A Shifting M&A Market
By Adam Burroughs On July 6, 2022
The U.S. M&A market has experienced a long bull run. That’s had companies wondering for years what’s potentially lurking around the corner.
“I think we all can attest that maybe what’s happening right now with (interest) rates is certainly that thing that’s been lurking around the corner, from an economic perspective,” says Fifth Third Securities Director – Investment Banking, Matt Francati.
That’s changed some of the M&A math for both buyers and sellers. It’s also made deal prep increasingly important.
Speaking at the Cleveland Smart Business Dealmakers Conference about mitigating risk and navigating current trends in today’s mergers and acquisitions market, a panel moderated by Oswald Companies Sr. VP – Private Equity Services Jeff Schwab, Francati says there’s an effort to reduce deal timelines. To that end, process timelines have condensed and there’s been a switch from using broad auctions to targeted processes. Instead of going to 200 to 300 buyers, for example, seller advisers are going to 40 to 75 buyers, allowing them to cut time off the process.
The other part of the process that can be cut, he says, is the post-LOI diligence phase. Typically, the post-LOI diligence process is around 90 days. Advisers now are pushing for that to be closer to 45 days, sometimes less.
For sellers, the trend of condensing the processes means they need to be very well prepared.
“We’ve been in a really strong market,” Francati says. “Multiples are certainly high across many industries. Buyers are turning over every rock during diligence. If they’re going to go out and be really aggressive and pay up for assets, they’re going to really want to understand what they’re buying. The days of doing 80 percent of the diligence work and hoping you get there and maybe there’s a few things that go by the wayside, those days are over. Buyers are looking extremely hard at businesses.”
M&A’s mental prep
For sellers, condensed timelines and increased buyer scrutiny certainly means documentation and data availability. But it’s also mentally and emotionally preparing.
“It’s an arduous process as sellers of businesses,” he says. “Not only on the emotional side for business owners, but also on management teams. There are certain parts of the M&A processes that really take a lot of time for your management team to be involved in.”
Signet Enterprises Chairman Anthony Manna, says the mental preparedness of the seller is an important, and often overlooked, aspect of a process.
“We’ve been involved in different deals where small, family-owned businesses are trying to sell their manufacturing company and the seller really doesn’t know why they’re selling at times,” Manna says. “We were in one situation where it was the death of a family member caused them to sell. As the time went on, the family decided, Why are we selling this? They got hold of their emotions. Took the company off the market.”
Preparedness in all aspects, Mana says, is increasingly important for sellers because of the increased scrutiny on the part of buyers, which has been brought on in large part because of shifting economic conditions.
“With interest rates rising for a lot of companies, their market value will start to decrease,” Mana says. “You’re going to see a lot of VC firms becoming pickier, and some companies that have some cash-flow issues are going to have some difficult times, which is going to make some buyers some great opportunities.”
Francati says one of the more significant factors is the debt markets as The Federal Reserve has talked about potentially raising interest rates up to nine times.
“It doesn’t feel like a lot when they talk about 50-basis-point moves or 25-basis-point moves, but the futures market has already predicted a significant rise in rates,” Francati says.” On the bank side, I know we’re starting to quote commercial loans over 5 percent again. We haven’t seen that in 12-plus years. But interest rates moving just a little bit, the interest expense, if you’re going to do an M&A transaction, is suddenly widening quickly.”
He says for private equity buyers, their interest expense on a senior loan might increase by 50 percent when there are small moves in interest rates because the raise is coming off such a small base. PR firms, then, are likely going to model lower valuations in their leveraged buyout analysis because they can’t really move their Internal Rate of Return (IRR).
“They have to target a certain IRR that’s required by their LPs or their fund,” he says. “So, where they have to make up for it is in valuation and, frankly, we think valuations are going to come down. The pitches that we have coming up in our investment bank, and we have several of them — there’s a flood of family business owners looking to exit right now and we think a lot of it is market driven — but we are modeling slightly lower valuations going forward and we haven’t done that in a very long time.”
Changing seller math
With these changes happening in the market, Cyprium Investment Partners Partner Beth Haas says sellers need to think carefully about what they’re signing up for.
“Historically, where you had a disconnect between valuation expectations between the seller and the buyer, there were a lot of things you could do about that,” Haas says. “You could take that paper, you could roll a larger stake. There were ways to try to bridge that. As a seller, that becomes an interesting calculus now where, are you better off just taking a lower headline number but getting all that cash today and being able to put that somewhere else versus sitting there underneath a bunch of debt with a floating rate in an inflationary environment and hoping that that second bite is worth more than the first? That becomes a little bit trickier to bank on right now then I would have told you 18 months ago.”
Inflation is also posing challenges for managers. She says most of the CEOs of the companies in her portfolio haven’t managed in a truly inflationary environment, and everybody has already pushed pricing.
“There’s a real question about how much elasticity is left,” she says. “When you start seeing some real softness in consumer demand, because right now it’s really been much more of a question of output constraints, and so everybody’s forecasting based on how many components can we get? How much labor can we throw at this? And I don’t think we’ve truly appreciated what softness in demand will look like and how quickly we’re going to see that. I think it may surprise us to see where that falls off.”