For more than ten years, business owners have enjoyed a sellers’ market in the lower and middle markets. But the tide is turning. Here’s the headline: Multiples are not trending downward, buyers are slower, more cautious, and cockier, and deals are taking longer.
The best analogy is that we have been on a roller coaster, and we no longer hear the clicking sound as we go up, but we’ve also not started to feel anything in our stomachs. It’s almost as if we are paused, and we feel certain that we know what is coming next. Buyers feel as if they’ve been bullied for the last decade by aspirational sellers and their agents. They have pent-up resentment. Some of it is starting to show.
Call after call is now ending with references to how “the market has changed.” Buyers’ interest in being the first to speak with the seller, or the first to come onsite, has mellowed. When follow-up on data is sent, buyers are slower to digest it and respond. More follow-up is required from the sell-side at every step of the process. In short, buyers are feeling their oats.
The next step will be that this attitude makes its way into the later stages of deals. Due diligence will become more rigorous. The most minor finding will lead to more significant asks. Threats to go back to market if a retrade occurs will be viewed with less credibility.
But here are the eight real truths about how the market changes will affect deals and valuation:
1) It is true that sellers have been able to use the concept that time is on their side for the last ten years, and that is no longer the case. Time is now on the side of the buyer.
2) Privately held companies are not publicly traded stocks. Their long-term intrinsic value does not move up and down with unemployment blips and temporary changes to interest rates. At the same time, buyers will play up this public company paradigm in their negotiations, and it’s malarkey. These macroeconomic changes or conditions only affect the value of the business if and to the extent that they relate to the company’s ability to generate free cash flow. Like it or not, the relationship of economics to company valuations has become more complex due to recent events.
3) Speaking of economics, there are no signs that either the supply curve or the demand curve has moved or is going to move in the short term. The much-vaunted “dry powder” filling private equity coffers only has one place to go: into the seller’s pockets. Trade buyers that need add-ons will mostly seek add-ons, and any dip in that will be replaced with other trade players who find it harder to grow revenue in hard times as they turn to M&A to see that growth. As for sellers, some may decide to sit out a “bad market,” thus constraining supply with the corresponding favorable result of moving the supply curve to the right, therefore offsetting any macro effects that are attempting to push it to the left. After some time, the existing dry powder may be dissipated and not replaced as the traditional providers of that capital return to adding bonds (now with acceptable interest rates) to their holdings.
4) Rising interest rates will make the debt more expensive for buyers. With today’s high multiples, buyers are using as much debt as possible on acquisitions. Over the last ten years, the limiting factor has been how much the lenders will supply. Because the debt has been almost free for the buyers, they have been borrowing as much as they are offered. But that debt is no longer “almost free.” So, buyers will now be looking at the amount of interest they think the business can pay post-acquisition and how that fits into their needs for the business’s cash to fuel growth. Of all the things happening in the world today, this is the one that will likely have the first and most significant impact on valuations. As interest rates rise, the impact on pricing will only increase.
5) Capturing total value for a business involves much more than just the headline price. While this is true in all markets, it is even more so in volatile times. One of the most significant value components beyond the price is the “net working capital” construct. It calls for the cost to fluctuate based on whether the company has more or less working capital at closing than it has traditionally carried on the books. This is an incredibly complicated part of the process, even in stable times. Still, when the environment bends and twists as it has since 2019, the process is even tougher to handle well and can have even more significant consequences on the deal’s overall value.
6) There is a great deal of static in the markets because this economic turn comes from three years of idiosyncratic bumpiness thanks to COVID, parts shortages, fear of a tax increase, etc. This is not just the roller coaster reaching the pinnacle, it’s a rolling cost that slips back and accelerates forward on the last part of the way up. This means even more unpredictability in the near term, a lessened ability to read the tea leaves in the future, and more opportunity for buyers to claim something wrong for valuation or to dismiss some event or trend that would have been good for valuation. After all, they are professional buyers, and the sellers are probably in the market for the first time. As a result, any complication (or noise) is likely advantageous to the more seasoned party.
7) Buyer attitudes will swing back to normal. The current attitudes are an overreaction. While they won’t go back to pre-2021 levels any time soon, they can’t stay as skewed as they are now. So, they will get it out of their system even though more market deterioration is likely.
8) This is likely to be at least a five-year swing. While the market is not as rosy as last year, we are not yet in the depths of any drawback and, therefore, not at the bottom of the adverse market. Today is not as good as yesterday for anyone needing to sell, but it is better than tomorrow. And that will be a true statement for a few years to come.
Author
Clinton Johnston
Managing Director
Benchmark International
T: +1 813 898 2350
E: JOHNSTON@BENCHMARKINTL.COM
Americas: Sam Smoot at +1 (813) 898 2350 / Smoot@BenchmarkIntl.com
Europe: Michael Lawrie at +44 (0) 161 359 4400 / Enquiries@BenchmarkIntl.com
Africa: Anthony McCardle at +27 21 300 2055 / McCardle@BenchmarkIntl.com
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Benchmark International’s global offices provide business owners in the middle market and lower middle market with creative, value-maximizing solutions for growing and exiting their businesses. To date, Benchmark International has handled engagements in excess of $8.25B across various industries worldwide. With decades of global M&A experience, Benchmark International’s deal teams, working from 14 offices across the world, have assisted thousands of owners with achieving their personal objectives and ensuring the continued growth of their businesses.
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