The mergers and acquisitions market enters the second half of 2022 facing a stack of issues that may affect deal flow and how transactions are structured.
Economic uncertainty and worries of a looming recession, inflation that’s running at 40-year highs, steep stock market declines, persistent supply chain issues and labor shortages, and rapidly rising interest rates are altering the M&A landscape, leading both buyers and sellers to adjust to the market conditions, advisers say.
“We’re sort of at an inflection point,” said Matt Miller, managing partner at BlueWater Partners LLC in Grand Rapids. “Depending on what inflation does going forward — if it moderates or accelerates — will really dictate where the M&A market goes over the second half of the year and into 2023.”
Through the first half of 2022, BlueWater Partners’ volume was down “a little bit” coming off of a record 2021 and as the market “faces significant headwinds,” Miller said.
MiBiz spoke with six M&A professionals who say deal flow remains in good shape, but they are beginning to see a shift brought on by the economic uncertainty that is driving more seller interest.
Small Business Deal Advisors LLC Partner and Calder Capital LLC Managing Partner Max Friar has recently seen more sellers coming to market to exit the business prior to a potential economic recession. At the same time, strategic buyers are easing up to get a better feel for what lies ahead economically.
However, “deals are going to get done” and “the market is just fine right now,” Friar said.
“There’s just been a very definite shift and it’s slight, not huge, but it’s just maybe less favorable to sellers and the buyer pool is thinning a bit,” he said. “This past quarter, buyers have fallen back, sellers have come on very strong.”
Some buyers such as private equity investors and family offices have been focusing inward on their portfolio companies “and devoting extra resources to those to make sure they stay strong in case this recession on the horizon comes to fruition,” Friar said.
As well, the present economic conditions—and the potential effects on future revenues and earnings at prospective acquisition targets—has made buyers “pause and really take their time and do their diligence to try to get their arms around what these businesses look like going forward,” Miller said.
Miller expects prospective buyers to take deeper dives into due diligence, become more selective in the targets they pursue, and get “more creative” in structuring deals “that are contingency-based” with more earnouts.
The greater use of earnouts to bridge valuation gaps between buyers and sellers is a regular occurrence in uncertain conditions and rising interest rates, said Tracy Larsen, co-chair of the Mergers and Acquisitions practice group at Honigman LLP and managing partner of the firm’s Grand Rapids office.
“I’ve seen quite a bit of earnouts in the deals that I’m doing right now,” Larsen said.
Larsen, whose practice focuses on middle-market deals, reports a “very active” M&A market at midyear, albeit with some sense of caution.
“It’s been on fire for the last two years and it is as busy now as it was any time during that two-year period,” he said. “I am cautiously optimistic, but I am still optimistic that we’re going to have a great year.”
PE activity moderates
One sign of the U.S. market response to economic issues comes in a recent Pitchbook.com analysis of the U.S. middle market and private equity that remains a major driver in M&A, despite an easing of activity early in the year.
Pitchbook reports that M&A for private equity in the U.S. “got off to a moderate start in 2022” after a “historic run” in 2021. As uncertainty loomed, “many buyers hit pause on processes … but markets appear to be moving forward as investors adjust and look for opportunities in a volatile market,” according to Pitchbook.
“With ample dry powder on hand, PE firms are more than equipped to do deals, especially in a market that has become cheaper thanks to falling prices and lower valuations in some sectors,” according to the firm’s report on first-quarter activity. “We can expect to see more deals close in the middle market going forward as lofty valuations come down and buyers and sellers find they can agree on pricing.”
Private equity’s $423 billion intended for the middle market “in a sense creates a floor underneath M&A activity,” Miller said.
“They’re more inclined to take on a certain amount of risk to continue to invest and be opportunistic as well,” Miller said. “The search for great businesses will continue and great businesses that continue to perform and outperform their peers, they will continue to be attractive.”
Cristian Anastasiu, founder and managing director of Grand Rapids-based Excendio Advisors LLC that works nationally in information technology M&A, said deal flow to date within the sector “has been great.” Even as economic headwinds swirl, deal flow and inquiries remain unchanged, driven partly by private equity interest in the sector, Anastasiu said.
“The amount of money that’s on the sidelines didn’t change over the last six months,” he said. “It’s still there and there’s a lot of pressure from these guys who raised all these funds to go and invest.”
I.T. deals today are also driven by larger companies seeking acquisitions to pick up specialized services, Anastasiu said. He expects activity in the sector to remain steady, adding that his firm has received more calls in recent weeks from owners who are “getting ready or probably making a move” as valuations remain high and they “start to get concerned about what’s going to happen” with the economy.
“They want to get ahead of that,” Anastasiu said.
At Honigman, “we still see a lot of private equity bids on our sell-side transactions,” said Larsen, adding that the firm’s buy-side practice for private equity is “still going gangbusters.”
As well, the present economic uncertainty after business owners navigated through the COVID-19 pandemic is driving more sellers to the market.
“COVID was burnout, and I think there are some people saying, ‘How much more can I take?’” Friar said. “They’re thinking, ‘I’m going to go out when I’m showing some strength here and when things still feel good. I don’t want to go in 12 months, and if all this stuff comes true, I don’t want to sell into that market.’”
Comerica Inc. Chief Economist Bill Adams recently gauged the chances of a U.S. recession starting in 2022 at one in five, up from one in 10 previously. He raised the chances of a recession starting in 2023 to one in three, from his prior one in four. Adams issued the June 16 briefing to clients after the Federal Open Market Committee raised the federal funds rate by three-quarters of a point.
Concerns about economic headwinds and what the future may hold are “really just kind of hitting right now,” bringing more sellers to the market, said Mike Brown, who leads the M&A group for Charter Capital Partners LLC.
Brown estimates that seller inquiries to Charter Capital are up about 50 percent in the last month or so.
“The owners that we’re signing up now as clients have some of those fears. A lot of it is they’re tired and they just went through COVID. A lot of our clients went through recessions in their careers and they just don’t want to do it again and they’re nervous of what’s going to come,” Brown said. “We’re seeing more sellers who just want to be out, and that will continue to drive deal flow. The interesting part is: How do buyers react? Are they still willing to pay the premium multiples they were a year ago with a higher degree of uncertainty?”
Brown — who works primarily in the lower middle market and expects good deal flow through the second half because of the increase in sellers — speculates that private equity buyers will still have to pay elevated multiples as they face pressure to deploy capital and compete with one another and other buyers for good deals.
“As long as there’s that high demand from private equity groups, buyers are just going to have to pay top-tier multiples,” he said.
‘Busier than we can handle’
Grand Rapids private equity firm Auxo Investment Partners is “busier than we can handle when it comes to new opportunities,” said co-founder and Managing Partner Jeff Helminski.
The year started slowly for new investment activity, picked up around March, “and has not slowed down,” Helminski said.
Auxo presently has four deals under a letter of intent and 23 prospects that “we’re serious about, spending time on and deeply engaged in conversation,” Helminski said. The number of the firm’s deal prospects at midyear are about twice as many as the same time in 2021, he said.
Auxo most recently acquired Indiana-based Breyden Products Inc., a maker of braided lacing tapes, twines, cords and sleeving for the electrical, defense and aerospace markets. Breyden Products will operate under Precision Products Group Inc., the parent company of Paramount Tube that Auxo acquired in 2020.
As an active buyer, Auxo has been more selective in picking potential acquisition targets, but it also has been doing deeper analyses on how inflation, an economic downturn and other economic headwinds of today may affect a company in the future, Helminski said.
“We’ve got to be prudent in our systems of where the world’s headed in the next couple years,” he said. “We’ve always been fairly selective about what we’ll invest in and what’s a fit for us. What we’re spending more time doing now than what we did a year ago is thinking through downside scenarios, economic pullback, higher interest rate environments, and evaluating what that means for a given business … to make sure we’re making good decisions.”