Short answer – We don’t know. The M&A market has never interacted with this much inflation before. Inflation is now at a 40-year high. In 1982, there was no M&A market. The birth of the market is most often traced to KKR’s 1988 takeover of RJR Nabisco, as made famous in the 1989 book “Barbarians at the Gate” and the 1993 movie of the same name. Whether that is the actual date of birth or not can be argued. Still, at the time it was commonly thought that the cash for the $25 billion price tag was unattainable because, as the book says, there was a belief that there was not anywhere near that much excess cash floating around for doing deals in the entire world. Fast forward to 2022, and the amount of “dry powder” held by private equity amounts to an estimated $2.9 trillion. That is just the equity portion. Many deals are currently leveraged at nearly 50%.
Then, we have the strategic acquirers, companies with massive cash balance sheets (and the debt capacity to match). Shall we call it $6 trillion of capital available for M&A deals now? Or shall we call it 240 RJR Nabiscos? You get the point: When the whirlwind of inflation deposits us in a new economy, we won’t be in Kansas anymore.
Long answer – We have some pretty good ideas on a few specific and material effects a decent run of inflation will have on the market, and, more importantly, the owner’s ability to sell in comparison to the present (i.e., Oz vs. Kansas).
The run for the gate; the supply curve (for businesses) moves right – Uncertainty drives sellers to the market. This is true of good uncertainty (if there is such a thing in business) and bad uncertainty. Business owners who made it through the Great Recession and then COVID will have less of a stomach for a third round of unpredictability.
- The resulting imbalance in the buyer and seller curves on that old basic econ graph will push the deal volume up but prices down. Our eleven-year sellers’ market will be a buyers’ market if this factor is viewed in isolation.
Buyers leaving the market; the demand curve moves left – One of the major reasons there is so much “dry powder” and willingness to lend into the M&A markets is that businesses are, and have been for the last decade, the best yielding asset class for the amount of risk undertaken by the investor. The two quintessential examples here are insurance companies and pension funds. Both have mandates to make low-risk investments.
But both also have mandates to turn small amounts of money into big amounts to pay out claims and retirements.
- For decades, this meant they bought bonds. And where have bonds been for the last decade of low-interest rates? It takes some odd anti-matter type level of risk to justify investing in an asset class (like bonds) that yields close to 1 to 3% year after year. So the money that used to go into bonds has been going into private equity for a generation. But inflation causes bond yields to increase. It also places a new challenge in front of privately held companies. One asset class increases its yield while the other increases its risk profile, and business sellers lose out.
- Multiples fall – The buyers who remain, and there will be many, will still want to borrow money to finance their deals. Let’s look at an oversimplified example. Senior debt on many deals runs about 5% in today’s market. The average buyer constructs its deals these days with a bit under 50% coming from creditors but let’s use 50% for simplicity. If interest rates on a $100 deal increase from 5% to 10% due to inflation, the business on sale just got 25% more expensive for the buyer with none of that money going into the seller’s pocket. Half of the funds just doubled in cost in this example. The model looks even worse if the already-higher cost mezzanine portion of the debt is added into the model. Let’s look at that same statement in a different way to ensure it hits home. One of the limiting factors on bidders offers in a good competitive competition is that when the “cash flows are modeled” by the spreadsheet junkies, they kick out the maximum amount of cash that the business can generate to service and pay down that acquisition debt while still leaving enough in the company to keep it growing. If buyers were already borrowing so much that they were committing ALL the excess funds to servicing and paying debt (and they are, trust me), then when the interest rates double, they can only borrow half as much.
- Some businesses will look good, most won’t; they will all suffer – There are some businesses that can benefit from inflation – some. There are also some who can pass the costs onto their customers and thus not have their bottom line suffer. Others aren’t so lucky. But regardless of which of the three buckets a company falls into, just the mere presence of ongoing inflation will cause the purchase price to fall. Acquirers, especially private equity funds, think in terms of how much return they can get for each unit of risk they undertake. Guess what inflation is called in this equation – another unit of risk. Every company has one more unit of risk when banks freeze up when a pandemic sends everyone home, and when inflation lurks about.
- Buyers will want to stretch out delivery of the consideration – How have sellers felt about seller notes and earnouts over the last decade, plus the bull market for businesses? Exactly. Now take that deferred payment and reduce its value by 7.4% every year. Then compound it annually. One of today’s market realities is that the outsized multiples are achievable only with seller notes or earn outs. Buyers tend to be proud of being called “financial engineers.” Financial engineers largest magic trip is playing around with the time value of money. In a high inflationary scenario, the time value of money declines rapidly and the financial engineer knows that. So he will be pushing for bigger deferred comp with longer terms. Meanwhile, by the time the seller gets her hands on the money, it will be worth 90 cents on the dollar or worse. Welcome back to the age of small cash at close percentages and the transaction being more of the starting point of a multi-year debtor-creditor relationship. But in this relationship, the creditor doesn’t usually get a market interest rate.
So M&A will continue through inflation. Now that the market has been institutionalized with several decades of service businesses popping up, the market will survive. There are simply too many people in the game to allow it to die off. But where the brick road that appears through the fog of inflation will lead the business seller is not entirely clear and there are sure to be some weird things happening along the way; few, if any, will be pleasant, and most will be surprising. This is the first time we’ve had to try to sell businesses from the other side of the rainbow after all.
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
ABOUT BENCHMARK INTERNATIONAL
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.