Capital Markets Update – Q1 2024

Capstone Partners Q1 2024 Capital Markets Update

Long-Awaited M&A Resurgence May Have Arrived, But It’s Complicated

The first quarter of 2024 may have marked the end of the downcycle for middle market merger and acquisition (M&A) activity. Historically, downcycles have lasted for 18 to 24 months and March 2024 was the 24^th month of the current downturn. We expect deal activity to increase over the coming 12 months, building off the positive signals of the first quarter. In the first quarter, deal volume increased quarter-over-quarter (QoQ) for the first time since Q1 2023 (up 1.5%) and the average deal value rose by 26.7% year-over-year (YOY). The average EBITDA multiple has marked another positive development, rising nearly a full turn over the same period in 2023 to 10.0x in Q1 2024.

So, what exactly is so complicated about this market?

The market continued to labor against macroeconomic headwinds and the downcycle in M&A activity. The interest rate environment remains stubbornly elevated and early U.S. economic data for 2024 still hasn’t supported the potential for interest rate easing by the Federal Reserve. Additionally, private equity fund general partners continue to feel pressure to return capital to limited partners (LPs), which has been exacerbated by these market dynamics.

All these factors made it difficult to read the results of the M&A market in the first quarter. Though first quarter deal volume improved QoQ, it was significantly off from the first quarter of 2023, down 21.1% YOY. Private equity acquisitions declined significantly, down 29.9% YOY, with platform acquisitions dropping 21.1% in the same period. These trends highlight the phenomenon we discussed in last quarter’s Capital Markets Update—described as private equity on Ozempic—that private equity buyers are looking at deals, but they have little interest in pursuing them unless the companies are pristine.

Accordingly, we expect to see a heightened focus on growth and performance improvement initiatives in private equity portfolio companies, especially those with extended hold periods. Many of our advisory services clients have benefitted from this opportunity to optimize the operational activities of their investments and increase growth and profitability during the hold period. We have been helping clients with the realization of growth and margin improvement initiatives, enhancing financial reporting including leveraging process changes to achieve a five-day close. When it comes to returning value to a fund’s LPs, an exit is an exit; the fact that many funds are essentially resetting the clock on select investments means that the pressure to derive incremental value from the entity is still highly important. Exit dynamics notwithstanding, we expect a gradual return to normal levels of sponsor acquisition activity over the next 12 months.

While Q1 2024 recorded a slight improvement in middle market deal activity, stubbornly elevated interest rates and other macroeconomic pressures have made it difficult to read the results of the M&A market in the first quarter. However, we expect that the deal climate will continue to improve for both strategic and, eventually, financial acquirers, as interest rate cuts materialize and the economy continues on the path to normalization.

Jim CalandraHead of Financial Advisory Services, Capstone Partners

Total middle market M&A volume declined 21.1% YOY, as an elevated interest rate environment and depressed private equity activity contributed to the fall in transaction volume. However, middle market dealmaking in Q1 rose 1.5% from the prior quarter compared to the 4.7% QoQ fall in Q4 20243, highlighting improvement in M&A volume on a quarterly basis. The first quarter 2024 has continued to show an improving valuation environment as the average deal value amounted to $70.9 million in Q1, a 26.7% YOY increase.

Average middle market M&A valuations in Q1 2024 amounted to 10.0x EV/EBITDA, outpacing Q1 2023 by nearly a full turn. Transactions in the lower middle market ($10-$100 million) continued to drive M&A in Q1. Of note, deals less than $100 million in enterprise value accounted for 77.8% of disclosed acquisitions in Q1 2024 compared to 52% in full-year 2023. Privately-owned businesses with limited debt exposure, strong margin performance, and recurring revenue have typically achieved healthy M&A pricing in this market. Additionally, the average valuation in the upper middle market ($250-$500 million) improved YOY to 10.7x EV/EBITDA—leading average pricing across all enterprise value ranges. While upper middle market valuations in Q1 remained compressed compared to full year 2023 and 2022, this YOY increase indicated buyers’ appetite for established middle market businesses with scale.

Closed transactions by private equity firms registered their largest decline since Q2 2020, falling 29.9% YOY in Q1. A lack of meaningful LP returns caused private equity capital deployment and fundraising to stall in Q1. Sponsor activity is expected to increase once return distributions have been realized by LPs. Additionally, sponsors’ average internal rate of return (IRR) per fund declined 15.3% in Q1, as the average IRR per fund has fallen every year since 2021’s peak (22.3%). However, private equity exits rose 30.5% QoQ to 201 realized investments in Q1 2024, representing the first quarterly increase since Q4 2021. Total private equity exit value in Q1 amounted to $66.7 billion, marking an increase of 27.1% YOY and 49.3% QoQ. As a crucial element of capital formation and buyer capacity, heightened private equity exit activity bodes well for middle market dealmaking.

Dealmaking among strategic buyers was resilient in Q1 2024 and fared better compared to financial acquirers. Private strategic buyers, shielded from public equity market turbulence and stringent regulatory oversight, outpaced public strategic M&A volume in Q1. Deal volume closed by private strategics in Q1 rose 8.2% QoQ, while the average enterprise value paid by private strategic buyers increased 8.8% YOY to $68.4 million. Public strategic buyers paid an average enterprise value of $86.4 million in Q1, a 38.7% increase YOY.

Although 2024 is off to a promising start for M&A activity, Capstone still anticipates some complexity to remain for private equity participants—both in transaction processes and in the operations of portfolio companies. These conditions are not insurmountable and may even carry an upside if investors are willing to look for it.

Download our full Q1 2024 Capital Markets Update Report Publication:

Request 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.
• A breakdown of the top sectors preferred by Capstone’s sponsor network throughout 2023.
• An economic update from Ian Wyatt, Huntington Commercial Bank’s Director of Economics.
• Credit market conditions including an excerpt from Capstone’s Winter 2024 Middle Market Leveraged Finance Report.
• An overview on equity private capital market conditions, featuring Capstone’s Equity Capital Advisory group.
• How carveouts and divestitures offer business owners and investors an avenue for growth, according to Capstone’s Financial Advisory Services group.