Where Are We In the Current M&A Cycle?
Despite headlines suggesting a slowdown, better metrics are needed to paint an accurate
picture of what is actually happening in the lower middle market (LMM). While reporting suggests that there’s been a
drastic decrease in activity in M&A, this reflects a drop-off in larger deals in the bulge bracket of large,
multinational investment banks. There is more public data on these deals and as a result, does not reflect the lower
middle and middle market segments, which have shown incredible resilience and are primed for a strong Q4 and what’s
shaping up to be a robust 2024.
While it’s true to say that headwinds have impacted M&A in 2023, the lower middle
and middle market segments have continued to shrug off disruptions caused by interest rate increases, supply chain challenges, geopolitical
unrest and the lingering effects of Covid-era
dealmaking.
Private Equity Activity & M&A
With 2021 and 2022 reaching historic deal volumes as a result of cheap
– almost free – debt, it’s easy to mislabel the pullback in 2023 looking too narrowly at certain performance
data.
In Q2 of 2022, interest rates started to creep up as the Fed hoped to cool down what was
a white-hot inflationary market. Looking back a little further, we see that while this was the beginning of a
visible decline in the bulge bracket, the lower middle and middle markets remained active and continued to attract
investors seeking good deals with quality organizations.
Not only have these segments remained strong – with steady activity – there is still
plenty of cash that private equity needs to put to work.
What Should We Expect From Valuations?
As business prospects improve and valuations reset to pre-pandemic levels,
lower middle-market and middle-market companies have become more attractive to investors. These smaller, strategic targets are often perceived as having substantial growth potential in terms of scale and
operations. There has only been a slight decrease in multiples for smaller transactions and a missing piece of this
puzzle is that data is often excluded from strategic activity.
Lenders are still eager to offer
financing in the active lower middle market and buyers are now
directing their attention towards LMM opportunities, where lenders are still capable of facilitating
deals. Following a remarkable surge in deal activity in 2021, the initial six months of 2023 have showcased enthusiasm and heightened transaction
engagement within lower and middle-market companies.
Adaptable M&A Strategy: Growth and Competitive Edge Amid Shifting Markets
M&A continues to be an essential strategy for companies seeking growth and a
practical route to gaining a competitive advantage that responds to changing market conditions. The appetite for
M&A has remained healthy as acquirers have shifted focus to smaller businesses. While companies in the lower and lower middle markets
continue to remain appetizing to buyers, challenges do remain.
Challenges Facing The Lower Middle & Middle Markets
The lower middle market faces unique challenges in M&A transactions, including
limited access to capital, competition from strategic buyers, valuation and pricing pressures, lack of professional advisory support, talent retention and transition issues, regulatory complexities, scalability constraints, and information
asymmetry.
- Limited Access to Capital
For lower-middle market companies, the struggle to access
the necessary capital to fund M&A activities remains challenging. Traditional lenders and financial
institutions may be hesitant to extend credit or provide financing due to perceived higher risks associated with
smaller companies. However, larger companies are taking advantage of this opportunity to realign their strategic
targets and scoop up smaller, well-run companies.
- Competition from Strategic Buyers
Lower middle market companies face intense competition
from strategic buyers, larger corporations seeking acquisitions to expand their market reach, capabilities,
or product portfolio. Strategic buyers often have more financial resources, industry expertise, and established
networks, giving them a competitive advantage when pursuing attractive acquisition targets.
- Valuation and Pricing Pressures
Valuation and pricing challenges persist in the lower middle market segment. Determining the
fair value of a company can be complex, particularly when financial data and performance metrics may not be as
comprehensive or readily available as they are for larger enterprises. The valuation gap between buyer and
seller expectations can lead to stalled negotiations and difficulties in reaching mutually beneficial
agreements.
- Talent Retention and Transition
Employee retention and management transition can be complex in the lower middle market. When smaller companies are
acquired, the integration process can disrupt the existing workforce, leading to potential talent attrition.
Additionally, management succession planning may be lacking, making it challenging for the company to ensure a
smooth transition of leadership during and after the M&A transaction.
- Lack of Scalability and Infrastructure
Some lower middle market companies may lack the scalability and infrastructure necessary to support rapid growth or integration into a larger organization.
Inadequate systems, processes, and technology can hinder the smooth integration of operations and limit the
potential synergies that could be achieved through the M&A transaction.
- Due Diligence and Information Asymmetry
Due diligence is crucial in M&A transactions to
assess risks, uncover potential liabilities, and validate financial and operational information. However, lower
middle market companies may face challenges in providing comprehensive due diligence materials or accessing
the same level of information about potential targets. Information asymmetry can create uncertainties and
increase perceived risks for buyers, potentially impacting deal negotiations.
Overcoming these challenges requires strategic planning, specialized expertise, and a deep
understanding of lower-middle market dynamics. Despite these hurdles, successful M&A transactions in this
segment can unlock growth opportunities, facilitate industry consolidation, and drive value creation for both buyers and
sellers.
How to Navigate Current Market Challenges
With the support of a strong M&A advisory team, buyers and sellers
can unlock opportunities, make informed decisions, and prioritize acquisitions that align with investment criteria
and business priorities.
Above all, as your M&A advisory team, REAG can help entrepreneurs navigate complex
transactions, optimize valuations, and ensure a smoother and more successful M&A process by communicating clearly and effectively throughout our work together.
If you are ready for the next chapter of your entrepreneurial journey, reach
out and let’s begin together.
