Last summer, I participated in a webinar with Kyle Madden, partner at KLH Capital. Kyle and I talked about the current state of mergers and acquisitions in the lower-middle market and answered questions from the CEPAs in attendance.
A few weeks ago, Kyle and I hosted another webinar, this time to discuss what we’ve seen so far in Q1 and what we can expect in 2022.
Here are some of the highlights of our conversation:
How has M&A activity in 2022 differed so far from activity in 2021?
As we discussed back in July, 2021 was a banner year for deal volume and valuations. During the first half of the year, legislators were considering a capital gains tax increase, but by late summer, it became clear the proposal would fail. M&A activity continued gaining momentum through the end of the year
Now a couple months into 2022, it’s still full steam ahead. Many M&A advisors and CEPAs are having conversations with business owners looking to take their companies to market in Q1 or Q2.
While I’m optimistic about the future, I also realize all good things must come to an end. We’ll inevitably experience headwinds before the end of the year with multiple rate hikes. However, the demand for good quality businesses and the amount of capital in the marketplace will keep the market rolling into the foreseeable future.
What industries are hot in 2022?
In Q4, we continued to see a shift toward service-based companies (landscaping, HVAC, plumbing)—a trend that’s been building over the past several years. We expect to see these companies continue to attract buyers, and we also expect to see manufacturing businesses take the spotlight. Across the board, interest rates are still low, valuations are high, and there’s an excess of capital flooding the market.
One other sector to monitor is infrastructure, which has become a buzzword in the private equity and M&A space. The industrial services vertical that spans public and private infrastructure is experiencing booming interest due to the recent federal infrastructure bill.
What challenges can we expect for 2022?
You can probably already predict the top three challenges on our list—the labor market, commodity pricing, and supply chain issues.
Businesses across all industries are facing macroeconomic headwinds. Companies are competing to attract and retain talent, while job seekers have the upper hand. These same companies are sourcing new vendors and working to get ahead of supply and build up their inventory. And don’t forget to add inflation to the mix.
“The world economy is simultaneously facing COVID-19, inflation, and policy uncertainty, with government spending and monetary policies in uncharted territory,” said World Bank Group President David Malpass. “Rising inequality and security challenges are particularly harmful for developing countries.”
The big question: Will macroeconomic headwinds chisel away at margins, or can rising costs be passed along to customers?
What about valuation?
We’re in a seller’s market, and valuation multiples should remain high. But there’s a caveat: not all deal flow is created equal. Not every business will attract premium multiples.
Peak acquirer interest is driven primarily by quality companies. There’s an influx of companies coming to market not yet ready to sell—with the hopes of taking advantage of current market conditions—and facing some disappointment.
There are no magic multiples. Multiples are averages, and when you play the market seeking a specific multiple, you need the quality to back it up. Quality deals in the lower-middle market are closing at about 7-7.5x EBITDA on average, but that’s the average. Lower quality businesses trade lower. Higher quality businesses trade higher.
It’s also important to note that REAG’s role in the sell-side process is about creating competition. We find the right buyer, the right situation, and the highest possible valuation for the seller. When the seller has a high sense of confidence in the quality of the assets and cash flow being acquired, that’s when premium multiples are obtained.
What should you look out for on behalf of clients?
This is a great question that came up during the Q&A portion of the webinar. Here are a few of the topics you’ll want to address if you have a business owner considering a major liquidity event in 2022 and beyond:
- Customer concentration issues
- Diversification and recurrence of revenue streams
- Depth and caliber of management teams
I’ve included a clip from the webinar that answers the question in more detail.
How REAG Can Help
We’re here to help you and your clients facilitate a smooth transaction and achieve the best possible outcome for the client. REAG has a proven track record of converting illiquid business assets into investable capital. Reach out and let’s have a conversation.