CIBC US Middle Market Investment Banking’s Alex Eskra and Dan Riley 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. Dan also provides his insights on current trends within the IT 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 Dan Riley, who are both directors within CIBC's U.S. Middle Market Investment Banking team. Alex is a recurring guest on this show, and Dan covers software and technology in our group. Thank you both for speaking with me today.
Alex Eskra: Thanks for having me back, Ron.
Dan Riley: Looking forward to it.
Ron Miller: Today we're going to talk about the current state of the U.S. middle market M&A market with a focus on activity in the IT services sector. Alex will be discussing the M&A market more broadly, including deal volumes, private equity activity, valuations and the debt markets. Dan will also add his insights on what he's seeing in the IT services sector as part of this conversation. Alex, let's start today's discussion with transaction volume. When we talked last time there was improvement within larger transactions. What happened in Q3 of 2024?
Alex Eskra: Yeah, Ron, that's a good question. Q3 provided some reasons to be fairly optimistic going into 2025. Based on the latest data, U.S. middle market deal volume declined by about 11 % year over year. But just looking at Q3 2024 compared to last year, deal volume actually increased by 17%. Looking into the data, smaller transactions generally continue to be the primary contributor for that decline. However, if we look at transactions between 100 million to 500 million, that's really the sub-segment that drove the rebound in Q3. And this is creating some optimism, at least within our group on a few fronts. Increases in transaction volume for larger deals typically indicates a healthier debt market, which with increased competition and the potential for further rate cuts should bode well for M&A activity in 2025. As more transactions are getting done it signals growing confidence between deal makers and improve financial performance for target companies.
Ron Miller: Dan, what can you tell us about Deal Volume in the IT services sector?
Dan Riley: Yeah, I would say the short answer is that deal volume is down year over year by about 7%. But the longer answer here is that activity is still very much in line with pre-pandemic levels and IT services remains a very attractive sector. Some of the recent declines are due to a challenging deal making environment that's been marked by depressed private equity exit activity and some more caution on the part of larger and publicly traded strategic acquirers. But I would say despite the overall year over year decrease, 2024's transaction volume has been pretty resilient compared to other sectors. And you're seeing several mega trends across the industry, like cloud and AI adoption, that are driving pretty significant growth for the industry.
Ron Miller: Alex, we generally discuss what's happening within private equity since it's a good indication of the broader &A market. What trends did we see in Q3 of 2024?
Alex Eskra: Yeah, so private equity also showed some signs of recovery in 2024. Year over year, deal volume increased by about 7%. Of that deal volume, sponsor to sponsor exits also gained momentum. They accounted for just under 60 % of Q3 exit volume when we exclude IPOs. It's important to note though that these types of exits are still below their historical average. Typically, sponsor to sponsor exits have averaged around 75%. I think within our group, we're expecting this to increase in 2025 as portfolio company performance increases, the potential for lower interest rates, gap between buyer and sellers tend to align more. overall, hitting into 2025, we expect to see an increase. This is all against the backdrop of a significant level of private equity inventory. Since 2018, there's been a significant increase in the number of private equity portfolio companies increasing by about 27%, where many PE firms are just waiting for more favorable market conditions before launching sale processes. There's a number of factors that contributed to this, including, you pretty significant valuations in 2021 where many private equity firms, quite frankly, overpaid for their portfolio companies with low interest rates, easy access to capital, and are simply waiting for more favorable exit conditions before launching sale processes. Also, we noticed that there are a significant number of sellers that were waiting on the outcome of the presidential election and seeing where rate cuts were going to shake out in 2024.
Ron Miller: Very interesting Alex. Dan, how is private equity activity impacting the IT services sector right now?
Dan Riley: Yeah, we've definitely seen increased interest from private equity firms across the IT services sector. And there's an interesting trend here where many buyers are viewing IT services as a nice entry point for making technology investments for the first time. If you compare it to a pure software company, IT services firms tend to trade on a more traditional EBITDA multiple, and they're often less exposed to technology risk because they often have it more. vendor and technology agnostic approach. And then another key trend within the sector is that it's a very fragmented market. So it's a nice opportunity for private equity firms to pursue a buy and build strategy.
Ron Miller: Alex, let's turn to valuations. How have they continued to fare in the last part of 2024?
Alex Eskra: Yeah, that's a good question, Ron. So valuation multiples have remained fairly stable. According to GF data, the average purchase price multiple for deals completed through Q3 2024 was about seven times, which is just slightly down from 2023. But it's important to keep these numbers in context. Valuations are still slightly above the historical average of 6.9 times. which is measured over the last two decades. I think the conclusion that we can draw is the stability and valuations can be attributed to ongoing demand for quality assets. There is sort of this expectation of future interest rate cuts. And there's a significant portion of deal volume that's coming from add-on acquisitions, which is helping to support the current multiples. When we look at a breakdown by sector, It's not surprising to see healthcare, business services, distribution companies have remained pretty stable when it comes to their valuations. As it relates to healthcare, obviously there's continuous demand for these services. It's a very stable sector. Similarly, when we look at business services companies, they generally have steady cash flows, scalable business models, which make them attractive investments. I'll obviously let Dan speak to software and technology, but even if we look at manufacturing multiples, those have remained steady or increased over the last year.
Ron Miller: Dan, Alex set you up. What can you tell us about valuation multiples in the IT services sector?
Dan Riley: Yeah, I'd say IT services companies have definitely seen strong valuations in 2024. If you look at the data through September, the average EBD multiple was 11.3 times. And that's even an increase over 2023 is already pretty strong, 10.8 times multiple. And it's also a substantial improvement over 2022 where multiples really did come down pretty significantly due to all the economic and interest rate headwinds.
Ron Miller: Great. Alex, given the current dynamics in the market, we've already mentioned leverage and debt a couple of times in this conversation. What can you tell us about the debt markets and any notable changes over 2024?
Alex Eskra: Debt markets have also shown some signs of improvement in 2024. You know, based on GF data's data, total debt multiples averaged at about 3.7 times EBITDA across all deal sizes, which is pretty consistent with the historical average and slightly higher than 3.6 times, which was recorded in 2023. We've seen some more favorable lending conditions as commercial banks and debt funds. increasingly compete for high quality assets. Direct lenders, they continue to make up the bulk of LBO financing or leveraged buyouts. But the return of the syndicated market has definitely helped improve overall debt availability, better terms, more competition with interest rates. So it'll be interesting to see how 2025 shapes up. Potential rate cuts are still on the table. But obviously, the Fed's economic indicators are stronger than what they expected. which is good news sort of on both accounts. A strong economy will generally boost &A, but additional rate cuts on top of that would be a real tailwind. But I'd say overall, Ron, we're seeing gradual strengthening in the debt market following disruptions that we have from COVID, rising interest rates and economic uncertainty. So it's a good backdrop for going into 2025.
Ron Miller: Thanks Alex. Dan, before we conclude, got just a couple questions specifically on IT services. What factors are making IT services companies so attractive as acquisition targets? You quoted some pretty high multiples.
Dan Riley: Yeah, I think there are a few different factors that are driving interest in the sector and that's part of what's driving valuation so high. IT services, it's a pretty massive, fragmented market. So very ripe for consolidation and buy and build strategies, as I mentioned before. IT systems and cybersecurity threats are only increasing and they're driving demand for outsourced partners. And what you're seeing too is IT organizations at companies are shrinking. So they're really having to turn to outsourcing. And then once you outsource it to a key partner, you're not going to bring it back in-house. So there's some real stickiness in those relationships.
Ron Miller: Makes a lot of sense. What type of buyers are most active in the IT services space? You just quoted quite a few tailwinds in the sector.
Dan Riley: It's a nice mix between strategic buyers and private equity firms. As I mentioned before, for private equity firms, it's a nice entry point for technology investments and especially for companies or for firms that haven't historically done technology related investments. And then there are number of strategic acquirers out there, whether it's vertical focused, horizontal focused IT services companies and a number of larger publicly traded companies.
Ron Miller: Thank you, Alex and Dan, for your insights. Very, very interesting. I took a few things away from this conversation. First, while overall deal volume is down compared to 2023, we've really seen some positive momentum, especially in larger transactions and during the last quarter or two. Private equity activity is showing signs of recovery. There's still a huge backlog of inventory for PE-backed waiting favorable market exit conditions, which we feel are, you know, kind of more heading our way right now. Next, valuation multiples have remained stable in the broader market, while IT service companies are commanding quite a premium to the general overall market. Next, that the debt market has improved with increased availability, improving syndication market and more favorable terms, debt is pretty readily available. And lastly, as Dan kind of concluded, the IT services sector remains attractive. There are many strong fundamentals and an ongoing digital transformation, which is really driving a lot of trends in the overall market. So Alex and Dan, thank you again for your time and listeners. Thanks for tuning in.
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