Written by Andrew Rice, CPA, CVA, Managing Director of Trout CPA’s Transaction Advisory Services
Make no mistake, most individuals will readily admit that the last two years have not been smooth sailing. Almost daily, the news outlets churn headlines that put some of these challenges front and center: supply-chain disasters, international conflicts, societal tensions over justice and equality, and, of course, the sobering reality of life amidst the COVID pandemic, including the prospect of a prolonged recessionary period.
During this same period, however, we have witnessed one of the greatest M&A markets in modern history. So, what do we make of this? And what does it mean for 2023?
The blistering pace of transactions (and valuations) during the last 24 months have been multifactorial. Cheap credit, frothy public markets, the padding of private equity fund sizes, the rise of new asset classes (e.g., family offices), and the mismatch between seller supply and buyer demand have attributed to the robust market.
As we approach the back half of 2022 and enter 2023, the landscape is more complicated. The geopolitical shockwaves continue to reverberate from the Russian invasion of Ukraine. Interest rates are rising rapidly and driving up the cost of capital for acquirers (particularly impactful for financial buyers employing leveraged buyouts (LBO). Inflation is driving up input costs. Qualified, or even available, labor is hard to come by.
Have hope, lower middle-market; it’s not all doom and gloom. No matter what is going on in the greater, macroeconomic landscape, buyers will always be chasing alpha. If your business is a premium asset, in a growing industry, with exceptional management, the other noise falls away. Unfortunately, not everyone is operating a recurring-revenue business generating 80% gross profit margins in the beloved technology, media, and telecom (TMT) sector. However, recent layoffs have proved that even the tech world has its own blemishes.
Fortunately, the largest demographic of central Pennsylvania businesses reside in the lower middle- market, loosely defined as businesses generating less than $10mm in EBITDA and/or $100mm in revenue. We believe that the lower middle-market will not see a dramatic drop-off in transaction activity as the middle and upper middle-market. Why?
Private equity firms and family offices are still flush with cash. Trillions, to be exact. So, where will they put these dollars to use? Add-on acquisitions. Typically, financial buyers enter a new industry or vertical via a more substantial “platform investment.” From there, the buy-and-build strategy is the most common path forward. To build, of course, these buyers will pursue add-on acquisitions of smaller enterprises that fold into the platform, vertically or tangentially. Add-on acquisitions should remain appealing compared to larger platform acquisitions because there is simply less risk. In addition, the check sizes are smaller, the integration is less complex, and by virtue of being an add-on, the buyer is already familiar with the industry (less industry diligence needed).
There is an abundance of companies in the mid-state pumping out $1-10mm EBITDA, which make ideal add-on candidates. This does not solely apply to private equity and family office acquirers. Larger corporate enterprises may be interested in continuing a programmatic M&A strategy as organic growth is challenged by the factors mentioned above.
Whether you are looking to buy or sell, how you execute will make or break a transaction. Surround yourself with the best possible team of attorneys, accountants, and intermediaries. Off we go!
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