Capstone Partners Q4 2022 Capital Markets Update
Middle Market M&A Participants Remain Cautious of Uncertain Economic Conditions
The collapse of Silicon Valley Bank and Signature Bank has sent shockwaves throughout the market, leading many to ask if this is the “break” in the economy that will quell the Federal Reserve’s rapid interest rate hikes. Market participants have meticulously evaluated the level of systemic risk presented by the second and third largest bank failures—bringing increased uncertainty to an already precarious economic environment. Few envy the task assigned to Chair Powell as the Fed now must contend with vicious market volatility in addition to stubborn levels of inflation that has been buoyed by a resilient labor market. While job creation in February decelerated from January’s consensus shattering number (504,000), the employment market remains stronger than many have expected. Our Q4 2022 Capital Markets Update — available for download below — reports that, as the U.S. faces a potential recession, merger and acquisition (M&A) activity has been mixed as many privately-owned businesses have continued to pursue liquidity, while financial buyers have largely delayed exits from portfolio companies. The second half of the year and into 2024 may provide breathing room, or at least improved visibility, in credit conditions and capital markets. A robust level of pent-up demand will be waiting to hit the market, creating a healthy pipeline of M&A transaction activity.
Capital markets are holding their breath. Investors are trying to figure out if the sell-off associated with recent bank failures constitutes a long-awaited buying opportunity. However, the recession case is firmly back on the table, so buyers and lenders are proceeding with extreme caution.
Economists and market strategists have found it difficult to normalize economic data after COVID-19 disrupted nearly every facet of the economy. The same challenge applies to M&A activity. In the middle market, M&A volume declined 15.9% year-over-year (YOY). However, a historic view is more telling than a YOY comparison given the record number of transactions in 2021. Deal volume in 2022 registered a modest 5.8% decline compared to 2019—while operating amid significantly higher levels of inflation and the looming risk of a widespread recession. While the average enterprise value for closed deals in 2022 declined 7.1% YOY to $69.5 million, it still marked the second-highest average deal value in the past two decades, trailing only 2021.
Our Capital Markets Update reports that in Q4 2022, M&A valuations began to reflect recession risks as the average EBITDA multiple plunged to 7.2x in the quarter, leading to a full year average of 9.6x. This marked a significant drop from the steady valuation environment from 2019-2021, which averaged 10.7x EV/EBITDA. However, certain pockets of the market have demonstrated substantial resilience and even improvement from a valuation perspective. The core middle market, defined as transactions between $100-$250 million in enterprise value, experienced an increase in the average EBITDA multiple in 2022, rising to 12.4x from 11.3x in 2021. The upper middle market ($250-$500 million) also registered an uptick in pricing, rising YOY to 11.9x EV/EBITDA in 2022 from 11.7x. The drag on overall middle market valuations came largely from smaller transactions where target companies may have had less scale, reach, and potentially poorer margins—which inherently leads to less negotiating power in buyer conversations. Notably, 2022 valuations for transactions under $100 million in enterprise value fell drastically to 8.8x from 9.7x in 2021.
Strategic buyers were increasingly cautious in their acquisition pursuits, focusing on acquiring companies that could provide earnings accretion and operational synergies. The number of closed transactions by private strategics fell 13.8% YOY in 2022, however the average transaction value remained robust at $71.3 million. Closed acquisitions by public companies registered deeper declines, as volatile equity and capital market conditions created pressure by stakeholders to focus on the health and defensibility of internal operations. As a result, deal volume by public strategics fell 35.1% YOY with the average deal value declining 5.9%.
The strength of the U.S. dollar and persistent supply chain issues slowed foreign buyer activity in 2022. The number of transactions closed by international acquirers fell 26.2% YOY, although accounted for a healthy 10.1% of all U.S. middle market deals. Cross-border M&A is expected to continue to be impacted by the war in Ukraine in 2023. However, a weakening U.S. dollar may make domestic assets more attractive to foreign buyers seeking a foothold in the U.S. Notably, 76.3% of North American M&A advisors anticipate cross-border M&A volume to increase or remain the same in 2023, according to Capstone and IMAP’s Global M&A Trends Survey Report (2022-2023).
Private equity dealmaking in 2022 notched one of its strongest years on record, despite volume declining 29.8% YOY. 2021 was a banner year for sponsors, with many firms liberally deploying capital post-pandemic which led to a historic surge in deal activity. Rising interest rates, macroeconomic headwinds, and a challenging fundraising environment encouraged selectivity among private equity firms in 2022. While the average EBITDA multiple paid by private equity increased slightly YOY to 7.5x from 7.4x (GF Data®), elevated financing costs significantly weighed on pricing at year end. In Q4, the average multiple paid by sponsors for transactions between $10 and $250 million dropped to 6.8x EV/EBITDA from 8.2x in Q3. Lower levels of debt utilization also likely impacted valuations, as the average 2022 equity contribution for platform deals increased to 56.1% from 54.4% in 2021.
Many prospective sellers and dealmakers are sitting on the sidelines in Q1 2023, waiting for further market visibility before launching a process. This dearth of sellers in the current market has contributed to an eagerness among private equity firms for new investment opportunities. A backlog of transactions has been steadily building in recent months, a dynamic that Capstone has seen firsthand. With significant levels of transaction inventory and pent-up demand, middle market M&A activity is expected to be robust in the second half of 2023.
Download our full Q4 2022 Capital Markets Update Report Publication:
Request instant access to 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 Q4 2022.
- Forecasts on 2023 M&A volume and valuations from Capstone’s 2022-2023 Global M&A Trends Survey Report.
- A breakdown of private equity dealmaking activity and data on dry powder reserves.
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