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Capstone Partners Q3 2023 Capital Markets Update

Building the Foundation for a Resurgence

Steadily retreating inflation has given credence to the elusive soft-landing scenario that the market has eagerly rallied behind. While 10-year treasury yields briefly flashed at 5% in October, confidence in the disinflation trend has since cooled bond yields and given equity markets breathing room. The Fed’s 525 basis points of tightening has coerced a moderation in prices, with the core personal consumption expenditures index rising 3.5% year-over-year (YOY) in October—a continued decline from prior months and the lowest level since April 2021. Federal funds rate futures have even indicated that some market participants are anticipating interest rate cuts as soon as March. While the economy has seemingly avoided a crash landing, persistent progress in disinflation is needed before declaring victory. As noted by Huntington Bank (NASDAQ:HBAN) Commercial Bank Economist Ian Wyatt in a feature on page four, interest rate forecasts have continually missed the mark—who’s to say an unexpected interest rate hike is not a possibility?

2024 is something of an opaque mirror to forecast. There is a massive liquidity overhang in the market, an impactful rate environment in regards to our national debt, and the massive white noise of a chaotic election year cycle. Capstone accurately predicted how 2023 would play out, 2024 is much more difficult to predict with any confidence.

Paul JansonHead of Investment Banking, Capstone Partners

Merger and acquisition (M&A) markets are waiting for the “all clear” sign. Lending standards have tightened, valuations have contracted, and due diligence requirements have heightened; all against a backdrop of a more stringent regulatory environment. Sell-side participants have been grappling with these headwinds for several quarters and it is largely symptomatic of the business cycle. However, dealmaking remained sluggish through Q3 with total closed transactions falling 13.7% YOY with average deal value declining 24.7%. Dealmakers expect volume to remain tepid to close the year. Meanwhile, optimism in transaction markets is quietly building with business owners increasingly eyeing exit opportunities for the first half of 2024. Middle market business owners are planning to go on the offensive, with over half (50.8%) looking to execute growth strategies over the next 12 months, according to Capstone’s Business Owners Survey.

M&A valuations retreated significantly in Q3, falling to 8.1x EV/EBITDA, from 9.2x in the previous quarter. The compression in debt multiples has weighed on pricing, as buyers are not receiving the same degree of turns on EBITDA as prior years. The average debt multiple for private equity middle market transactions amounted to 3.5x Total Debt/EBITDA in Q3, which marked a decline from 3.7x in Q3 2022, according to GF Data®. Private equity buyers have been forced to put forth greater equity contributions to close deals and meet this valuation gap. However, even at an average equity contribution of 57.9%, valuations have remained lower.

Higher transaction financing costs and a challenging exit environment have stifled private equity returns. In 2023, private equity gains have trailed public markets, with one-year rolling internal rates of return amounting to 0.7%, according to PitchBook. As a result, many large private equity firms have placed increased focus on private credit lending and secondaries investing to bolster returns for limited partners. However, capital deployment towards acquisitions continued to slow through year-to-date (YTD) Q3, with total closed private equity transactions falling 26.1% YOY.

Sponsors have increasingly eyed smaller transactions that require less debt utilization, which has benefited select middle market targets. Notably, add-ons accounted for 76.1% of total private equity dealmaking through Q3. Moving through year end and into early 2024, the exit environment remains clouded with sponsors extending holding times. The number of exits in Q3 fell to its lowest level since Q2 2020—pointing to hesitancy among many sponsors to realize investments at potentially discounted valuations. While business owners and financial acquirers will likely need to contend with a higher-for-longer rate environment, this is not entirely new territory. The cost of money becoming meaningful again will likely place a greater premium on high-quality targets with robust cash flows that can quickly service debt. Private equity firms still have the luxury of vast reserves of dry powder, and following lackluster returns in recent quarters, limited partners will want to see this capital put to work.

Strategic buyers have slowed acquisition activity through Q3, with closed deals among private and public buyers falling 19.4% and 26.7% YOY, respectively. An uncertain macro backdrop has pressured dealmaking with many strategics seeking greater economic transparency before deploying significant dollars towards acquisitions. As a result, the average purchase price has retreated through Q3 with the average enterprise value for deals closed by private buyers falling 26.7% YOY. Average enterprise value for transactions closed by public buyers has been more resilient, declining a modest 4.9% YOY.

Many corporate players in highly cyclical industries have refrained from aggressive inorganic growth strategies in recent quarters, choosing to prioritize internal operations. However, others have pursued acquisitions to offset slowing organic sales which may fuel further consolidation across industries facing challenges to top-line growth. As strategics look towards growth strategies for 2024, dealmaking is likely to accelerate in the next several quarters.

M&A markets have seemingly been approaching its trough for the past few quarters. However, many middle market business owners have bolstered their financial profiles and are optimistically looking toward 2024. Notably, 31.2% of middle market business owners plan to engage in M&A either as a buyer or a seller in the new year, according to Capstone’s Business Owners Survey. As dealmakers and prospective sellers eagerly move into 2024, confidence is building for a return to the rapid pace of M&A that has characterized prior years.

Download our full Q3 2023 Capital Markets Update Report Publication:

Get instant access to the full Capital Markets Update 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 Q3 2023.
  • A breakdown of private equity dealmaking activity and data on dry powder reserves.
  • An overview on equity private capital market conditions, featuring Capstone’s Equity Capital Advisory group.
  • The increasing relevancy of fairness opinions in private M&A deals, featuring Capstone’s Financial Advisory Services group.

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