CIBC US Middle Market Investment Banking’s Alex Eskra, Director, and Jim Olson, Executive 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. Jim also provides his insights on current trends within the consumer 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 Jim Olson, who bring a wealth of knowledge from CIBC's U.S. Middle Market Investment Banking Team. Alex, Jim, thank you for joining me today.
Alex Eskra: Pleasure to be here, Ron.
Jim Olson: 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. Alex will be discussing the M&A market broadly, including deal volumes, private equity activity, valuations, and the debt markets. Jim will add his insights on consumer product sector throughout our conversation. Alex, let's kick things off with transaction volume. The last report showed a significant decline in deal volume. How did Q4 2023 shape up in the M&A markets?
Alex Eskra: Good question, Ron. So Q4 continued to reflect a bit of a cautious sentiment in the market, and deal volumes largely remain subdued. This was due to a couple of things, largely due to tight lending markets, but also some overall economic uncertainties and geopolitical tensions weighed on deal volumes as well. Overall, deal volume was down 26% in 2023 compared to 2022. That said, throughout 2023, certain sectors like aerospace and defense and industrials showed resilience and benefited from reshoring and automation trends, which attracted significant buyer interest. I'd say as a group, our expectation is for slow deal volumes to persist for the first half of 2024 in hopes that there's going to be a rebound in the latter half of the year as conditions are expected to improve.We'll talk about this a little later on in the podcast, but we expect the debt markets to be more supportive and with expectations of potential rate cuts, this could bode really well for M&A activity.
Ron Miller: Jim, how about the consumer deal volume last year?
Jim Olson: The consumer product sector saw a slight increase in transaction volume in 2023 compared to 2022, but is still significantly down from 2021. Early indications show consumer transaction volume up to start 2024, but full year expectations are only modestly optimistic when compared to 2023. The consumer sector continues to navigate post-COVID challenges, including persistent inflation, inventory rightsizing, and high interest rates. But there is growing consensus that both inflation and interest rates will improve later this year.
Ron Miller: Let's drill down into private equity. Alex, what trends did you see in Q4 of 2023?
Alex Eskra: Certainly, Ron. So there's a couple of interesting trends taking place in the world of private equity. At the end of 2023, the median holding period for PE-backed companies reached 4.2 years. So companies that are actively being held within private equity funds. And this represents an 11% increase over the five-year average. Probably the more interesting stat is the median holding period for private equity investments that were exited in 2023 reached6.4 years, which is marking the first time that this has happened since 2015, that this crossed sort of that six year threshold. So this indicates to us that private equity firms are taking a much more patient approach and are waiting longer to exit their investments, really hoping for more favorable terms and potentially a more favorable deal making environment.We can really see this borne out in the data. The number of private equity exits were down about 33% in 2023 compared to 2022.And they're actually down 50% from 2021. So there's a pretty significant decline in exit activities suggesting that private equity firms are really concerned about the timing of their exits, potentially leading to what folks are calling the maturity wall for investments that were made five to seven years ago.
Ron Miller: So Alex, that maturity wall sounds ominous, but I think that might bode well for private equity exits. What's your expectation about the future with regard to PE?
Alex Eskra: Absolutely, Ron. So looking ahead, we believe that this maturity wall, albeit maybe sounding ominous, but in the late 2024, 2025, could create periods of high exit activities for PE funds. And this is based on current fund dynamics, which with funds coming to an end of their life, limited partners expecting a return of capital, and anticipation of an improved environment for M&A transactions.
Ron Miller: Jim, I want to turn to consumer products again. Any insights into how these longer hold periods have impacted the consumer sector?
Jim Olson: Yeah, Ron, there's definitely a feeling of optimism for consumer product transactions long term because of the longer than average hold period of PE-owned consumer product companies. But we anticipate deal volume to only be modestly up in 2023. Many consumer product companies are coming off a challenging second half of 2023 in which margins were down and growth was driven by inflation versus units sold. As we get past the election and companies come into easier year over year comps, we expect transaction activity to tick up.
Ron Miller: Thanks Jim. I want to switch to valuations overall. Alex, how did valuations fair in Q4 of 2023 and what do you expect moving forward?
Alex Eskra: So Q4 was an interesting quarter. So we saw EBITDA multiples actually strengthen. So average multiple for completed deals reached 7.5 times, which is a slight uptick from Q3, but a fairly notable increase from Q2's average of 6.7. And this really just demonstrates that buyers are still willing to pay up for quality assets. For the full year, 2023, the average multiple did decline slightly to about 7.3 times compared to the 7.6 times average in 2021 and 2022.However, it's really important for listeners to note that this is still above long-term averages, indicating that there is a sustained evaluation premium for high-quality companies.
Ron Miller: Jim, anything that listeners should be aware of as it relates to consumer valuations?
Jim Olson: Good question, Ron. I'd really just echo the themes Alex has noted. Consumer companies that have performed well in what has been a very challenging consumer products environment are commanding strong valuations, particularly for companies that demonstrate sustainable financial performance driven by increased unit sales versus price increases.
Ron Miller: Alex, as you know, the public markets can have an effect on lower middle market values, albeit somewhat of a delay. What do the valuations in the public markets, how does that reflect on M&A activity and the companies that you're working with?
Alex Eskra: Ron, totally agree. Public market valuations are correlated to private market valuations, but as you noted, there can be a significant lag effect. As for what we're seeing in the public market data, it's been a bit of a mixed bag. We've seen really, really solid returns in the industrial sector over the last two years, about eight plus percent.On the other hand, technology stocks basically broke even during the same period. And hitting on some of the themes that Jim touched on, consumer discretionary stocks took a bit of a beating, losing about 12% over the same period. The strong performance for industrials and the recovery in technology could potentially bode well for valuations of similar company in our space, but really remains to be seen at this point.
Ron Miller: Thanks, Alex. I want to switch to the debt markets. It's been a very interesting last six months. What's going on in the debt markets and what trends have you seen in 2023 going into 2024?
Alex Eskra: Great question, Ron. So this is probably the most optimistic we've been about the debt markets since the Fed started raising rates. So the debt market showed some signs of stabilizing in the second half of 2023. Senior debt multiples were still down about 10% compared to 2022 at about 2.9 times EBITDA. Subordinated debt multiples, on the other hand, remain pretty much unchanged at about 0.7 times, with a modest increase in their use. Buyers are really seeing the benefits of fixed rates and no amortization, which really makes it an attractive product in this type of an environment. Other things to note, the investment-grade debt market began to strengthen in Q4. Average yields for B-rated credits tightened. And the tightening of these spreads and yields indicates that there's a much more competitive market for strong credits. This is re-open, refinancing, and recapitalization availability. Borrowers are taking advantage of those lower rates. The strength of the debt markets is really evident in the public high-yield market, which had near-record issuance in the first quarter of 2024. And combined with near-historic low spreads, this signals a much more receptive lending environment. So I think these things are important to note as we look at 2024 with the debt markets recovery, particularly as it comes to the bank syndication market for recapitalizations. Overall, it's a really positive sign. This improvement is expected to have a trickle down effect into the lower middle market supporting M&A activity and what we hope is the second half of 2024.
Ron Miller: Alex, I think this is one of the most interesting trends right now. The strength up market really bodes well for the middle market M&A volume as we finish 24 and head into 25. So now let's look at the consumer market specifically. Jim, I want to drill down on a couple topics here. I'm not sure this is as optimistic as Alex’s view of the debt markets and maybe the overall M&A markets. What obstacles are you seeing and how are your clients addressing them in the market right now?
Jim Olson: Many consumer product companies continue to face challenges related to the Red Sea, commodity input, price, volatility and uncertainty related to profitability as companies face pressure to moderate price increases or even reduce prices. Demonstrating growth in units and consistent profit margins are key to getting these deals done.
Ron Miller: How do you see the rest of the year playing out in the consumer landscape?
Jim Olson: Consumer deal volume should be up in the first half of 2024 when compared to 2023, but we suspect deal volume will moderate in the second half of the year due to the presidential election. Companies manufacturing in China will face very different operational challenges depending on who wins the election.
Ron Miller: Yeah, that's really interesting. If you're a company that manufactures in China, how do you navigate these uncertain times?
Jim Olson: If you manufacture or source from China, it is important to have a multi-country manufacturing and sourcing capability strategy with an ability to flex production out of China and into the US or countries like Mexico if needed. In the current environment, you must have an established plan with detailed cost assumptions that allows you to flex production in months, not years.
Ron Miller: Wow. So there are some definitely mixed trends. If you're the owner of a consumer products company right now, is it a good time to sell?
Jim Olson: In 2024, we believe the M&A market will continue to support the sellers of top performing consumer companies that have a track record of growth, consistent, sustainable profits and margins. For companies with these credentials, we believe 2024 represents a good opportunity to go to market and benefit from scarcity value and command a premium for A asset characteristics and management teams.
Ron Miller: Very interesting. So, thank you, Alex and Jim, for your insights today. I have a couple takeaways. That the market is definitely navigating through a period of adjustment with transaction volumes and PE activity reflecting a cautious but selective approach. Top assets are commanding strong prices. Valuations are strong. The debt markets are showing signs of recovery that should facilitate better transaction volume in the months that are coming. And the consumer sector, despite facing challenges, is showing signs of optimism and a potential increase in activity, particularly after the election. Alex and Jim, thanks again for your time, and thank you to our listeners for tuning in.
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