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Middle Market Merger & Acquisition Activity During the Recession
The M&A market is hot, with current M&A trends indicating an upcoming run. But that doesn't mean 2023 will come without challenges.
According to Deloitte's 2022 Future of M&A Trends Survey, M&A executives are sending clear and strong signals that deal-making activity will provide important levers for businesses as they navigate regulatory tightening and an evolving economic environment.
While recessions usually result in job losses and other financial problems for average Americans, they are also great M&A opportunities for investors and acquirers.
The good news is that if a recession does occur, it is likely to be tamer and less damaging to company earnings than other recent downturns because of several factors.
First, a credit-driven recession damages corporate earnings more than an inflation-driven recession. The dot-com bust of 2001 and the 2008 recession were both credit driven as debt-related excesses built up, and the economy took nearly a decade to absorb them. Currently, there is excess liquidity instead of debt which is a significant difference.
Second, fundamentals are stronger, and economic factors predict a less severe recession.
- Housing is robust, as prices have remained high, while inventories could drop off even more with higher interest rates.
- Auto production rates are lower due to semiconductor shortages, but supply chains are clearing, and order backlogs could keep manufacturing unusually high for a recession.
- Labor markets remain strong and point to record-high ratios of new job openings, reducing the likelihood of layoffs.
- For companies and individuals, balance sheets are in great shape. With needs surrounding energy infrastructure, national defense, and automation, there are solid catalysts for corporate capital spending.
- Corporate revenue streams may be more stable as more companies build subscription and fee-based models.
Generally speaking, the variables that drive lower-middle-market M&A include lending capacity and appetite, cost of capital, buyer's access to equity capital, and supply and demand for deals.
Lending capacity: Unlike the last downturn, any potential slowdown that may be approaching would likely not be led or ignited by the financial institution community. Any slowdown will affect lending capacity, but only through banks' natural tendency to adopt a conservative view during underwriting. Generally speaking, the less money a would-be buyer can borrow to purchase a business, the less the buyer is willing to pay for the business.
Cost of capital: The Fed usually does not continue increasing rates during periods of economic contraction or on what it considers the eve of an economic recession. The cheaper the cost of borrowed money, the more a would-be buyer may be willing to pay, assuming they base their valuation levels on expected returns and the desired return remains consistent with historical hurdles.
Buyer's access to equity capital: If we do enter a slowdown period, strategic and financial buyers' cash surpluses will remain strong, just as they have through the expansion. Government subsidies fill company coffers, and private equity funds remain flush with capital ready to invest. Substantial cash piles bode well for sellers, creating the motivation to spur activity.
Supply and demand: Many business owners have taken advantage of a prolonged sellers' market. 2021 was a record year for M&A activity and deal value. Owner demographics continue to favor high-quality deal supply as older business owners continue to retire. Demand will remain strong as strategic buyers continue seeking growth, and private equity funds must deploy capital. Less-than-certain economic outlooks affect sellers' willingness to fear a reduced purchase price stemming from lower earnings.
While some contraction will likely occur, it probably will not be so pronounced that it should derail anyone's plans to sell or buy a business.
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