CIBC US Middle Market Investment Banking’s Alex Eskra, Director, and Ryan Olsta, Managing Director, joins Ron Miller to discuss the current state of U.S. middle market M&A. They discuss M&A transaction volume, focusing on private equity activity, valuations, and then the credit markets. They also discuss current trends within the business services sector and whether it is a good time to launch a transaction process.
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 Ryan Olsta, Managing Director at CIBC. Alex and Ryan work across several of our vertical markets. Alex is going to speak about the current M&A market and financing markets more broadly, and Ryan is going to drill in more specifically on business services. Alex and Ryan, how are you guys today?
Alex Eskra: Great. Thanks for having us.
Ron Miller: Fantastic.
Ryan Olsta: Appreciate being on.
Ron Miller: Alex, let's start with transaction volume. Last time we spoke, Q1 2023 transaction volume was down compared to the same period in 2022. Can you tell us how Q2 2023 shook out?
Alex Eskra: Yeah, Ron. Well, you know, we talked about this last time, but I think most of the market was expecting a slower first half of the year, and the second quarter didn't change that trend. So volume was down almost 30% in the first half of 2023 compared to the same time frame in 2022. Now, based on our discussions, you know, across the bank and, you know, with our private equity relationships, you know, there were a lot of us that thought the first half of 2023 was going to be slow. And, you know, we were right. You know, that said, there were a number of us, including myself, that thought the second half of the year would see a rebound. And while M&A activity is continuing on, it seems the rebound and transaction volume might not begin until 2024. You know, there's a couple of reasons, I think, you know, to be optimistic for the months ahead. You know, we've talked about this in prior episodes. But, you know, strategic and financial buyers have plenty of resources to deploy in order to complete acquisitions. There's this growing backlog of portfolio companies within private equity funds that need to transact in order to return capital to LPs or limited partners. And finally, banks are returning to the syndication market after taking what seemed to be a several quarter hiatus. And then more recently, the public and high yield debt markets have had a pretty strong September.
Ron Miller: Ryan, how about the business service deal volume last quarter?
Ryan Olsta: Yeah, the first half of 2023, deal volume in the business services sector was down about 26%. And again, that's comparing it to the general market that Alex referenced of 29% to 30% down relative to the same period in 2022, so slightly less than the general market. Important to keep in mind, though, that on an annualised basis, the transaction volume was actually very much in line with sort of the pre-COVID levels. There was actually a little, you know, spike in the market, if you will, that this is down from.
Ron Miller: Great. Thanks, Ryan. Alex, what can we tell our listeners as it relates to the private equity world?
Alex Eskra: You know, we talked about this before. You know, private equity isn't the entire M&A market, but it's a good proxy for the, you know, the broader market. You know, these firms are in the business of buying and selling companies. So it's important to look at trends within private equity. And there's a couple of things that I think are important for our listeners. You know, first and foremost, I talked about it before, but there's this growing backlog of portfolio companies that need to transact. And, you know, this is causing sort of a mismatch in the fund level capital flows. So, recently the average hold period for portfolio companies reached 5.6 years, which is meaningfully higher than the recent average of just below five years. You know, in addition to that, investments are outnumbering exits 3 to 1, which will impact liquidity for limited partners. You know, who are, quite frankly, going to need to adjust to a slower return of capital.
Ron Miller: Alex, that that last point is very interesting to turn this and look from the private equity perspective. Can you discuss that a little more?
Alex Eskra: Yeah, sure. Private equity funds return capital to limited partners more slowly. You know, new private equity fund raising is also going to be slow. So if hold periods are longer, private equity funds are probably going to be doing more recapitalisation, partial sales or continuation vehicles in order to give limited partners some level of liquidity.
Ron Miller: Very interesting. Alex, let's turn to valuations. What happened in Q2 of 2023?
Alex Eskra: Yeah. So you know there's the headline numbers, and then there's just a little bit more of a nuance to answer. So Q2 saw a pullback in valuations compared to what we saw just a quarter ago. You know valuations for buyouts under 250 million enterprise value went from 7.7 times to 6.4 times in Q2, which you know is a meaningful decline. And this put valuations for the first half of 2023 at about 7.2 times, which, you know, is in line with, you know, sort of pre-COVID averages. But, you know, definitely not what we've seen over the last couple of years. And there's a couple of factors for that. High interest rates continue to put pressure on valuations, but more notably think this quarter and the first half of 2023. The mix of deals has changed. You know, one of the things that we saw over the last couple of years is a significant number of really high quality companies trading, which pushed up valuations, but there are definitely more low quality deals transacting than there were just a year ago. And then you also have filled out in the specific industry. You know, there's certain companies and end markets that continue to attract buyer interest and support strong valuations. You know, think you look at health care services and business services. You know, don't think it's going to come to a surprise to any of our listeners. But sort of more non-cyclical businesses have garnered a lot more buyer interest.
Ron Miller: Great. Let's turn to Ryan. This is really your sector. Given your recent deal experiences, what are buyers looking at and what's happening broadly in business services?
Ryan Olsta: Yeah. Within the business services sector, you know, there's some key characteristics that buyers are really focusing in on. You know, high free cash flow customer retention that they can count on consistent and predictable business models. You know, the businesses that have long term contracts or recurring revenue are particularly attractive to buyers. And that's in light of people's concerns about what may happen for the future, be it a recession or a slowdown or whatever they might be factoring. Again, that predictability is really highly valued.
Ron Miller: Alex, can you comment on any trends we're seeing in other sectors?
Alex Eskra: Yeah, I mean, I think there's a lot of businesses that, you know, had a lot of interest during Covid, but those some of those businesses have lost their lustre. So, you know, for example, consumer and distribution deals seem to be the hardest hit in the first half of 2023. You know, there's a lot of buyers that are worried about core demand for consumer companies. So, you know, while inflation has come down year over year, it continues to be persistent. And don't think the full impact of inflation on the consumer has been fully felt. Distribution has also softened coming out of the pandemic. A lot of us remember all the supply chain disruption that occurred, you know, during Covid and coming out of Covid. So to meet demand during 2021 and 2022, a lot of manufacturers built up record raw material and finished good inventories in order to fill orders. But as demand for new orders has softened in 2023, firms have not only reduced their purchasing activity through distributors, but they've also tried to whittle down those those vast inventories that they built up during the pandemic. The other thing to note is that distribution businesses often have bigger balance sheets, and with a higher cost of debt, they can borrow less money than they could a couple of years ago. You know, not surprisingly, there's also significant demand for high quality companies. So we track the so-called quality premium. You know, these companies have above average margins and growth prospects. The thing to note in the first half of 2023 is that the premium paid for these companies has normalised with what we saw pre-COVID at about 8%, which is down from the 20% plus that we saw over the last few years. You know, I think a lot of this is attributed to buyers shifting their focus in the current market. You know, there's a lot more focus on sustainability and visibility in the company's forecasts, and they're often less trusting of the recent financial performance. And then we also don't want to discount the impact that the debt markets have had on buyers ability to pay premiums. If you can put less debt on a business, you're often paying less for it. It's simple math.
Ron Miller: Alex. Really interesting and a good segue to my next topic, which is the debt markets. You talked today and last time a lot about rising interest rates. How is that working its way through the debt markets and maybe what are a couple other trends you're seeing in debt availability right now?
Alex Eskra: Yeah. You know high interest rates have obviously impacted the financing. You hit the nail on the head. There's some other factors under the surface there, you know, including increasing bank capital requirements, declining hold sizes. You know, as lenders feel more cautious, they're not going to know put as much debt on a certain business. There's often increasing thresholds. And then there's other, you know, internal factors within traditional lenders over the last couple of years, you know, a lot of these lenders, you know, might feel comfortable being the second or third, you know, in a deal. But, you know, now want to be the first in terms of, you know, for their core customers. You know, during the first half of 2023, data reports that total debt is down about a third of a turn, which doesn't seem significant. But it's also showing that the impact of the current lending market is being borne out in the data. You know, in terms of optimism, there's a lot of industry experts that are expecting rates to peak, you know, in Q4 of this year. And, you know, while that very well may be true, you know, I think broadly, CIBC expects higher interest rates to persist for the foreseeable future. It's also worth noting, you know, direct lenders continue to support, you know, buyout activity. But, you know, overall new debt issuance is, you know, probably going to be down for the remainder of 2023, you know, largely due to just lower volume. But also, you know, there's a continued focus on add on activity, which uses existing credit facilities. And then, you know, just a challenging syndication market, you know, all sort of putting downward pressure on new issuances.
Ron Miller: Thanks, Alex. I'd like to now turn to Ryan's expertise in business services and ask a few questions specifically to you, Ryan. First, Alex touched on the outsourcing trend earlier. What are you seeing in terms of outsourcing and what makes that attractive to buyers?
Ryan Olsta: Yeah, I think the outsourcing trend is is one that's existed for quite a long period of time, but I think is really accelerated post Covid era, really because of the tight labour market. If you think about what that's caused for a lot of companies in terms of their ability to do things on the periphery, really what they've done instead is really deploy their resources, be it labour or capital or whatever else, really into their core operations, what they do better and outsource as much of that ancillary work as they can to groups that focus in those respective areas. Think about it from any company's perspective. If they're doing, you know, marketing or IT work or some type of facility services that they need to do, but they don't necessarily have to do it themselves. And so looking for other groups to sort of help them from the outside perspective. And as that lever continues to turn a little bit more from that perspective, it makes these business services companies that focus in those areas all that more appealing because they're going to continue to benefit from this outsourcing trend. You know, for quite some time.
Ron Miller: Ryan, Alex just commented on a couple headwinds. You know, interest rates. You just talked about a couple of tailwinds on the outsourcing trend. Is now a good time to sell if you're an owner of a business services company?
Ryan Olsta: I think if you look at the deal volume and the valuations, you know, potentially down a little bit from its peak, but really in historical norms in terms of what's been out there, and we're in a marketplace now at the end of 2023 where you've seen a bit of stabilisation and you don't really see any large critical events on the horizon, which I think shape up well for trying to get a deal done during this time frame.
Ron Miller: Great. Thank you. And a last question. What obstacles are you seeing and how are you addressing those in the deals that you're working on right now?
Ryan Olsta: Yeah, I'd say the number of obstacles. And again this goes to sort of deal timing. You know, in your last question, I think the number of obstacles is actually kind of decreasing. You still have to explain the Covid and supply chain disruption that took place over the last couple of years. But again, that's in the rear view mirror you're looking at for most companies is a relatively clean 2023. And so I think this is creating a bit of a window from that perspective. And if you look at the valuations in business services on an EBITDA multiple basis, they've actually been strong. You know, as a result.
Ron Miller: Alex and Ryan, thank you for joining me today. From what you've said I have a few takeaways. First volume in 2023 is down compared to the same period in 2022. But there's some positive underlying dynamics that should drive M&A activity over the next several quarters. Next, the premium buyers are willing to pay for high quality companies has reverted to pre-COVID level norms, still very attractive in a historical context. Next, the debt markets remain challenging, but both banks and direct lenders continue to support LBO activity and the syndication market has returned. Some deals are tougher than others, but the credit markets are open. And lastly, certain segments of the business services sector are still really strong for buyers due to the positive industry tailwinds and predictable business models. In fact, a number of the trends or obstacles that have traditionally faced some of these companies have lessened. Alex and Ryan, thanks again for taking the time and listeners. Thanks for tuning in.
Ryan Olsta: Thank you Ron. We appreciate it.
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