Capstone Partners Q3 2022 Capital Markets Update
Middle Market M&A Moderates, Demonstrates Resilience Amid Difficult Operating Environment
Stubbornly high inflation and slowing economic growth have called into question the Federal Reserve’s ability to engineer a soft landing for the U.S. economy—one that stabilizes elevated prices without triggering a recession. With the Fed unlikely to pivot from its mandate in the near term, the U.S. and global economy are likely to be operating in a much higher interest rate environment than in the past decade. The confluence of a strong U.S. dollar, energy supply concerns, and falling consumer sentiment have contributed to substantial volatility in equity markets. While this uneasy environment has caused significant challenges, it has not halted merger and acquisition (M&A) volume in the middle market. In our Q3 2022 Capital Markets Update, available for download below, we report that through year-to-date (YTD) Q3, total middle market (under $500 million in enterprise value) transaction activity has declined 9.2% year-over-year (YOY). This compares to a 14.1% decline in transaction volume for the broader M&A market, inclusive of all enterprise value ranges.
The middle market M&A market has an interesting and unique dynamic. Supply and demand do not disappear; they just bottleneck and uncork at a later point. Owners do not grow younger, timestamps on PE funds do not get a time out, and strategic acquirers don’t stop consolidating. Every quarter that goes by with pent-up activity will translate to a recovery boom in the quarters that follow. It’s a longer cycle game, the health of which cannot be measured by any specific quarter, or even year for that matter.
Drawing comparisons to past economic downturns can help contextualize the current middle market deal environment—and support its resilience. The short but sharp recession of 2020 saw middle market deal volume fall by 16.4% YOY, a drastic blow to a surging M&A market leading up to the pandemic. Nearly 15 years ago, the Global Financial Crisis (GFC) of 2008/2009 triggered a fall of 14.1% in middle market volume. It is important to note that each of these downturns have been met with a furry of dealmaking in the following year. When the U.S. began to re-emerge from the GFC in 2010, middle market dealmaking jumped 38.4%. Similarly, following the acute recession during the height of the pandemic, 2021 middle market volume rose 34.1% YOY. While adverse market forces can present hurdles to M&A activity due to fluctuations in lending, cost of capital, buyer balance sheet health, and demand for deals, many of the drivers of the middle market revolve around aging demographics—specifically, an increasing share of baby boomer business owners entering a prime stage to maximize personal liquidity.
Buyers have demonstrated greater selectivity in assessing targets, scrutinizing any material COVID-bumps in performance that may not be sustainable. However, quality businesses with strong margins and defendable revenues continue to attract premium valuations. Notably, in Q3 2022 the average middle market EBITDA multiple increased to 11.0x from 10.2x in Q3 2021. A flight to quality may explain the healthy multiple as buyers have sought accretive and scalable targets to add to their portfolios. Acquirers are still paying up for strong businesses, evidenced by the average deal value increasing 18.3% from Q2 to $77.6 million.
Strategic buyers have slowed their acquisition pursuits through Q3, with closed transactions falling 29.6% YOY as many have focused on balance sheet strength amid economic uncertainty. However, those that have gone on the offensive have demonstrated their willingness to pay premiums for quality assets. In Q3 alone, the average enterprise value paid by private strategic buyers jumped 38.6% from Q2 to $91 million. Public strategic buyers have followed a similar trend, with average deal value paid rising 29.1% to $79.6 million.
Foreign buyer activity continued to slump through Q3, falling 22.9% YOY as a strong U.S. dollar has negatively impacted many foreign operations. Even large multinational companies have noted foreign exchange headwinds impacting revenues in recent quarters. Global supply chain disruptions, central bank tightening, and Russia’s war on Ukraine are likely to continue to weigh on international deal activity in the near term.
Private equity buyers have continued to be a staple of middle market deal activity, actively pursuing privately-owned targets to bolster sector platform holdings. The significant drop in closed transactions by sponsors compared to last year, which fell by 27.3%, should be analyzed in the context of the past several years. 2021 was a banner year for private equity dealmaking, one that may not be replicated for quite some time. Closed transactions by sponsors in full year 2022 will certainly not eclipse 2021, but it is tracking above levels seen in 2018, 2019, and 2020. The continued abundance of dry powder also bodes well for private equity dealmaking in the near-term. While fundraising may become more challenging, particularly as some limited partners (LPs) pull back on commitments to avoid over-allocation, quality companies will still garner robust financial buyer attention.
Predicting economic conditions for the next 12 or even six months is a fruitless exercise, but several factors remain constant. One, middle market M&A is often more insulated from macro and capital markets headwinds than broader transaction markets. Two, the low interest rate environment the market has enjoyed in recent years is likely in the rearview, placing an emphasis on quality companies propped up by performance rather than cheap debt financing. And three, the rapidly aging demographics of private business owners are set to provide a robust inventory of deals to come.
Download our full Q3 2022 Capital Markets Update Report Publication:
Download the full report for a deep dive into recent Middle Market activity and trends including:
- Commentary on the key drivers of transaction volume and valuations through Q3 2022.
- Middle market purchase multiple data broken down by industry, captured by Capstone’s proprietary Middle Market M&A Valuations Index.
- Insights and data on private equity dealmaking activity in the middle market.
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