CIBC US Middle Market Investment Banking’s Alex Eskra, Director, and Jim Olson, Executive Director, join Ron Miller to discuss the current state of the US middle market M&A landscape, transaction volumes and values, and overall credit markets.
Ron Miller: Welcome to the Monitor by CIBC's US Middle Market Investment Banking Group. A podcast series focusing on key insights, strategies and trends in the US middle market landscape. I'm your host, Ron Miller. On today's episode, I'm speaking with Alex Eskra, Director and Jim Olson, Executive Director at CIBC. Good morning, gentlemen. Welcome to the podcast. How are you today?
Alex Eskra: Great. Thanks for having us.
Jim Olson: Appreciate it, Ron.
Ron Miller: Today we're going to talk about the current state of M&A in the US middle market. We'll look at M&A transaction volume, focusing on private equity activity, valuations and then the credit markets. Jim will also add some commentary on the consumer marketplace. Alex, last time we spoke, transaction volumes were decelerating throughout 2022. Tell us how the full year turned out.
Alex Eskra: Yeah, absolutely, Ron. So, you know, Q4, I would say was no different than earlier in the year. I will say there was a little bit more of a decline in Q4. It was about 24% lower than the average quarterly volume sort of through September 2022. And I would say, you know, the majority of that decline was a result of the pullback in the debt markets. We'll talk about this a little bit later in the podcast. But ultimately, it was a reduction in total leverage and increase in debt pricing, resulting in a pullback in valuation comparing year over year 2022, volume was down about 21% compared to 2021. But the one thing that we should keep in mind here is this is more of a reversion to the mean or a normal level of deal volume. I think it's important to keep in mind that 2020, a lot of the deals that would have taken place were pushed into 2021 as a result of COVID, and one of the reasons 2021 is such a significant outlier. So if we compare 2020 to deal volume to pre-COVID levels, we're right in line with that level of deal volume.
Ron Miller: Jim, how about consumer deal volume last year?
Jim Olson: Yeah. Thanks, Ron. It was a tough year for consumer deals. 2022 volume was down 48% compared to 2021. A lot more than the overall general market. Early data suggests the significant slowdown in the second half of 2022 will continue through the first half of 2023, with deal volume down approximately 40% to start the year. There is some good news as we are seeing a lot of deals being prepared to launch which should drive deal activity the second half of the year.
Ron Miller: Hm, interesting. Alex, any other trends in the deal market that you want listeners to hear?
Alex Eskra: Yeah, I think one of the interesting things we may have talked about this in our last podcast, but add ons continue to dominate the number of buyouts that are closing in 2022. Add ons made up something like 78% of the total buyouts, which is a pretty significant level compared to historic levels. One of the other interesting things I think, too, is that carve outs were actually up in 2022 compared to Q4 in 2021, they increased something like 2.5% or so, which sort of signals to me that people are looking for value buys as the debt market becomes more challenging. People are looking for deals that are easier to finance, and one of the reasons add ons is so prevalent is that they're smaller, they're easier to finance with existing lender relationships, generally with a platform company. The other thing that we'll talk about is that, a little later on in this podcast, is leverage for new platform companies is down material.
Ron Miller: That's pretty interesting. So what happened with valuations in the fourth quarter of last year?
Alex Eskra: So I think through most of 2022, we talked about valuations steadily increasing. In Q4, there was a decline from 8.2 times in Q3 to about 6.8 times in Q4. I think there's a variety of reasons why that happened. Some lower quality deals traded at reduced multiples which brought the average down. There's obviously the macroeconomic landscape, which includes inflation and recession fears. And then I think the other item that we should talk about is that there are certain companies that got a COVID bump. So during 2020 and 2021, they benefited from the work at home environment. I think most people are familiar with Peloton, for example, the stock price skyrocketed through COVID and then I think in the last two years it's shaved off most of those gains, if not all of them. On the other hand, there are a lot of companies out there that sort of meet the A+ quality standard as we think about them. They're recession resistant. They have supportable forecasts, great management teams, and then they have some element of a recurring revenue component. And these companies were actually seeing a multiple expansion.
Ron Miller: Jim, you've had a number of consumer deals in the last year. What are buyers focusing on and the consumer market?
Jim Olson: Yeah Ron, in consumer, buyers are especially focused on understanding the impacts of inflation and supply chain constraints in an effort to better assess the normalized profitability of companies in the market. Things like unit growth, normalized margins and backlog are very important when it comes to valuation. It is not just the traditional revenues and LTM EBITDA driving value.
Ron Miller: Yeah, it seems like a lot of moving parts in the performance of the companies that we've worked on over the last year. I want to turn to the debt markets and Alex, let's talk about what happened over the last year. You referred to this earlier in the podcast, but how have higher interest rates and wider credit spreads impact the availability of leverage in the middle market?
Alex Eskra: Yeah so, 2022 was an interesting year. It probably saw the fastest credit tightening cycle in 40 plus years. The Fed funds rate increased over 4% over the course of the year, and this really took the all in cost of debt for private equity backed portfolio companies from 6 to 9% at the beginning of the year to something around 11 to 13% by the end of the year. On top of which, you know, lending standards tightened as well. You know, lenders focused a lot more on historical performance, whether that's during the last recession or during the last cycle, depending on the industry. And also, you know, really focused in on interest coverage and fixed charge ratios, which I'd say the combination of all of these factors has led to, you know, half a turn to a turn decline in leverage for smaller deals and, you know, a turn to a turn and a half for the larger middle market transactions.
Ron Miller: So how has this affected valuations? Obviously, if you can borrow less money, you're going to pay less. Is it dollar for dollar or how do you how is this translated into, you know, overall valuations?
Alex Eskra: That's a great question, Ron. You know, every situation is a little different. But, you know, simply put, you can't borrow as much. You can't pay as much. Just like you said, it's just math. You know, I think depending on the situation, you might not see this. But I would say just in general terms, you know, based on our experience, we've seen anywhere between three quarters of a turn to, you know, a turn or maybe more decline in valuation.
Ron Miller: But buyers are also putting in more equity into deals. So what have you seen with that regard?
Alex Eskra: Yeah, that's exactly right. I mean, when you have a shortfall in debt, it has to be made up somewhere for smaller deals, private equity funds. Then buying large, it's been writing larger equity checks. You know, in Q4, the average equity check exceeded 60%, which, you know, historically anything over 55% has put a lot of downward pressure on valuations. You know, on the other hand, larger deals, buyers are just, you know, relying on other forms of credit, particularly the direct lending market. In Q4, the private credit market basically supported LBOs, while the syndicated bank market was was basically closed. In 2023, the syndicated market is returning, but their hold sizes are smaller and their risk appetite is cautious, risk off as it were. And so although, you know, the pricing on direct lending has increased, they still have quite a bit of market share and leveraged transactions. Direct lenders are closing something like 2 to 1 compared to the syndicated banks for LBOs. And really just to put a bow on it, you know, private credit funds have raised significant amounts of capital in 2022 compared to 2021. It's a second largest raise year, 133 billion. So even though, you know, people are maybe a little bit more cautious, there's still a lot of credit out there to support.
Ron Miller: Valuations have clearly pulled back, but there is a lot of equity, capital and debt capital that's still in the marketplace despite the credit pressures that you're talking about. Jim, I'd like to turn again to consumer transactions. If you're an owner of a consumer business, is now a good time to sell?
Jim Olson: Well, Ron, I wouldn't call it a great time to sell, but if you can prove that you're able to pass along some of the inflationary input costs, inventories are returning to normal levels and you have a strong backlog for the remainder of 2023. Buyers will look favourably upon the company, if you go to market,
Ron Miller: What advice would you give sellers who are thinking about transacting this year?
Jim Olson: Yeah, we are doing more work than ever to prepare for sale side assignments. This includes performing analytics around customers and products to be out in front of buyers concerns. That's in addition to the traditional quality of earnings reports, market studies, customer surveys and legal review that have become commonplace in deals today. Things like customer retention, new customers, market share and unit economics are important to buyers and therefore should be tracked and analyzed by our clients before they go to market. I expect certain categories like health and wellness as well as consumer services to perform well in 2023. After what everybody had to endure during the pandemic, people are spending more money on activities to take care of themselves, both mentally and physically, and enjoy experiences like entertainment and vacations with their family and friends. This should be a significant segment of the consumer deals this year.
Ron Miller: Alex and Jim, thank you very much for joining me today. From what I've heard you say, I have the following takeaways. First, although 2022 and 2023 deal volumes are down from 2021, they're still consistent with pre-COVID levels. There's also quite a bit of capital, both debt and equity that are chasing transactions to make good deals attractive for both buyers and sellers. Second value. Patients have been impacted by the pullback in the debt markets and softer demand for certain sectors, particularly those that achieved a COVID bump. Third, the cost of debt has increased and the availability of debt has decreased, reducing buyers ability to pay, but they are making back a portion of this by raising their equity checks and focusing probably a little more on value oriented transactions. And lastly, consumer deals have been negatively impacted, but well-prepared sellers in certain segments of the market, those that are well prepared with the appropriate data to get under the performance, can still have a strong reception to their companies. Alex and Jim, thanks again for the time and listeners for tuning in.
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