CIBC US Middle Market Investment Banking’s Alex Eskra and Dan Riley, Directors, join Ron Miller to discuss the current state of US middle market M&A. They discuss M&A transaction volume, private equity activity, valuations, and the credit markets. They also discuss current trends within the software and technology sector and Dan shares his observations in the market.
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 speaking with Alex Eskra and Dan Riley, who are both Directors at CIBC. Gentlemen, thanks for joining the podcast.
Alex Eskra: Absolutely, thanks for having us.
Dan Riley: Yeah, thank you.
Ron Miller: Today we're going to talk about the current state of the US middle market. Alex is going to discuss the M&A market broadly, including deal volumes, private equity activity, valuations and the debt markets. And Dan is going to add some of his insights on the software and technology industry. Alex, let's start with transaction volume. Last time we spoke Q2 2023 transaction volume was down compared to 22. Can you tell us how Q3 2023 shook out?
Alex Eskra: Absolutely, Ron. So I think broadly, the market was bracing for a bit of a slower quarter, and third quarter confirmed that trend. Year over year, we saw a 26% decline in deal volume compared to the same period in 2022. And I know we start every podcast talking about volume, but it's not all doom and gloom here. There's a bit of a silver lining at the end of Q3. Deal volumes were up, you know, sort of slightly from the previous quarter, which suggests there may be a potential rebound coming in 2024. You know, strategic buyers, I think, by and large, filled a bit of a gap where private equity firms have been more cautious lately. We'll talk about this a little bit more detail later in the podcast, but there's sort of a trend related to slumping private equity exit activity, which is causing a bit of a backlog of portfolio companies that at some point will need to transact and should provide some good fuel for the M&A market going forward. It's also important to note that while overall volume has decreased year over year, the quality of deals hasn't necessarily followed the same trend. We've seen a number of high quality transactions taking place, particularly in sectors that have shown resilience, especially in the face of economic uncertainty. The usual suspects like health care and software, we've seen a lot of interest, but also areas like home and facility services, tech enabled businesses and then there's also a big push into clean energy. So I think this is really, you know, sort of a testament to the middle market and how deal makers, you know, have been able to adapt and in some cases even thrive in what's otherwise a challenging environment.
Ron Miller: Great. Thanks, Alex. Dan, what's happened in software and technology deal and deal volume over the last quarter?
Dan Riley: Yeah. You know, I'd say in software and technology we've seen a pretty similar pattern where volumes are down about 28.5% year over year, but the sector is still active due to its resilience and sort of continuous innovation driving demand, and even in a downturn, companies in the space that show strong growth potential and scalability continue to attract a lot of interest.
Ron Miller: Great. Let's turn to private equity activity more specifically, Alex, what's happened in the private equity world in the last quarter?
Alex Eskra: As I mentioned, private equity exit activity slowed considerably in Q3, was no exception to that. There was a bit of a, you know, crack in the IPO window in late Q2, which I think for some people offered a glimmer of hope. But unfortunately, a looming government shutdown and the Federal Reserve's hawkish stance on interest rates thrown a wet blanket on investor sentiment. While the traditional LBO market has regained some stability, I think stalled exit activity on the PE front is really, you know, the new focal point and what dealmakers are focusing on. According to PitchBook, exit value was down 41%, you know, from last quarter, which, you know, actually matched the lowest level achieved during the pandemic, which was Q2 2020 when we had all the lockdowns. Q3 essentially reversed all the gains that we made in Q2, essentially a 85% drop from, you know, the height Q2 2021. That being said, I think it's important to keep this in a historical context. You know, Q3 2023 is well above what we saw during the Great Recession, which, you know, was basically a third of the value that was achieved Q3 2023.
Ron Miller: Very interesting. Any insights, Alex, on the implications of this slower exit activity.
Alex Eskra: Exit activity is, you know, really important factor in the PE capital formation cycle. And really, you know, an indicator of industry health. You know, in addition to determining fund performance, it provides cash flows that investors then recycle into new fund investments. So a prolonged imbalance between selling and buying can really disrupt the cycle. And it poses a real problem for the industry. I think, you know, by and large, a lot of this is caused by the contracted debt market. You have less debt you can put. On a business, the less you can pay for it. So a lot of fund operators are reluctant to sell at what they view as reduced prices. So they're going to need to come up with some creative solutions. I would expect that we're going to see a lot more announcements relating to secondary sales or continuation funds in the next year or two of exit activity doesn't pick up.
Ron Miller: Dan, have any of the themes that Alex just highlighted impact the software and the technology sectors?
Dan Riley: I would say the sector overall is somewhat insulated due to its high growth nature. You know, private equity exits may have slowed like in other industries, but there's still strong appetite for tech companies out there, and especially the ones with stronger recurring revenue models and high customer retention rates.
Ron Miller: Great. I think we've just talked about deal volume. I'd like to turn to valuation. So Alex what's happening with valuations. You know over the last quarter recently.
Alex Eskra: Yeah. So valuations have been a bit of a complex story this year through Q3 year to date we've seen sort of EBITDA multiples for private equity backed LBOs around 7.3 times, which is really just kind of a slight decline from what we saw in 2021 and 2022, which was 7.6 times. But there's a couple of factors at play here. You know, I think top of everyone's mind is higher interest rates, which have posed a pretty significant headwind. You know, I mentioned before, the less debt you can put on a business, less you can pay for it. So, you know, that's exerting some downward pressure on valuations. I think the other thing at play here is there's a lot of economic uncertainty, which has made buyers a little bit more cautious and more discerning, which has largely translated into increased scrutiny on these potential acquisitions. Buyers are spending a lot more time with businesses, and we always say time is the enemy of all deals, which can impact our valuation and outcome. A couple of things that I would note here is that it's not all doom and gloom. Current multiples are still above pre-COVID levels, which suggests that, you know, the market is adjusting, but there's still a premium on quality investments. One of the things that we've noted this year is that the market has seen a shift. With more lower quality companies trading. These assets will naturally have lower value at lower quality, but that's been somewhat balanced by the premium that buyers are willing to pay for those higher quality companies, which has kept multiples only slightly lower than what we've seen last year.
Ron Miller: Great. Dan, let's turn to software. Any recent trends going on in software valuations?
Dan Riley: Yeah. You know I think the sector overall continues to command strong valuations, particularly with companies that are demonstrating sustainable growth and who are in more non-cyclical end markets. And this ongoing digital transformation is really supporting that trend, where you see software just becoming more and more a key part of every industry.
Ron Miller: Great. Thanks, Alex. We've talked a lot about the debt markets over the last couple episodes of The monitor. It's been a tougher market over the last year. What's going on with the debt markets now and any trends that have recently emerged?
Alex Eskra: Yeah, I'm happy to shed some more light here. So the average total debt across all deals year to date through 2023 was 3.6 times as a point of perspective, was down from 3.9 times all last year. Interesting thing I'd note here is that the subordinated debt has remained unchanged at about 0.7 times. We've really seen that decrease in the senior debt market, with senior debt multiples being at 2.9 times. You know, just showing that there's a lot more caution in the traditional banking market. I would say that there's, you know, one bright spot in Q3 was that there was a significant rebound in the leveraged loan market, reaching a five quarter high volume of new loans surged by about 30% in Q3, which, you know, definitely exceeded expectations and is signalling to us that there's some renewed investor confidence. This increase was, you know, largely driven by an increase in leveraged buyouts, which accounted for almost 40% of all issuance, which is, you know, a notable increase from the 25% that we observed in the first half of 2023. I'd say one of the biggest concerns over the last year has been that, you know, what we call the debt maturity wall, which, you know, is really just the number of loans that are up for repayment or refinancing, which, you know, a lot of these loans when they were taken out, were significantly lower rates. But in the current rate environment, it poses challenges for refinancing. Interestingly, the immediate maturity wall has been significantly mitigated through amend and extend activity. For listeners, this is where borrowers will offer lenders, you know, a higher interest rate or other covenant concessions to extend the maturity of their loans. In the last time that this was really prevalent was during the Great Recession. But in the context of 2023, this activity has essentially doubled from what we saw in 2022. Overall, I think the market's done a really nice job of pushing out the maturity wall. With about 16 billion in loans due before the end of 2024, which is down from 180 million at the end of 2021. So, you know, a significant change in outlook here. But it's not all roses. The long Terme risk profile has shifted as that maturity wall has been pushed further out. The amount of debt that's due in 2028 and later has increased by about 370 billion. And then also the maturities have become riskier. There's a larger share of lower rated borrowers, which, depending on how the market looks in 2028, could be fine. But, you know, definitely more vulnerable to defaults if economic conditions are worse at that point.
Ron Miller: Interesting. Thanks, Alex. That could prove to make next year pretty interesting. I'd like to turn now to software and technology more broadly. And Dan, I got a couple questions for you on on what you're seeing in the market. So for businesses that you've worked with recently, what is made some of these assets, you know, really stand out in the marketplace?
Dan Riley: Yeah, I'd say there have been a few key factors at play. You know, strong performance, even in a slightly more challenging economic backdrop, would be one, uh, very strong recurring revenue mix would definitely be another. And then you also see private equity firms being very thematic right now and looking at industries with secular tailwinds. And as you might imagine, if you can get if you can get all three of these together, it's really a great combination.
Ron Miller: Great. I'm sure we have some, you know, company owners or, advisors to companies listening. And if you were an owner of a tech company right now, I think we've heard some mixed things about the market. Is now a good time to sell and how should someone prepare or how could we help them prepare for a transaction if it is the right time?
Dan Riley: Yeah. I think what we're seeing right now is that there's a lot of demand out there for deals, but very low supply, particularly in the software and technology space. So we're seeing a lot of interest in a or even less than a assets right now. So I think we can really do a great job of running a process that takes advantage of that right now and really maximises competitive tension to get that best outcome.
Ron Miller: Interesting. I mean, it's a choppy market. What are the obstacles that you're seeing in the marketplace right now?
Dan Riley: Yeah, I think within software, the primary thing we're maybe seeing right now is that it's a little bit harder to pinpoint on valuation for those companies, because you see a lot of the public comparables are still down versus maybe 2021 or early 2022 levels. And there's also a wider dispersion in where M&A deals are maybe getting done from a multiple standpoint. But that kind of plays into our approach, where we always want to be transparent with our clients up front and really set the right expectations on valuation and tell our clients, you know, this is the level where we're highly confident in getting a deal done, and then we go deliver on that.
Ron Miller: Okay, great. Interesting times in all kinds of markets. So Alex and Dan, I'd like to thank you for joining me today. What I've heard, if I can summarise the themes that I think that I've heard both of you talk about, you know, first volumes in 2023 have been down compared to 2022. But there's some positive underlying dynamics which make that trend, you know, probably having been reversed and gives us some optimism for 24. Next valuations are, you know, in some instances not as robust as they were in 2021. But high quality companies given the supply demand imbalance, are really attracting record or near record prices. I think we talked about the debt markets. They remain constructive. You know, leveraged loans are doing quite well right now. Interest rates seem to have maybe turned the corner. You know, the maturity wall, which Alex, you know, talked about in great detail. There's some good mitigants to that. There's some optimism to think that we could get through that. And then lastly, although software deal volume is down, there's still a significant demand for software businesses. And if you tell the story right, there's a wide range of value, but there's a premium value that can also be achieved for the right assets in this market. So Alex and Dan, thanks again for your time and listeners. Thanks for tuning in.
Alex Eskra: Thanks, Ron.
Dan Riley: Thank you.
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