Capital Markets Update – Q2 2023

Capstone Partners Q2 2023 Capital Markets Update

Middle Market M&A Likely Reaches Trough, Near-Term Rebound Expected

Following 525 basis points of interest rates hikes since March 2022, the unemployment rate has hovered near 3.5% in 2023, equity markets have recorded positive gains, and consumer spending has incrementally ticked upwards—a scenario that may have been deemed an unrealistic best case outcome at the start of the Fed’s monetary tightening campaign. It is too early for the Fed to declare victory but the current state of the market begs the question, is this really an economy on the brink of a recession? The U.S. has seemingly entered a structurally higher rate environment, one that may persist in the near-term. However, through the first half of 2023, the economy has largely shown its ability to contend with a higher cost of capital. Equity indices have continued to record healthy returns, despite a higher rate environment, and even shrugged off a downgrade to U.S. debt. Continued disinflation in the following quarters will likely prove pivotal for near-term economic growth. Through the first half of 2023, macroeconomic headwinds have failed to derail a resilient U.S. economy—which bodes well for near-term dealmaking opportunities.

After a historic 2021 for M&A, recessionary fears coupled with rising interest rates and challenging credit markets created a wait-and-see mentality for business owners from Q2 2022 through Q2 2023 regarding the M&A market. However, Q3 2023 has shown a steady increase in business owner response and owners’ willingness to transact in 2024. From the conversations we have had in Q3 2023, there is an appearing latent interest in dealmaking and accessing capital and we anticipate those businesses that are best prepared will be in a prime position to capture opportunities as the fog lifts.

Peter AsiafHead of Business Development, Capstone Partners

Merger and acquisition (M&A) volume is likely approaching or has reached its trough, with deal volume declining 15.9% year-over-year (YOY) in Q2. Middle market dealmaking (under $500 million in enterprise value) has continued to remain more resilient than broader M&A markets, as total transaction volume across all deal sizes declined 24.8% YOY. Anecdotally, dealmakers are noting a buildup in transaction inventory, with the expectation for a rebound towards Q1 2024. In addition, following recent years of COVID bumps to revenue, the market has entered a more normalized EBITDA environment for many private businesses. Strategics have continued to pursue quality companies, and while sponsors have largely held off on exits, they have continued to actively evaluate investment opportunities.

M&A valuations compressed in Q2 compared to the prior year, falling nearly a full turn to 9.2x EV/EBITDA from 10.0x EV/EBITDA. Rising interest rates have facilitated a tightened lending environment, contributing to downward pressure on transaction pricing. However, quality businesses with sustainable cash flows and a track record of performance have continued to attract buyer attention. Buyers have also increasingly sought businesses with revenues driven by volume growth, rather than elevated prices, an important consideration as U.S. disinflation has continued to moderate the cost environment. Average multiples in the lower middle market (categorized as having an enterprise value of between $10 and $100 million) have trailed the broader market average, falling to 8.2x EV/EBITDA in Q2 from 9.6x in the previous year. While the core middle market ($100-$250 million) and upper middle market ($250-$500 million) outperformed the overall average at 9.6x and 10.9x, respectively, these market levels recorded deeper YOY declines compared to the lower middle market. This has reflected a continuation of buyers moving down market to pursue smaller deal sizes. Notably, average deal value through the first two quarters fell 27% YOY to $49.5 million.

Private equity dealmaking through Q2 painted a dim picture of sponsor activity, with transactions closed by private equity firms declining 17.6% YOY through Q2. The dearth of exits has been among the most notable headlines, with the number of realized private equity investments falling 44.1% YOY through Q2—a far greater fall than the decline in closed transactions. This highlights two key takeaways; one, that the sponsor exit market has greater sensitivity to the valuation environment, and two, that financial buyers are optimistic about the next five to seven years as they have continued to deploy capital at relatively healthy levels. Many sponsors have been opportunistic in the current environment—either establishing platforms at lower buy in multiples or providing liquidity through a buy-and-build strategy. The vast reserve of dry powder available to private equity firms is expected to support near-term deal activity.

Transaction activity among strategic buyers continued to slow through Q2, with deals closed by private and public acquirers falling 20.3% and 29.9% YOY, respectively. However, the average value of deals closed by public buyers recorded a modest YOY uptick of 5.1%. Many prospective sellers opted to wait for further market transparency in the first half of the year, which depressed the available inventory of transactions. Moving towards the final two quarters of 2023 and into 2024, sellers are likely to increasingly eye liquidity events, providing a boost to strategics seeking efficient growth and synergies through acquisitions.

Middle market deal activity has continually showcased its resilience as business owners do not always have the option to wait out market turbulence. Deal markets ebb and flow as economic cycles permit but the drivers of private markets differ from other areas of the economy. LPs demand return on their invested capital, and strategics in competitive markets are in constant need of operational synergies and new growth channels—all amid one of the most notable wealth transfers in history as the baby boomer generation ages. The exact future inflection point in M&A activity cannot be known, but it is likely sooner than many had forecasted.

Download our full Q2 2023 Capital Markets Update Report Publication:

Get instant access to the full report for a deep dive into recent Middle Market activity and trends including:

• Key considerations for middle market business owners regarding dry powder levels, buyer appetite, lending conditions, and M&A pricing trends.
• Commentary on the primary drivers of transaction volume and valuations through Q2 2023.
• Assessing technology assets to protect transaction value, featuring Capstone's Financial Advisory Services group.
• An overview on equity private capital market conditions, featuring Capstone’s Equity Capital Advisory group.
• A breakdown of private equity dealmaking activity and data on dry powder reserves.