Middle Market M&A Activity Surges as Favorable Dealmaking Dynamics Fuel Historic Levels of Transaction Activity
In a famous “I Love Lucy” episode, Lucy and Ethel worked in a candy factory, hopelessly trying to wrap every chocolate on the conveyer belt. That was what managing a transaction pipeline felt like in 2021. For years we heard “too much capital chasing too few deals.” This past year was “too many deals, too little processing capacity.”
The M&A industry was operating at or above full capacity in 2021, significantly influencing deal dynamics. While volume seems to be normalizing, buyers and sellers alike are enthusiastically looking to transact. We’ve gone from COVID and supply chain adjustments to energy price adjustments and inflation considerations, but the market just keeps moving forward with confidence.
With 2020 transactions delayed by the COVID crisis and 2022 deals pulled forward to avoid possible tax rate increases, the market in 2021 tried to absorb three years of supply in one calendar year. Middle market deals closed with private equity (PE) buyers were up 49% in 2021, to a record high. Total transaction volume increased sequentially every quarter throughout 2021. The M&A ecosystem was operating above capacity levels – it was literally “sold out.”
The overloaded system had meaningful impacts on buyer behavior, deal timing, deal selection, and process strategies. Buyers became much more selective and fled to quality in order to make diligence less time consuming and to deploy more capital on fewer deals. “Story deals” were often passed over or subject to stop-and-start processes. We also saw buyers increasingly rely on outsourced service providers, including diligence consultants and accounting firms (offering services like Quality of Earnings reports). Deals with resources in place moved quicker than normal, while many other transactions were meaningfully delayed or even postponed due to a lack of bandwidth in the system, particularly in the Q4 crunch. Investment bankers were challenged to manage less predictable processes as buyers were thinly staffed and managing their own heavy deal loads.
Overall valuation metrics for deals below $500 million remained remarkably steady between 10.7x-10.8x from 2019 through 2021. Similarly, in the $100-$250 million market for PE deals, valuations remained in a steady range of 8.6x-9.3x, according to GF Data®.1 Multiples for smaller deals are quite size-sensitive with significant drop-offs at the $50 million and $25 million level. The tricky part of dealmaking in 2021 was mutually agreeing on an EBITDA number! There were many adjustments for COVID-bumps, COVID-addbacks, and supply chain issues.
Well into 2022, we see a continued elevated level of supply, but not at the frenetic pace of the fourth quarter of last year. Many sellers chose to wait out the supply rush, especially if they had a complicated story to tell. So, we now have some 2021 overflow coupled with the steady drumbeat of middle market deal activity.
Of course, there are new challenges to consider. The Federal Reserve has increased interest rates and signaled further monetary tightening. A partially inverted yield curve could portend a future recession. Supply chains have not recovered from COVID shocks; labor is still scarce. Inflation is a major issue in every analysis – input costs and pricing power are deal volume considerations in nearly every transaction. Energy costs are high and the war in Ukraine creates significant geopolitical uncertainty. Despite these challenges, 47% of small business leaders remain “highly optimistic” about their own company’s prospects (according to a recent PNC survey)2 with very few (~2%) feeling pessimistic about their own company. However, these same leaders are less positive about the larger economy, with only 15% highly optimistic and 23% pessimistic. Regardless, these positive attitudes about individual businesses plus continued low interest rates and plenty of available capital should continue to drive deal activity in 2022. In the case of extreme volatility, major policy changes, or global crises, times of change can fuel more M&A activity or temporarily shut it down. We currently see no signs of sellers pulling back given the continued strength of the M&A market. Buyers are reacting to changing operating conditions by seeking to pursue strategic combinations and improve their competitive position. Importantly, recent noise surrounding inflation has further pronounced the flight to quality in many sectors; margins are increasingly a focus, as buyers look at target companies’ ability to absorb cost increases, as well as pricing power.
We expect a more varied menu of deals in 2022, namely the reappearance of interesting deals from the 2021 calendar. We anticipate more volume in Energy, Infrastructure, and Defense in addition to continued brisk activity in Technology, Consumer, and Healthcare. The M&A market is very much open for business and valuations remain strong despite the modest Q1 ’22 decline in public equities and other recent developments. We expect high levels of activity to continue in 2022 with valuations in line with recent historical averages. Hopefully, Lucy and Ethel can get caught up…
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- GF Data®, “GF Data® M&A Report,” https://gfdata.com/about/reports/, accessed April 17, 2022.
- PNC, “Squeezed By Inflation, Small Business Owners Expect To Raise Prices; Supply Chain Disruptions To Ease, PNC Survey Shows,” https://pnc.mediaroom.com/2022-03-10-SQUEEZED-BY-INFLATION,-SMALL-BUSINESS-OWNERS-EXPECT-TO-RAISE-PRICES-SUPPLY-CHAIN-DISRUPTIONS-TO-EASE,-PNC-SURVEY-SHOWS, accessed April 16, 2022.
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