It’s been an interesting last few years in the M&A world, to say the least.
First, deal-making fell off the cliff during the pandemic.
But, in 2021, after we emerged from lockdown, we had a record-breaking year for M&A activity due to pent-up demand and a tremendous amount of dry powder in the hands of eager PE firms and Strategic Buyers. According to Prequin Alternatives report from that time, PE firms alone had $1.32T on hand as of September 2021.
Things slowed slightly towards the end of 2021 and there was a distinct – but inevitable – drop in deals in 2022 and prices leveled off. Although if it hadn’t been for the record-making post-pandemic year, 2022 would have been considered a banner year.
As I said in May 2022:
“What has happened in 2022 so far would be considered strong in any other year, with deal volume close to 2,000. It’s about on the same level of deal volume as all four quarters of 2019 and the first quarter 2020. In other words, pre-pandemic. As with many things, the pandemic threw deal-making out of whack.”
Still, as I say, 2022 did feature robust deal-making. But we entered 2023, facing significant headwinds that slowed down deal-making, including inflation, high interest rates, the war in Ukraine, and the worldwide economic slowdown… even talk of recession.
Not surprisingly, prices came down. Sellers figured they would wait it out and wait until prices increased. Buyers waited too – to see if prices might go lower.
As a result, M&A was “on hold” for the second half of 2023… but not for all sectors. It’s the same call I made back in January 2023, when I said I expected that despite headwinds that lower middle market M&A would continue in force, especially with regards to tech, media, and telecommunications firms and business services companies.
These industries would stay strong, I said, because “existing businesses will always need new tech and key business services. However, they also benefit because there are new markets are opening up all the time that need the capabilities of small tech and business services companies.
AIG put it this way in their recent report, M&A: Small Deals and Emerging Markets Drive Claims Activity:
“Throughout this quieter period of M&A activity, deal activity in the mid-to- large segment was particularly impacted, as deal parties considered various issues – sellers calibrating the level of acceptable return for their assets, and hoping to achieve a greater exit price if they deferred the timing of their deal – and buyers focusing on other things, such as the cost of debt to fund any available transactions.
“The consequence of this dynamic has been an acceleration in trend toward the smaller end of the market or in the emerging markets segment (which for AIG includes Latin America, India, Middle-East, and Africa).”
What’s on Tap for the Coming Year
But I expect a turnaround in 2024. Deal-making will not just make a comeback but come roaring back.
Why? The slowdown in 2023 was artificially created by the financial headwinds and the perception of them by Buyers and Sellers.
However, recently the Fed has announced that they will not only pause interest rate increases but also potentially cut rates. I think they are motivated to do this because they do not want to be perceived as having a negative impact on the economy in an election year. In addition, a lot of capital has been sidelined as a result of these perceived headwinds, leading to increasing demand for private M&A and capital financing.
This all will be the catalyst for increased M&A activity across the board. That will be the signal the market needs to let them know that they can move forward without any big surprises. Other market watchers agree.
Michael Butler with Cascadia Capital contends there has been a big first step toward the opening of the financing and M&A markets, and the next big one will come when there is an actual rate cut:
“The consensus at Cascadia is that there has been significant capital on the sidelines creating a pent-up demand for private M&A and capital financing as we waited for clarity that interest rates have peaked. Markets have been waiting for a signal that rate increases are over, and this is a very positive sign.
“Additionally, while the private markets have been active and valuations remain relatively high for ‘A assets,’ the Fed’s signal of peak rates will likely broaden interest and activity across a wider range of industries and companies. [It] creates a positive market tone and frees up operating cash flow for U.S. companies to invest in people, capital goods, and acquisitions.”
As this happens, there are other impacts. The market will shift to a more buyer-friendly environment. Not only are valuations coming down, but there are fewer auctions as well. And if there are fewer auctions, that means Strategic Buyers – companies buying other companies – do not have to compete with other cash-rich PE firms. That means better prices, of course. I see strategic acquisitions taking off in the coming year as a result. I see the perennially popular tech industry to be a big beneficiary of this, even as it was one of the least impacted by the drop off in deal-making in the last couple of years.
As far as Private Equity, there remains a tremendous amount of dry powder out there. The amount PE firms had to invest went from $3.2T in 2022 to $3.7T in 2023. Those firms risk losing their investors if they’re not putting that money to work soon. So, while firms had been concerned about the cost of capital, the interest rate news means they are less wary. Add in pressure from their investors, and you are looking at a recipe for more deal-making in 2024.
Plus, there are also more creative ways to structure deals. In the recent era of high interest rates, Buyers engaged in a lot of cash deals. Or they financed a portion of the purchase price and gave the Seller the rest in stock. This was a new strategy to contend with the high cost of borrowing. But even as rates drop, I expect that these creative solutions to remain an option. And that can only drive more acquisitions.
A Warning for Buyers
Perhaps one of the most promising signs of a pick-up in M&A activity is that folks like Cascadia Capital are warning clients that there is going to be so much demand for their M&A transaction services, that they should book early. Otherwise… they may be too busy.
This happened at the end of 2021. During that rush of record-breaking deal-making, you could not get a lawyer, accountant, or other service providers. Even insurers offering transactional liability coverage were overwhelmed. People lost deals because of the lack of bandwidth.
Fortunately, the insurance industry responded and has since staffed up. They were a bit worried when M&A activity fell and the demand for products like Representations and Warranty (R&W) insurance fell. But it just means they are very ready for the upcoming upswing. The great news for Buyers and Sellers is that the cost for coverage has gone down in tandem with purchase prices.
In short, there has not been a better time to make a deal than now in a long time. Prices are lower, borrowing is getting cheaper, and R&W and other insurance products are more affordable too. And I see the lower middle market to be a sector with some of the most deal activity because there is less regulatory scrutiny than with bigger transactions.
I’m standing by to help you get your deals done on the insurance side of things. At Rubicon M&A Insurance Services, we have experience in R&W insurance, as well as new, cutting-edge coverage created especially to cover the smaller deals in the lower middle market. We are standing by to answer your questions.
Please contact me, Patrick Stroth, at pstroth@rubiconins.com