Alex Eskra and Dan Riley, Directors at CIBC Cleary Gull, 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 Cleary Gull, 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 and Dan Riley, who are both directors at CIBC Cleary Gull. Good morning, gentlemen. Welcome to the podcast. How are you today?
Alex Eskra: Great. Happy New Year. Did you both have a good holiday season?
Dan Riley: Yeah, it was good. Good to be here.
Ron Miller: Glad to be back with everyone today. We're going to talk to Alex about the current state in the US middle market. We'll look at M&A transaction volume, focusing on private equity activity valuations and the credit markets, and Dan's going to add some colour around the software and technology space, an area where he spends a significant amount of his time. So first with regard to transaction volume, Alex, last time we spoke, transaction volume had declined throughout the second quarter. Can you tell us how the third quarter turned out?
Alex Eskra: Yeah, absolutely. So year over year decline persisted. Robert W Baird reported a little over a 20% decline in volumes year to date compared to the same period in 2021. This likely won't come as a surprise to anybody listening to this, but macroeconomic conditions have made buyers and sellers a little bit more cautious as 2022 has gone on. We've talked about some of these before, at least internally. You know, inflation, rising interest rates and recession concerns are probably making the biggest impact right now. That said, it's not all doom and gloom. Annualizing volume year to date puts us on a healthy year when compared to historical years before 2021, and there are certain reasons to be optimistic going forward.
Ron Miller: Dan, can you talk about volume in the software and technology area?
Dan Riley: Yeah, for sure. I'd say it's a pretty similar story to the overall M&A market based on some data from Pitchbook. Software M&A volume was down about 24% year to date in 2022 through Q3, but that's fairly in line, I would say, with long term averages. So a bit of a return to normalcy after 2021. More outlier volumes.
Ron Miller: Great. Turning to private equity activity overall, Alex, what's happening in the private equity world, although it's not the entire market, it is a good proxy for the broader market, and there actually is pretty good data about private equity activity.
Alex Eskra: Yeah, that's absolutely right, Ron. So while strategist will often look at their businesses a bit differently. Private equity firms serve as a good barometer for the overall market sentiment. You know, after all, you know, private equity is in the business of buying and selling companies. So understanding what they're seeing in the market is really helpful to us. There's a couple of things that happened that I think are worth noting in Q3. So, you know, add on acquisitions increased as a percentage of overall buyout activity and exits decreased. So we'll start with the easy one, add ons, you know, many who are listening know this, but you know, add on acquisitions are common playbook for PE firms to build size and scale. You'll find that this is particularly common in more fragmented markets. You know, one of the textbook examples I use is always, you know, waste management. I think in the history of their company they've made something like over 1000 acquisitions. So just to serve as an example. Add on acquisitions, you know, they're often smaller. They trade at lower multiples and they're generally a lot easier to finance. So given recession concerns and debt availability, it's not surprising to see that add on acquisitions made up about a little under 80% of buyouts year to date. In terms of exit activity, this is where it gets a little bit more complicated. So PE exit activity has slowed from a high in 2021. This is largely due to a higher percentage of the transactions taking place being high quality assets. So these high quality or A assets, as we talk about in the report, they have strong management teams. A clear growth strategy were minimally impacted by COVID and they serve, most importantly, recession resistant end markets. On the other side of that coin, there's a significant number of lower quality assets that either fail to transact or chose not to transact at all. So these lower quality or B assets, as we talk about in the report, were heavily impacted by COVID, and they tend to serve more cyclical end markets, and one of the things that I'd like to keep in mind here is that some of these assets may have done really well during COVID, but now the air is coming out, so to speak. So they're impacted in terms of that bubble. So that probably seems a little negative, which I'm sure you two are used to coming from me. But it's also important to remember that 2021 was a significant outlier year in a fantastic year at that when it came to M&A. So I would expect when the dust settles, 2022 will be a strong year by historical standards. And there are reasons to be optimistic about 2023. First and foremost, I'd say that strategic and financial buyers have a significant amount of capital that they need to deploy. And should you own one of those high quality or A assets, there'll be plenty of options for you.
Ron Miller: Great. I agree with that. I think it's really a tale of two cities. I mean, some of our strong transactions are doing really, really well. And a lot of the factors that you just talked about are causing challenges to some of the other transactions. Dan, with your recent deal experience, what's how is private equity shaped up in the technology space?
Dan Riley: Yeah. You know, I would say there's still a pretty significant amount of interest out there. Tech focused private equity firms are still raising record amounts of capital that they need to deploy in new deals. I would say that maybe within technology, private equity firms have gotten a little bit more focused and they're really trying to pursue deals that fit within their niche strategies, you know, deals where they can add more value beyond just being an investor. And they're also looking for companies that are more profitable and recession resistant.
Ron Miller: Let's turn our attention to LBO multiples. The data seems to remain very strong on transaction volume, but given the state of the credit markets, Alex, what are you seeing in the in the LBO arena right now?
Alex Eskra: Yeah. So on its face, I mean, Q3 was was a bright spot. So we can start with the positive and then I'll flinch, so to speak. So in Q3, you know, valuations, they reached a new peak. So just for context, data notes that, you know, EBITDA multiples hit 7.7 times compared to 7.4 times in 2021. However, this was largely due to declines in volumes. So, you know, deals that were getting closed, as I mentioned before, were primarily for high quality assets. You know, I think I've mentioned this, you know, many times before, you know, talking around the office. But I think it's worth repeating, this is really kind of ECON 101. There are less high quality companies out there. So as a result, that equals higher valuations. All that being said, and we'll talk about this as we get more into the debt markets, but there's been a pullback in LBO financing that really hasn't shown up in the data that's in our report. You know, as I said before, I think it's still a great time to sell high quality asset. But based on overall debt availability to fund buyouts, we would expect, you know, a half a turn or potentially more, depending on the assets, you know, as a decline in valuations going forward.
Ron Miller: Great. I agree. I think the data coming, I think even data said this last quarter that they thought that the last report kind of top ticked the market and that we'll see a little bit of pressure on financial buyer valuations going forward. However, a fraction of those deals are as hot as ever and we have a couple incredibly strong processes that we're working on right now. Dan, how is that affecting your market?
Dan Riley: Yeah, you know, I think companies and investors have certainly taken note of some of the pullback in the public markets. But in the middle market, I would say we're a bit more removed from that and we're definitely seeing strong valuations with the companies we're working with right now. You know, we're working with high quality technology assets where the market is very much the same for that type of business.
Alex Eskra: Yeah. On the other hand, I mean, retail I think is one of the other ones I'd highlight. It's been impacted by reduced consumer spending, primarily the result of inflation, rising interest rates, things like that that prevent people from necessarily financing their purchasing. You know, so we'll see how the fight against inflation shakes out. But, you know, buyers have become a little bit more cautious when things are connected to retail. Now, there's a whole other conversation, we don't need to get into this now. But obviously things that are more consumer staples are a totally different ballgame than, you know, luxury goods, for example.
Ron Miller: That's a good segue to the debt markets. Alex, can you get maybe a little more granular about what we're seeing in the debt markets and leverage multiples right now?
Alex Eskra: Yeah, absolutely. So, you know, total debt multiples for companies under 250 million of enterprise value are down slightly, you know, compared to Q2. So, you know, 3.7 in Q3 compared to four times in Q2. And the biggest change was was the rising interest rates. So, you know, leading up to this point, middle market lending was minimally impacted by rate hikes, you know, during the first half of the year, but it started to catch up. So, for example, you know, senior debt pricing rose about 2% to around 6.5% and direct lending rates were between 9 and 11%. So, you know, nearing mezzanine levels. While this isn't prohibitive to dealmaking, you know, see, before the financial crisis, prior to the financial crisis, you know, senior debt was around 8% and mezz debt was at 16%. It's not going to cause dealmaking to stop, but it will cause dealmaking to slow.
Ron Miller: Yeah, I think even though the market has pulled back, I mean, the financing market's very strong and a lot of these middle market deals do not use excess leverage. So there is pressure on it. But as you said, over a historical context between absolute rates and the overall cost of debt financing, it's pretty attractive.
Alex Eskra: Yeah, that's absolutely right. I mean, we've been spoilt by low interest rates for so long.
Ron Miller: I want to drill down a little bit into software and technology. Dan, given the continued demand for software and technology deals as you've cited, what attributes make an attractive transaction?
Dan Riley: Yeah, you know, I think investors are looking at traditional factors like SaaS, recurring revenue mix, revenue growth, rate retention in terms of revenue and customers profitability. Unit economics would also say that the investors are focusing more and more on some of the higher level qualitative aspects. So is the software really serving a critical need for customers? You know, when they're going to market, is it more of a customer focused purpose beyond just trying to sell as much software as possible, maybe not adding as much value long term?
Ron Miller: Great. You know, we talked about some of the headwinds in the market and the pullback in the public market. Is now a good time to sell a software business?
Dan Riley: Yeah, you know, like I said before, we're working with high quality middle market companies that tend to be winning in their space. So from our perspective, valuations and buyer interests for those companies remain really strong. So it definitely does make sense to launch sale processes at this time in our approach really is to be honest and transparent on what valuation we think we can achieve for our clients in the current environment. Right. And it's all about creating aligned expectations, and you know, we think through our disciplined sale process, we can create optimal results.
Ron Miller: Yeah, I think it's like what Alex and I were talking about. It's so much more about the asset than the overall market. Even when the market ebbs and flows on overall multiples, if the asset is really well positioned, there's going to be an attractive market and good valuations for sure. So Alex and Dan, thank you for joining me today. I think really interesting conversation from what I've heard. I have a few takeaways I guess, that I've reflected on. Deal volume continues to trail what we saw in 2021, but compared to prior years, it's pretty healthy. So down a little, not not too bad. Valuations remain strong for high quality assets. There's a little pressure in the market, but if you've got a strong asset, particularly compared to historic levels, valuations have really held up. And even though debt multiples have have softened, you know, due to sustainability concerns, you know, the leverage market does exist. It might be a half turn below where it was before, but if the story of the company is right with the demand that's out there, I think assets will trade at healthy prices. And the same really holds true for software companies and technology companies. There's some great powerful stories and if they have a niche that is really defensible on a strong growth story, you can have very attractive outcomes at this point in time. So Alex and Dan, thanks again for taking time and listeners, thanks for tuning in.
Dan Riley: Thank you.
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