncertain economic environment.
- Over the past five years (2018-2023), mezzanine debt averaged about 0.7x EBITDA in the typical capital structure. Through 2Q24 mezzanine leverage declined to 0.5x EBITDA which is likely a temporary reading.
- More conservative senior debt lending markets and higher interest rates through 3Q24 have negatively impacted the amount of senior debt in the typical capital structure. Bank lending remains conservative, but private credit funds are filling the needs of less creditworthy borrowers, but at a price.
Terry Bressler is a Managing Director and can be contacted at 312.348.1323 or by email, tbressler@prairiecap.com.
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