CIBC US Middle Market Investment Banking’s Ryan Olsta, 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 business services sector.
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 Olsta. Alex and Ryan focus much of their time in our business services vertical. Alex and Ryan, thanks for joining me today.
Ryan Olsta: Thanks for having us on, Ron.
Alex Eskra: Happy to be here.
Ron Miller: Today we're going to talk about the current state of U.S. middle market &A with particular focus on the business services sector. Alex will be discussing the &A market more broadly, including deal volumes, private equity activity, valuations, and the debt market. And Ryan will add his thoughts on what he's seeing in the business services sector throughout our conversation. Alex, let's start today's discussion with transaction volume. How was deal volume during the first half of 2024?
Alex Eskra: Good question, Ron. So I feel like our listeners are probably thinking I sound a lot like a broken record over the last few podcasts. Q2 2024 saw a further decline in deal volume compared to the same period in 2023. Looking at the latest data, the total number of deals in the US middle market fell by approximately 15 % from Q1 to Q2 in this year. This decline continues the trend that we've observed in prior quarters. And largely attributed to many of the things we've talked about, like ongoing economic uncertainties, higher interest rates. We just saw our first rate cut as we're recording this. So the Fed continues to engineer what a lot of people are calling that soft landing. We may take that interest rate component off the table. Interestingly enough, small transactions, so those under $100 million of enterprise value, were the primary contributor to the overall decrease. And on the flip side of that, transactions above $100 million actually saw a rebound in Q2 2024. And we think this is good news for a couple of reasons. Larger deals transacting is typically indicative of a healthy lending market. These companies tend to trade at a notable size premium, which requires a more supportive debt market. And additionally, based on our experience, activity up market tends to bode well for lower middle market transactions or those that are under 500 million of enterprise value.
Ron Miller: Ryan, how about deal volume in the business services sector?
Ryan Olsta: Yeah, the short answer is in the business services sector, you've seen the same trend that Alex noted in that deal volume is down year over year, approximately 18%. But the longer answer is that activity is still pretty high in the sector and actually kind of well above its pre -pandemic levels within the business services sector. So it's still a relatively attractive time. I'd say these slight declines that you've seen sort of year over year really have to do with a challenging deal making market. Again, highlighted by some of the comments Alex has already made with economic uncertainty, higher interest rates being some of the prime culprits. Certain end markets within the business services sectors such as facility and industrial services have actually been extremely strong during this time period. And I'd say companies across the board in business services where you have contracted revenue or specialized services have really been attractive and had very nice premiums associated with their prices.
Ron Miller: Alex, let's drill down into private equity activity since it's indicative of the broader &A market. What trends have you identified in the first half of 2024?
Alex Eskra: I think the big elephant in the room is exit activity. hold periods continue to lengthen for private equity company portfolios. And this is really disrupting the capital raising cycle. So according to PitchBook, average hold periods recently crossed the seven -year mark. And these private equity firms continue to face rising pressure to return capital to shareholders. Exit activity was essentially flat year over year. looking at the same period in 2023. And a lot of this is due to buyers remaining pretty cautious with where the economy is going, geopolitical uncertainty is now the right time to sell, depending on when they acquired these assets, particularly if it was during the peaks in 2021. We're certainly optimistic, given more active lending markets, which we'll touch on a little later, and how the data is showing up in the market. the number of larger deals, sort of upmarket from us, have increased in the last quarter and quite frankly, have the deal values.
Ron Miller: Ryan, any insights into how the trends that Alex identified have impacted the business services sector?
Ryan Olsta: Private equity firms have remained very active in the business services sectors. And I think you've seen some sectors that have been extremely robust, and that really has had to do with sort of the outsourcing trends within several of those markets, and in some cases, the essential nature of those services. Inherently, many of these businesses have sticky customer relationships. And after a service is generally outsourced, it becomes even more difficult for somebody to bring it back in -house. You've seen this where people have really specialized in these outside services to a point where these functions, it's really become an expertise, even if it's something as simple as lawn care or snow removal. or HVAC services, it's something that people don't do in -house the way they used to do them because there's a specialized nature to that type of service nowadays. And you get not only the expertise, but you also get the advantages of scale by doing that over a large number of customers in a variety of different markets.
Ron Miller: Great. Thanks, Ryan. Interesting trends. Alex, let's shift our conversation to valuations. How did valuations fair in the first part of 2024? And is there any indication of where valuations are expected to go over the next, over the balance of the year?
Alex Eskra: Good question, Ron. So valuation multiples for lower middle market LBOs increased in Q2. So in Q2, they hit 7 .4 times EBITDA, which is up from Q1, where they were at about 6 .9 times. This is also in excess of the 7 .2 times we saw in the first half of 2023. And largely, we suspect this increase is due to a combination of factors, including buyer confidence. You know the outlook for more interest rate cuts and then you know higher quality assets transacting One interesting element that we've observed is just know tighter valuation proposals submitted by buyers You know indicating you know greater efficiency in the market people are coming to you know very much the same conclusions You know ultimately buyers are then being selected based on their you know industry expertise who are their operating partners? Speed to close things of that nature So while valuations are down on an annualized basis, they continue to be at premium levels compared to what we saw prior to COVID. So we'd expect this to continue given the lower number of high quality assets trading. Plus, if there was a change in sort of confidence in the economy or interest rate cuts, that could provide more tailwinds.
Ron Miller: Thanks Alex. Ryan, can you tell us about valuations in the business services sector? I think you highlighted a few trends that were quite positive in some of your previous comments.
Alex Eskra: Yeah, you look over the last year, you'll see almost every sector in business services has been up. But if you compare it to the S &P 500, they've actually been down a little bit. That's because of some of the... high -flying nature of some of the technology groups and some other stuff, you know, sort of embedded in that S &P 500, if you think about it that way. But overall, the sector continues to command a very strong valuation in business services, particularly for the top performing companies. Again, as I mentioned, if you've got sort of resilient end markets like facility and industrial services, education and training, the buyers in those particular categories within business services, really continue to pay up for high quality assets.
Ron Miller: Thanks, Ryan. Let's turn to the debt markets. Alex, the Fed just cut interest rates, as you mentioned. What can you tell us about the debt markets and any trends that have come out in the first half of the year?
Alex Eskra: Yeah, Ron, to your point, it'll be interesting to see how that impacts data in our next report. As far as the first half of 2024, in Q2, senior debt multiples increased just slightly, three times to 3 .1 times, largely attributed to easing credit markets. But it's also so minimal that we'll have to wait and see how that continues to improve. the impact of that rate cut. The most notable trend that I would say that we have observed in the first half is the competition with senior debt pricing. So senior debt pricing decreased from a Q4 of last year at about 11 % to 9 .3 % in Q2 of 2024, which is a pretty notable decrease in the pricing, largely driven by increased regional bank activity. What's worth noting though is that despite the decrease in senior debt pricing and the competition there, the overall cost of debt remains high compared to historical averages, largely due to the impact of subordinated debt. When you factor in the coupon on the subordinated debt, any sort of pick interest were squarely in kind of the mid -teens rates. So looking at the market as a whole, think there's reasons to be optimistic. looking at the broadly syndicated loan market. According to PitchBook, they're expecting an increase in debt availability just due to gradual easing of credit conditions. The debt multiple for broadly syndicated transactions for sort of all private equity increased from 4 .8 times to 5 .2 times in Q2, which is meaningful given that historical averages have ranged somewhere between sort of five and a half to six times.
Ron Miller: Thanks, Alex. Ryan, I'd like to ask you a few different questions specifically on business services, as long as we have you here. first, for business services companies that you've worked with recently, what are factors that made those assets really stand out in a process?
Ryan Olsta: Sure. Maybe I'll just highlight a couple of particular factors that seem to be really critical in terms of being very value added in the sale process. The first would be just how recurring the revenue is in nature. Is it contracted over some long period of time? Is it locked in with a particular customer? That's a very important element in terms of valuation. Second is just how specialized that service is. And what I mean by that is can it be easily replaced by others within its given marketplace or is it something that really you're the only provider that can help out. And obviously there's a spectrum associated with that. And probably the third factor that I would highlight is scale and the benefits that you get from scale. Obviously, if you've got a particular business service that scales well within an area that provides a big barrier to entry for others within that market, and again, is more highly valued.
Ron Miller: All good points. Ryan, if you were an owner of a business services company, is now a good time to sell? And what might you do to prepare yourself for such a transaction?
Ryan Olsta: Yeah, I'd say that's two good questions, actually. The first is, is it a good time to sell? I'd say it really does depend on the specific business. But from an overall market perspective, yes, it's a good time, all in. If I was a business owner taking a look at what I would do to my business over the next say 12 to 24 months to potentially prepare it for sale, I would try to take a fresh look at it as a new owner would, sort of coming in. And again, I'll highlight a couple of different dimensions on which you could do that. A lot of business services companies, particularly on the smaller end of the spectrum, have a fair amount of customer concentration. And an individual business owner might be very comfortable with that, but you can imagine a new group coming in is always going to have concerns. And so,As it relates to that concentration, what can you do to lock in that customer or to make somebody feel better about that relationship on a go -forward basis? And that could take the form of contracts or a lot of different things. Another big dimension I would think about is just sort of the visibility for your business. I think a lot of individual business owners feel very comfortable. They've got a certain amount of visibility, three months, six months, a year out, that they can kind of know by gut feel. The reality is you've got to try and translate that gut feel into something tangible that a new owner can feel very comfortable with and say, yeah, now I know. I can see the trend six months ahead of time and I can prepare accordingly in terms of what I need to do with the business. So those are two items that I think would be really beneficial for entrepreneurs today to think about as they're positioning the business for sale.
Ron Miller: I think we can always tell when a business owners prepared and they have a strategic plan and they've looked at some of these weaknesses and have some mitigants. It really can make a difference. So Ryan, one last question of what obstacles are you seeing in the market? Have you seen in a couple of your processes and how are you addressing those?
Ryan Olsta: Yeah. I would highlight sort of the stickiness of the customer base in terms of its revenue and how recurring that is in nature. And again, that's something where it's always a challenge in any process, right? A new owner coming into a business says, want to know where next year's business is going to be. I want to know where the next two, three, five years business is going to be. You know, the reality is that's very hard to sort of predict. I think those are the obstacles that we try to help address. And it's whether it's looking back at the data, how long have you had that customer? Why are you so important to that customer? How can you give assurances to a new owner coming into the business that that customer's going to be there for the long term? I think the more you can get people comfortable with that, the better off you're going to be. And I think you almost see that across the board in business services when you have some level of customer concentration.
Ron Miller: That's really what the person, what the buyer's buying is the future revenue from those customers.
Ryan Olsta: Exactly right.
Ron Miller: So thank you, Alex and Ryan, and thank you for your insights today. I have a couple takeaways from this. There are definitely signs of optimism for the second half of 2024. Larger transaction volume has already increased, and we see that strength moving down market. Debt availability is increasing due to just a generally more competitive lending market and lower interest rates. Both of those should spur valuations for high quality companies. lastly, business service companies have remained very attractive and continue to command a premium, particularly compared to pre pandemic levels. I think Ryan outlined a number of factors on the recurring nature of these revenues and the trend towards outsourcing that make business services, you know, in the scheme of &A, some of the more attractive assets. So Alex and Ryan, thank you again for your time and listeners. Thanks for tuning in.
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