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Published in Finance

M&A ‘mixed bag’ expected in 2023 as interest rates, economic headwinds linger

BY Andy Balaskovitz and Mark Sanchez Tuesday, December 27, 2022 01:07pm

Investment bankers and deal advisers forecast a 2023 M&A market affected, but not necessarily stymied, by rising interest rates and other economic headwinds.

While the buyer pool may be thinning and quality deals for strong companies will be prioritized, experts still see plenty of capital on the sidelines for relatively strong activity to continue, albeit slower than the “gangbusters” deal pace of 2021 and early 2022.

After a record year last year, 2022 is “going to end up being a good year — still off the peak of 2021, but historically still a very good year” for investment banking and M&A firm Charter Capital Partners LLC, said President and Managing Partner John Kerschen.

Economic worries, rising interest rates and inflation began to change the market in the latter half of 2022, Kerschen said, noting that the firm’s deal activity was “kind of front-loaded” in the first half of the year.

“We can feel just sentiment changing in the second half of the year. Interest rate increases, talk of recession, inflation issues, labor issues, and the credit markets are starting to soften, so capital — at least the leverage side of the equation to do transactions — is starting to pull back with those issues. They’re certainly having an effect,” Kerschen said. “Buyers are starting to feel like they might be better off to wait and see what happens in the next few months, six months, a year, whatever it is.”

Still, many businesses are doing well and “there’s still a lot of capital” in the market, especially at private equity firms and strategic acquirers, Kerschen said. Deals are still getting done involving businesses “that are performing the best, and Charter Capital Partners represents multiple clients that have letters of intent for prospective transactions,” he said.

Kerschen expects a “mixed bag” in 2023 with what he considers a more normalized deal volume.

“I think ’23 is going to be a return to what might have been a more traditional market, and I think there is still a lot of capital, particularly in private equity and on strategic balance sheets,” he said. “Once we get some of the volatility and … disruption of interest rate hikes and inflation, the deal market still wants to snap back to a high level of activity and high valuation.

“I think it’s going to be a pretty good year. I don’t think it’s going to be gangbusters like ’21, and I don’t think we’re going into an overly quiet period in the deal market. There’s too much capital out there to let it go too soft.”

Max Friar, managing partner of Grand Rapids-based Calder Capital LLC who primarily represents sellers, said he’s noticed the buyer pool thin throughout 2022 as scrutiny on prospective acquirers grows.

“It’s making sure the buyer has some liquidity outside of what they’re injecting into the transaction, and making sure the buyer has relevant experience in the space,” Friar said. “Then it’s just a matter of structuring the deal, and what it feels like is increasingly the seller will probably be asked to take more risks.”

Overall, recent analyses suggest a softening M&A market, particularly for small businesses.

A BizBuySell Insight Report for the third quarter of this year found that U.S. small business deal activity had slowed after five consecutive quarters of year-over-year growth. As well, small business asking prices in the third quarter dropped 13 percent year-over-year while sale prices dropped 14 percent.

“These declining numbers suggest that sellers are reducing prices to accommodate buyers who are facing rising interest rates and higher acquisition costs. This is compounded by rising costs impacting sellers’ discretionary earnings,” according to a summary of the insight report.

Interest rates, deal flow

Despite multiple interest rate increases this year, some M&A experts say companies are still generally seeking to finance deals instead of turning to cash.

“I think people would still rather finance if it’s at a higher rate. There aren’t many companies sitting out there with the ability to do cash deals 100 percent,” said Pete Roth, partner at Grand Rapids-based Varnum LLP who specializes in mergers and acquisitions. “People are still financing deals. We’re not seeing good, strong deals not getting done because of financing.”

Roth also said deals that may be a “stretch” for banks or that confront issues in the due diligence process are “getting tighter and harder, which is driving down valuations, in my mind.”

Others are noting the M&A market slowing as interest rates climb, making it more costly to finance a deal. Eric Seifert, principal of Muskegon-based Left Coast Capital Resources LLC, described a recent transaction he was working on where the buyer was “starting to get cold feet” because of the rising rates. With the higher financing cost and debt payments, the deal “might go on the back burner,” Seifert said.

When considering an acquisition, buyers look at present interest rates and “then they rate-shock it by goosing it up two or three points to see how the business performs with that,” Seifert said.

“We’re starting to see some effects of the interest rates,” he said. “We’ve been really spoiled with very, very low interest rate levels for almost 20 years. We knew it was going to come to an end at some point.”

Seifert expects seller financing to become more common in future deals and has been seeing higher use of earnouts, particularly where “there’s a hurdle where the buyer and seller don’t see eye to eye on the price and the buyer says, ‘put your money where your mouth is and I’ll pay you back if things continue,’ but if they don’t they’ll want a discount.”

Bank financing remains “fairly readily available for a good borrower, a good deal and company,” Seifert said. “But those that might be susceptible to a recession and interest rates, they’re getting another close look.”

Until now, though, Calder and Roth have both experienced strong levels of M&A activity. The number of Calder’s closings in 2022 far exceeded 2021, while the firm’s revenue was up 45 percent heading into the fourth quarter of this year, Calder said.

Roth noted that some buyers view the current economic conditions as an opportunity following two years of high valuations during which buyers sat on the sidelines and built up dry powder.

“Anecdotally, our deal flow is as strong as it’s ever been,” said Roth, citing deal flow involving private equity firms and family offices. “I think the strategic (buyers) are being cautious, but some of our clients are looking at this as an opportunity.”

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