With M&A activity cooling in this volatile, uncertain environment, business owners might assume they must postpone their plans to sell the company and wait for better times. That’s not necessarily true. It’s still possible to close a great deal in this market, especially for exceptional companies that can withstand greater scrutiny and are perfectly positioned for the ideal buyer.
Macroeconomics Are Inhibiting M&A
After a record extraordinary year in 2021, the first half of 2022 returned the strong M&A market that existed pre-pandemic. But by late-summer, a convergence of macroeconomics began to dampen the market.
While everyone expected the Fed to hike interest rates in an effort to temper inflation, the Ukraine crisis (and resulting spike in energy prices) wasn’t on the radar. And while rising inflation seemed inevitable, most economists didn’t expect it to increase as far or as fast as it did. After two years of pandemic uncertainty, it didn’t take much to make business leaders more anxious about the future and investors less confident in a target company’s performance forecast or risk profile.
Further inhibiting M&A activity is the fact that many buyers are hopeful sellers will recalibrate their valuation expectations, driving down the lofty prices of the last two years. Some buyers are choosing to wait and see how far valuations drop; others have little choice but to hold off, because the debt they rely on to finance deals has become more expensive, reducing what they can afford to pay.
As a result, we’re seeing private equity (PE) groups terminate letters of intent, or constructively terminate them by attempting to re-trade the deal terms below what they know the seller will accept. The market is especially tough for companies in industries hit hard by current market forces, including certain technology subsectors, home construction, and financial industry businesses impacted by the sharp decline in lending.
It’s clearly not the same M&A market we experienced in 2021. Yet, it’s still a good time for owners to sell exceptional companies.
The Flight to Quality
Despite an uncertain environment, PE firms and corporate balance sheets have significant capital that must be deployed in return-generating assets. That means buyers remain eager to acquire quality businesses. In fact, the market’s response to investment-grade situations is as good or better than ever.
However, today’s market presents clear differences in what constitutes a strong target company, which geographic markets are ripe for activity, how valuations are trending, and how deals are structured.
Defining the A+ Company
In this climate, buyers are attracted to companies that are executing aggressive growth plans, are more insulated from adverse macroeconomics than their peers, and are staying nimble (both proactively and in response to changing conditions). They also look for businesses that perform well despite a difficult economy. While many companies rebounded nicely from the pandemic-induced low of spring 2020, buyers want to see that the business can sustain a positive trajectory in tougher times.
Quality of earnings remains an important criterion, with the predictability of a recurring revenue model proving especially attractive. In the absence of recurring revenue contracts, buyers will seek other drivers of customer stickiness, such as high switching costs. If your company doesn’t have a sticky business model, you will only be as good as your last purchase order —and in times like now, that kind of uncertainty turns buyers away.
While some industries are struggling more than others, one lesson learned from the pandemic is that customer behavior often bucks conventional wisdom. Witness how discretionary spending in some categories surged during the COVID lockdowns, despite unprecedented uncertainty. For that reason, buyers may not rule out entire industries in the search for A+ companies.
A Focus on Domestic Businesses
With the European market weakening sooner than the US and facing tougher economic conditions, US companies are expected to outperform their international counterparts. At the same time, buyers are wary of businesses that depend on global supply chains (which remain constrained) or are exposed to geopolitical risks.
For those reasons, the largest share of the deal volume in the short run is likely to involve US acquisitions of US companies, even though a strong dollar gives US buyers more purchasing power abroad. A domestic-first strategy will enable buyers to grow at a reasonable pace while mitigating risk.
The Impact on Valuations
In a competitive sale process, offers tend to fall along a typical bell curve—with a few outliers on the low and high ends, and most offers falling in the middle. For a couple of years, we saw heavier weighting along the right side of the curve, with more offers coming in at a premium. Now the bell curve is shifting to the left, with more offers along the value side of the equation.
Many buyers are banking on less competition and hoping they can pick up quality companies at a discount, resulting in fewer sky-high offers to negotiate against each other. Additionally, the higher cost of capital is driving down what buyers are willing to pay. While investors that previously secured capital at competitive rates have more flexibility, higher borrowing costs will depress valuations generally.
With a lower chance of seeing premium outlier offers to the right of the bell curve, it will become more important than ever for sellers to be totally prepared, and have the right message communicated to the right buyers.
The Impact on Deal Terms
The terms of the sale will always adapt to the market’s conditions. Today, that means buyers are structuring deals in ways that mitigate uncertainty about future company performance. Sellers should expect to see more earnouts (where a portion of the sale price is paid out over time, subject to the company hitting certain milestones) and other measures that shift risk away from the buyer.
What it Means for Business Owners
Owners of A+ companies shouldn’t sit on the sidelines assuming they can’t get a good deal now. On the contrary, exceptional companies can secure great deals in the near term if they are perfectly positioned to the perfect audience. With more buyers playing the wait-and-see game, the ability to capture and maintain the ideal buyer’s attention will demand a more strategic approach to messaging and more disciplined preparation for every aspect of the sale process—from initial discussions through due diligence.
Owners who don’t believe they’re in the best position to sell can use this time to tap growth capital through sources like non-bank lenders and family offices or shore up the business now to capitalize on a more robust M&A market later. It will only take a few quarters of stability to create an M&A rebound, with deal activity surging once again. There is just too much capital available and too much pressure to put it to work.
How Forbes M+A Can Help
In an uncertain market, it’s more important than ever to partner with an experienced investment banker to position your business for a strong outcome through a competitive sale process. Opportunistic buyers are knocking on the doors of exceptional companies, using fear and doubt to force owners into a panic-sell situation. Despite what a buyer may claim, it is never in a seller’s best interest to forgo a competitive sale.
The experts at Forbes M+A are skilled at achieving exceptional outcomes for business owners in any market, using a proven process that leverages both preparation and positioning. We prepare your company for the rigors of due diligence, create positioning that resonates with the perfect buyer, attract ideal buyers to the table, negotiate strategically, and get the best deal across the finish line. If you’re thinking about selling your exceptional company, contact Forbes M+A to learn how we can help you achieve an extraordinary outcome.