CIBC US Middle Market Investment Banking’s Ryan Chimenti, Managing Director, and Alex Eskra, Director, join Ron Miller to discuss the current state of U.S. middle market M&A. They discuss M&A transaction volume, private equity activity, valuations, and the credit markets. Ryan also provides his insights on current trends within the industrial and manufacturing sectors.
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. In today's episode, I'm joined by Alex Eskra and Ryan Chimenti, who bring a wealth of knowledge from CIBC's U.S. Middle Market Investment Banking Team. Alex, Ryan, thanks for joining me today.
Alex Eskra: Pleasure to be here.
Ryan Chimenti: Thanks for having us, Ron.
Ron Miller: Today we're going to talk about the current state of the U.S. Middle Market M&A landscape with a special focus on industrials and manufacturing. Alex will be discussing the M&A market more broadly, including deal volumes, private equity activity, valuations, and the debt markets. And Ryan will add his insights on the industrial sector. Alex, let's start today's discussion with transaction volume. The end of last year finished softly showing a decline in transaction volume. How did Q1 of 2024 start out this year?
Alex Eskra: Yeah, Ron, great question. And we saw a continuation of that trend. Q1 saw a 28 % decline in deal volume compared to Q1 in 2023. The decline was largely driven by higher financing costs due to elevated interest rates, persistent global conflicts, inflation, sort of you name it. These factors have made deal makers a lot more cautious, leading to delayed processes or broken auctions due to valuation gaps. And quite frankly, I mean, these things also have an impact on the financial performance of targets as well. Despite the decline, there is cautious optimism for the rest of 2024 and going into 2025. A potential decrease in interest rates later this year could make it easier for buyers to finance acquisitions. The lending market, as we'll talk about a little later, in our episode is already showing signs of increased competition, which, you know, if that persists, should spur M&A activity later this year and into 2025. One of the things that we've been asked a lot this year is what is the impact of the presidential election? And historically, election years have often influenced a owner's desire to sell their business before any new tax policy would go into force or changes in economic policy. However, 2024 is sort of an interesting year because it might not have a significant impact on the business decisions of companies or the economic health of the sellers, because both candidates are sort of a known commodity at this point. And have previously held office, their policies are well known. So one of the interesting things about 2024.
Ron Miller: Ryan, what can you say about deal volume in the industrial sector?
Ryan Chimenti: The industrial sector is held pretty constant other than a 2021 post-COVID bump. But we're seeing right now it's down in Q1 6%, which isn't bad given rising interest rates, material costs, volatility and fluctuations, and inventory and rationalization and kind of strategics feeling their way here early in Q1. You know, one thing that we're watching closely and we're kind of seeing a disconnect between the broader market and the industrial market is, you know, the PMI manufacturing index. It's been down, you know, 18 of the last 19 months and by down below 50, which means 50 is the mark where there's either growth in the industrial market or a recession. So we've been in kind of an industrial recessionary period, you know, for, for, you know, a year and a half and, and yet it hasn't impacted the industrial markets. Like we saw in the, you know, in the Great Recession, there's, there's pockets that are seeing, you know, high valuations and a lot of volume and momentum. And then there's other sectors that just aren't trading.
Ron Miller: Great. Alex, let's drill down into private equity activity specifically. What trends have you seen in Q1 of 2024?
Alex Eskra: Yeah, there's a couple of things, you know, sort of breaking into a couple of buckets. One has been activity with continuation funds. The second has been some notable trends within dry powder. And the third would be carve out activity. So continuation funds, you know, they become increasingly popular alternative for private equity to return liquidity to LPs without going through a traditional exit process. For our listeners, these vehicles allow private equity funds to transfer high performing assets into new vehicles, thereby extending their hold period, resetting the economics and potentially bringing on new investors. We would expect the trend to continue to support liquidity. There's been a record amount of dry powder that's been raised by secondary funds and just been a challenging exit environment. So private equity firms are looking for alternatives. The second item, the private equity dry powder reached a record of 993 billion, with nearly 800 billion of that raised in the last three years. And what gets really interesting is you dig down into the vintages, especially the older vintages, say before 2021. They're facing increasingly strong pressure to accelerate deal-making activities to deploy that capital. So, from our perspective, the record levels of dry powder suggests that there's potential for rebound and private equity activity, second half of this year going into 2025, you know, particularly if interest rates stabilize or we see reduction in interest rates. And then the last item on my list was related to carve out activity. So in Q1, carve out activity accounted for 12.6 % of all private equity buyout deals, which is coming off a low in Q4 of 2021 at 5.7%. So more than doubling. We've seen this increase driven by parent companies trying to right size their organizations and divest of non-core assets or underperforming assets. And really just shows that private equity is getting more creative in terms of trying to get deals done.
Ron Miller: Great, very interesting. Alex, thanks. Ryan, how have these trends impacted industrial or manufacturing?
Ryan Chimenti: So in the industrial and manufacturing market, we've seen private equity funds kind of post pandemic really focus on core expertise and where they can add value and where they have operating partners and experience and kind of areas and markets of interest and focus right now and growth and frankly, high valuations are falling within infrastructure, automation, aerospace and defense including space where there's you know high growth rates they're being they're not being impacted by inventory rationalizations you know haven't been impacted by weather which is becoming more of an impact you know across the U.S. and they haven't been impacted by interest rates. The other thing we're seeing from the private equity world is on exits. They are exiting their winners sooner. So we're seeing more 22, investments coming to market in under three years. If they've executed on their strategies, and they've got a good team and, and, and, you know, that's ready to run and looking for more capital. And two from a competitive set, we've seen private equity funds, fund deals with all equity. One, it's based on the dry powder. They're putting that to work and then utilizing recycle provisions to get some returns to the investors early and also invest in an incremental deal. And we're seeing those funds are using the first add-on acquisition as the catalyst to raise debt for those deals. So interest rates, unlike past environments, it hasn't impacted the good companies within the industrial and manufacturing world. And we're seeing valuations continue to tick up for the A plus companies.
Ron Miller: Very interesting, Ryan. I would agree. I mean, we're seeing a select group of companies really achieving near record valuations. Alex, Ryan started to talk about valuations, but at a more aggregate level, how have valuations held up during Q1 of 2024?
Alex Eskra: Yeah, absolutely, Ron, and definitely good insights from Ryan on the industrial manufacturing valuations. More broadly, valuation multiples for the middle market leverage buyouts declined in Q1. Average multiple fell from 7.2 times in Q4 to 6.6 times in Q1. The decline was more pronounced in larger transactions and that's largely due to the level of debt availability, borrowing costs, macroeconomic uncertainties, many of the same things that have impacted the deal volumes. Touching on a couple other sectors, healthcare and technology saw declines in Q1. So for example, facility-based healthcare saw the impact of, you know, elevated interest rates, higher labor costs and, you know, the inability to raise prices. So that really impacted valuations in the healthcare space, technology, everybody's heard about the Magnificent 7 stocks and how they're rallying based on AI technologies and things of that nature. More broadly, outside of those handful of stocks, technology stocks are generally more impacted by higher interest rates because more of their valuations are tied to the terminal values and that was reflected in lower middle market valuations. We saw technology decline from 10.2 times on average in 2023 to 7.2 in Q1.
Ron Miller: I think I'm going to turn to the debt markets now. Alex, what can you tell me about the debt markets and trends that have evolved in 2024? Ryan touched on higher interest rates and the impact or lack thereof depending on the deal.
Alex Eskra: Yeah, absolutely, Ron. So one of the things I think that's been a notable trend is senior lenders returning to the syndicated deal market. Senior debt multiples broadly actually declined slightly from Q4 to Q1. But all of that was attributed to platform deals that were over $100 million of enterprise value. Platform deals under $100 million actually experience an improvement in senior debt availability. They've also become a lot more competitive on debt pricing. So for example, senior debt pricing in Q4 was about 11%, and that declined to 9.3 in Q1. And that's just driven by increased activity, increased competition. This competition is actually helping with lower rates also offered by direct lenders. And really they're just competing for better businesses, stronger credits. We're seeing that in Q2 as well. So the return of regional banks to the syndicated deal market has provided additional financing options for more mid-sized businesses, leading to improved terms, lower rates. And our hope is that if this continues, it should help support deal making. The other item that we'd note in this episode is that the leverage loan market actually experienced a pretty significant uptake in activity. New loan issuance reached 343 billion in Q1, marking an over 100% increase from Q4. A lot of that's been due to more refinancing activity. But again, signals to us that debt markets could be more supportive for deal making later in the year and into the next year.
Ron Miller: Pretty interesting. It's a little bit of the haves and have nots, I think, in the market. I want to turn and drill down again into industrials a little more with Ryan. So for businesses, Ryan, that you've worked with recently, what factors made those assets stand out in the sale process?
Ryan Chimenti: The trends we've seen have been both strategic buyers and private equity groups focused on, you know, what I call companies that are strategic squares on the board. They've got a real competitive moat and significant barriers to entry. And then the common characteristics of these businesses, one, you've got high powered, high growth, continuing management. You don't have executives that are that are transitioning out. You know, those businesses are getting two turns more of value because you've got a team that can execute on a growth strategy on day one. Two, these companies as a result have expanding margins. They are taking share and people are paying them a premium for the products or services they're providing. Three, all of the businesses that we're seeing that are transacting have developed an operational model that is highly scalable and really metric and data driven. So they are using their data and analytics to invest in automation to utilize their employees better and to deliver products to customers faster with shorter lead times and higher quality. And those characteristics kind of are consistent themes throughout. And if we don't see that those are businesses we're currently just passing on the opportunity to pitch or telling them it's just not the right time.
Ron Miller: So if you have those characteristics, Ryan, that's a good time to sell or would you wait?
Ryan Chimenti: I'd say now is as good a time as any. There's really two factors. There's a small percentage of companies that are experiencing this type of growth and momentum. And as a result, there's scarcity value. Two, from what we're hearing from strategic buyers and private equity groups, there's still kind of a mixed bag on quality of businesses which is what is driving down, I'd say, some of the multiples in Q1 within the manufacturing sector, if you look at it broadly. If you've got good visibility right now and you've got consistency and growth, it's about as good a time as I've ever seen to sell a high-quality manufacturing company.
Ron Miller: Wow, interesting. Any obstacles that you're facing in the market?
Ryan Chimenti: The challenges are kind of the due diligence, hot buttons for buyers right now. One, you really need to spend a lot of time on growth and price volume. With inflation and materials, people want to understand what core growth is. And if you grew 20% but your raise prices 30%, that business really isn't saleable today because you've got the accelerated growth in unit volumes. And two would be the depth and continuation of management. It's a lot easier to sell people are moving faster, runningpreempting processes if you've got continuing management that can accelerate growth on day one. If you've got a management turnover, we're seeing that the bench strength both in strategic buyers and private equity groups is thinner than it's ever been. So it's negatively impacting valuations in businesses where you've got to change executive leadership.
Ron Miller: I would agree with that. If you've got the team and a plan and accelerating margins and sales, it's a pretty good time. Well, this episode, but thank you, Alex and Ryan for your insights today. I've had a few different takeaways from this conversation. There are definitely signs of optimism for the second half of 2024 with debt availability increasing and plenty of equity capital available for high quality deals. The industrial and manufacturing sectors have remained resilient and can definitely continue to realize premium valuations for high quality assets. As Ryan said, there's a little bit of benefit from scarcity value right now in this marketplace. Debt is surprisingly and increasingly available for refinancings and new transactions, which is a positive sign for deal making overall into 2025. So Alex and Ryan, thanks again for your time and listeners, thanks for tuning in.
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