The M&A Market and How It Affects You

Last year proved a record-breaker for mergers and acquisitions (M&A), with over $5 trillion worth of global deals completed. While some of this activity represented pent-up demand from pre-pandemic M&A, the market also is benefiting from investors looking to deploy large stores of capital.?

The forecasts for 2022 started out strong as well, with firms like Deloitte expressing optimism that a healthy M&A market would continue. However, that was before inflation heated up, the Federal Reserve announced an aggressive plan for raising interest rates, and the Russia-Ukraine conflict escalated.

Given the market’s current downward trend (at press-time), it is helpful to consider what the M&A market could look like this year and how it will affect business owners who are ready to sell, especially in the lower middle market.

Will M&A Continue in 2022?

Last year’s M&A surge was partially driven by low interest rates, which now represent a significant headwind for 2022 and beyond. Yet, the M&A market is not homogenous.?

On the mega-cap end of the spectrum, public companies have hit a rough patch recently which could temper their willingness to make acquisitions. Then again, it only takes one blockbuster deal—like Elon Musk’s proposed $44 billion purchase of Twitter—to get investors pondering big M&A possibilities.

It is a bit of a different story in the lower middle market, though, where it remains very much a seller’s market for strong businesses valued between $5 and 100 million.?

How Interest Rates Impact M&A…or Will They?

Anxiety and uncertainty over interest rates might have business owners wondering whether higher rates will reduce the investment community’s appetite for acquisitions.

The good news is, it typically takes dramatic rate increases before private equity (PE) investment contracts—and even then, the impact is not immediate. Valuations might be impacted but overall activity should remain strong, as limited partners who invest in PE firms have already committed over $1.8 trillion to private equity funds and that capital needs to be invested somewhere.?

Even beyond existing dry powder invested in private equity funds, it would take a significant and extended recession for the largest limited partners (such as endowments, pension funds, and insurance companies) to re-allocate their capital away from private equity.?

What about Company Valuations??

Where interest rates might impact M&A in the short term is in company valuations. If a PE firm is funding an acquisition partially with debt, and that debt carries an interest rate that is now 3 to 4% higher, the buyer will be willing to pay less for the business.

Rising inflation also could impact valuations by putting a damper on profitability as costs across organizations increase. As talent shortages continue to drive wages up and supply chain constraints continue to drive material costs higher, companies may see their gross margins drop, which in turn will reduce profitability and negatively impact their valuations. With the possibility of a recession looming, these pressures are likely to continue for the balance of 2022.?

Consider, too, that investors favor companies with strong track records and potential for growth; yet a recession may see lower middle market companies with diminished growth prospects, which will reduce investors’ desire to pay premium valuations. Technology-based companies that generate recurring revenue using a scalable platform may be the exception, since they can grow efficiently without adding staff.

What Does It Mean for You?

All in all, it remains a good time to sell a business, especially for companies that have a defensible market position and are growing profitably despite supply chain, talent and inflationary constraints.

Without a crystal ball, it’s difficult to say when M&A activity will begin to slow down. Back in 2019 we thought we were in the 8th inning of a great run. Now, it seems likely we have finally reached that 8th inning, thanks to rising interest rates, skyrocketing inflation, geopolitical risks, and the uncertainty of a mid-term election year. Given those factors, we see a short-term window for the highest likelihood of closing a transaction. After that, buyers may become more selective about the businesses they invest in and less willing to pay a premium for them.

If you do not feel equipped to sell just yet, there are ways to position your business for when M&A inevitably resurges. A corporate advisory firm that specializes in the lower middle market can help you build shareholder value in the meantime, positioning your company to achieve the best outcome when the time is right to sell.?