By Andy Greenberg
Greenberg Variations Capital and GF Data
Every conversation among deal professionals these days seems to come round to the contrast between a highly functional transaction environment and a global scene beset by chaos and uncertainty. Is it just a matter of time before so much ballast — inflation, interest rate increases, labor shortages, supply chain disruptions, war abroad, social division at home – pulls the buoyant M&A market to earth? The successful business owners we advise at Greenberg Variations Capital certainly have this question. Here is my response:
A Slowing Market
After a torrid 2021, the M&A market is already slowing – not because of the effect of all those issues on capital markets, but because of their effect on businesses considering exit. It is a rare company not grappling with one or more of those macro pressures. GF Data, the private equity data service I co-founded, recorded virtually no drop off in completed deal volume among contributing private equity firms from Q4 2020 to Q1 2021. Our Q1 2022 report, to be released in a few weeks, will show a decline from Q4 2021 of more than half.
Supply Chain Noise
Good businesses able to see through the noise of supply chain issues and other disruptions are receiving more attention than ever.
Completed deal data is being distorted by the number of less-favored businesses choosing not to transact. Looking once again to GF Data for perspective, we track a “quality premium” – the spread in valuation between selling firms with above-average financial characteristics and other businesses. In 2022, the spread continued to creep upward – to about 1.8x EBITDA – but the incidence of above-average performers was even more notable. It is almost always 56% to 57%. We don’t manage to that – it just works out that way.
In 2022, above-average performers accounted for 66% of completed deals. If more out-of-favor companies took the bitter pill of selling at prevailing pricing, that percentage would have been closer to past experience, total deal volume would have been up, and overall multiples would have declined. However, multiples of double digits or more for larger and/or more desirable businesses would be undiminished.
A Dynamic Market
Throughout the sustained seller’s market of the past decade, the deal ecosystem has not remained static. There have been meaningful shifts that have had the effect of “de-risking” transactions and enabling capital flows and deal activity to continue. In the pandemic and its aftermath, we’ve seen the acceleration of several inter-related mechanisms to help recalibrate risk:
Offloading of business-specific risk. Over the last half dozen years, rep and warranty insurance has come to permeate the private transactions market. In 2021, 56% of private equity buyers reported using an insurance product. In the $100 million to $250 million deal value range, it was nearly 75%. With that much more underwriting – and consequent loss experience – we have learned that the most frequent areas for insurance claims – misrepresentation of financial statements, inventory and other cost accounting issues – are specific, but not necessarily unique.
The insurance carriers are reaching deeper into deal documentation process to address the risks that have a certain commonality from deal to deal. This gives buyer and seller more bandwidth to grapple over less routine exposures.
Greater emphasis on industry-specific risk. I was talking the other week with a friend who has operated for 40 years in the flavors and fragrances industry. For most of that time, raw materials costs were not subject to surges. Delivery issues were rare. Global trade policies were stable. Now, a flavors formulator needs to understand a much more complex range of issues relating to the global supply chain.
Buyers in general are requiring a more highly detailed understanding of these issues. Market studies and similar due diligence has not been as prevalent in the United States as in Europe. That has changed, rapidly. This requirement also has steepened the tilt toward deep industry expertise on the part of buyers.
It is not new that an industry-focused acquirer is able to share relationships, tradecraft and jargon with a would-be seller. But now, let’s say the current year forecast requires a view on whether a principal supplier will remain available, or is likely to impose price increases mid-year. The buyer with a current portfolio holding or deep sectoral experience can more quickly come to a more authoritative assessment.
Lower targeted returns. How do buyers continue to pay ten times EBITDA or more for desirable platforms? Planning on lower-priced add-ons to “average down” has become a favored strategy. But as expected returns on public equities have declined, private equity and debt instruments have followed suit. Mezzanine financing, which for years gravitated to a “12 and 2” template in the middle market has pushed down to all-in pricing averaging in the 11 to 12 percent range. Target equity returns in many cases have similarly dropped from high to mid-teens. These compressed returns are instrumental in holding valuations aloft.
THE TAKEAWAY: Greater unpredictability imposed by the world at large means more moments when it will not be optimal for any given business owner to choose to sell. But the prevailing dynamic for years has been “demand push” rather than “supply pull.” That is, the owners of a successful private company tend to sell when the time is right in their lives and the life of the business, as opposed to being drawn in by favorable or unfavorable market conditions. For all of the accumulated potential hazards occupying our minds these days, I do not see that dynamic changing.
About the Author
Andy Greenberg is CEO of Greenberg Variations Capital, a mergers & acquisitions advisory firm based in suburban Philadelphia devoted to one-off or targeted transactions. He is also Founder of GF Data© (now an ACG Company) the leading provider of information on private transactions in the $10 to $500 million value range. For more information, visit www.greenbergvariations.com or www.gfdata.com.
© 2022 Private Equity Professional | May 5, 2022