CIBC US Middle Market Investment Banking’s Alex Eskra, 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 industrial sector and when 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 at CIBC. Good morning, Alex. Welcome to the podcast. Alex works across several of our vertical markets and can speak pretty broadly about the current M&A and financing markets. Alex, how are you today?
Alex Eskra: Great. Thanks for having me on again.
Ron Miller: Today we're going to talk about the current state of the US Middle Market M&A. We're going to look at M&A transaction volumes focusing particularly on private equity activity, general valuations and then the credit markets. Alex, let's start with transaction volume. Last time we spoke, 2022 transaction volume was down compared with what we saw in 2021. Can you tell us how Q1 2023 is looking to shake out? Has the downward trend reversed itself?
Alex Eskra: So there's actually a bit of a nuanced answer to that question. So Q1 2023 volume was down 33% year over year. However, compared to the last two quarters of 2022, Q1 2023 was up 16%. So on an annual basis, the answer is no. But on a quarterly basis it looks like we may have bottomed out a few months ago. Talking to our colleagues across CIBC, we expect deal activity to continue to increase in the second half of 2023 and this is largely due to interest rate hikes stabilizing. And you know, the fear of a hard landing, it may have subsided. Although M&A volume definitely varies, there's a lot of strong underlying drivers in the market, for example, strategic and financial buyers, they have significant amounts of resources to deploy. I think it was something like $4 trillion was sitting on strategic buyer balance sheets and financial buyers continue to have record amounts of dry powder. There's also a growing backlog of portfolio companies and private equity firms that will need to transact in order to return capital to LPs. So I guess the punch line is even with higher interest rates, there's definitely some market forces that will likely keep M&A volume reasonably strong.
Ron Miller: Now that's a great summary and I would agree. Are there other trends in the deals that are getting done that our listeners should think about?
Alex Eskra: Definitely. So buyers are generally taking more time to do due diligence to get deals done. You know, we're not in 2021 anymore where people are racing to close transactions with a lower deal count and some level of economic uncertainty. Buyer due diligence is as thorough as ever. We're definitely spending more time prepping our companies, whether it's environmental data analysis, tax due diligence, you know, you name it. We're spending more time prepping these companies on the front end, hopefully hoping to lead to a faster due diligence on the back end.
Ron Miller: Great. Let's turn our attention to the private equity activity. What should we tell our listeners about the current state of the private equity market?
Alex Eskra: Great, great question, Ron. So private equity isn't the whole market, but it's a good proxy for the broader M&A market, given the nature of how these firms operate. They're in the business of buying and selling companies. You know, ultimately private equity firms continue to look for ways to get deals done. Addons are making up an increasingly greater portion of LBOs. Now, looking back to 2015, about 60% of leveraged buyouts were addons and Q1 2023, that number has increased to 80%. Carveouts have also made a resurgence. You know, in a tougher economy, corporations are continually focusing on their strengths and evaluating unprofitable business lines. So LBOs are definitely getting done, but they often require more equity within their capital structure to close. In Q1 2023, the average transaction was 54% equity within the capital structure, which is up from 47% in 2019. All that increase in equity is simply a result of lower senior debt level supporting transactions.
Ron Miller: Let's look at valuations. What happened to valuations in the first quarter of 2023?
Alex Eskra: This is pretty interesting. So despite a pullback in the credit markets, we really didn't see, you know, publicly disclosed valuation data decline. Looking at GF data valuations for LBOs under 250 million, we're at eight times in Q1 2023, which rebounded from 6.9 times in Q4 of last year. So there's a couple of things happening here. There appears to be a little bit of a disconnect between sellers and buyers in terms of agreeing on valuation. So really only the highest quality companies are actually transacting. The other element too with the increase in addon acquisitions, these are often done with cash or with existing lines of credit. However, we do expect that as the credit market continues to be tight, this will be reflected in valuation data as the year progresses. You really have to drill down to the specific company or specific industry. So certain companies in end markets continue to attract strong buyer interest and support equally as strong valuations. So, you know, for example, non-cyclical end markets continue to garner interest, whether that's, you know, businesses that operate within healthcare services, tech enabled business services and even some specialty manufacturing. You know, as an example, our industrial team is really busy right now and there's a couple of trends that are helping to drive interest in the sector right now, including reshoring trends, continued infrastructure spending, and then really just the changing energy infrastructure, just to name a few. On the other hand, there are certain end markets that have lost their lustre. We talked about this on the last podcast, but consumer deals continue to be a little bit more difficult as well as some technology deals. As far as consumer buyers are worried about core demand with consumer companies, I think it sort of remains to be seen whether the impact of inflation and higher interest rates have, you know, ultimately entrenched themselves in the mind of the consumer. And as far as technology deals, most people listening to this will be familiar with the collapse of Silicon Valley Bank and the banking sector turmoil that followed, which ultimately reduced credit for technology deals and valuations for tech deals have definitely been impacted by that. You know, I've talked about this a little bit earlier, but, you know, high quality companies that are transacting, there continues to be strong demand for these assets. We track a so-called quality premium through GF data, which this premium reached 44% compared to average quality companies, which is probably one of the highest levels that we've seen. For context, in 2019, this quality premium is only at 21%, saying in another way, high quality companies traded for 9.2 times EBITDA in the first quarter, compared to 6.2 times EBITDA for average companies or 44% higher, which is a meaningful difference in valuation. There's definitely been more focus on the sustainability as well as any sort of EBITDA addbacks or adjustments. But if you can prove these attributes, the market will definitely pay a premium. The other thing I'll note here is that larger companies continue to trade at a premium as well. So companies that are above 100 million in enterprise value traded at ten and a half times EBITDA, which compared to companies under that 100 million in enterprise value were trading at something right around seven times. So almost a three and a half times difference, which is probably the largest gap we've seen in the last several years.
Ron Miller: Yeah, I think that's well said and really interesting. We've had a couple deals. We just got pre-empted on a transaction. They're going to close in 30 days, but it's a super quality company and we have other companies. We're getting through it, but it's taking 3 to 4 months in due diligence as this heightened due diligence is really impacting the market.
Alex Eskra: Yeah, definitely. I mean, we're on the opposite end of that spectrum where a buyer is really taking their time to understand the business and evaluate, you know, any sort of adjustments and do a thorough due diligence.
Ron Miller: So you talked about the debt market. Let's turn to leverage in the debt market. We previously talked about the Fed's fight against inflation and the impact on the cost of debt. What's happened to the debt markets in the first quarter of 2023 and into the current second quarter?
Alex Eskra: Yeah, absolutely. So, you know, cost of debt more than doubled year over year from Q1 of 2023 to Q1 of 2022. And 2021, I think it's worth noting that the cost of debt was under 5%. In Q1 2023, you know, buyers are paying more than 10%. You know, I think given sort of the current path of the Fed, you know, interest rates hikes, I don't think are off the table. But there's definitely a slowing or stopping that's occurring. You know, I think in terms of the total cost of debt, we'll expect this to, you know, ultimately decline. But it's going to be a while before we see debt, you know, less than 5%. You know, this is ultimately impacted available leverage. You know, Robert W Baird noted that total leverage was down a turn, a turn and a half. And lenders, you know, they're returning to the market, but their hold sizes are definitely smaller and they're focused more on their core customers. You know, a couple of years ago, a lender might be perfectly happy being, you know, sort of the third member of a syndicate and those days are over. You're going to focus more on your core customers.
Ron Miller: We also talked a little bit about industrials. And I know in our quarterly Market Monitor, we wrote specifically about industrial deal volume. What's driving this increase in industrial activity?
Alex Eskra: Well, I think the lending markets have something to do with it. You know, there's a lot of industrial companies out there that have large asset bases and they're simply easier to lend on. I think, you know, there's also a number of industrial companies that we've seen that have done a great job of capitalizing on macroeconomic trends. I know we touched on these earlier, but, you know, reshoring the construction industry and really just a changing energy infrastructure for those businesses that have capitalized on it. They're really attractive assets to buyers. You know, we're also witnessing sort of a flight to quality with a number of these companies. So certain companies have focused more on automation to increase capacity and improve their margins. They have strong engineering talent and had done a nice job of bringing up the younger generation of engineers. One of the themes that we're seeing more and more frequently is how these companies are focusing on their customers. You know, oftentimes these customers are only going to focus on a subset of potential customers that they can generate decent margins off of. They're actually firing customers where they're not generating decent margins on. The other factor and you'll find this all too often is a focus for buyers. But what is your leadership team look like? Do you have people with industry experience who are competent that can run the business and have a well formulated growth strategy? And then finally, you know, financial performance. You know, we talked about understanding sustainability of a company on a go forward basis. When we look at certain levels of economic uncertainty and those companies that have a proven track record of financial performance are fetching strong valuations.
Ron Miller: Very thoughtful. As you talk to sellers over the next couple of months, what advice would you give them?
Alex Eskra: So, you know, the M&A market is still active. It's not as active as maybe 2021. But, you know, we're definitely seeing continued interest in great businesses. I think ultimately timing should be more driven by the company specific situation. Do they have a strong backlog? Do they have, you know, good sales momentum? Are they capitalizing on those industry trends that we talked about? We're doing a lot of work, as I mentioned, to prepare for these sales assignments, whether that's getting a good quality of earnings report in place, doing market study, legal reviews. We've even seen, you know, more specific company videos and things like that to properly position a business. Ultimately, you can't be too prepared. I think if the timing is right for an individual organization, you do that preparation up front, you can have a really successful transaction.
Ron Miller: Thanks, Alex. From what I've heard and what you've said, I think I have the following takeaways. Volume in 2023 has been down compared to 2022, but the quarterly trends have been positive for a couple of quarters and the underlying dynamics should result in the rest of 2023 being a pretty good year for M&A. The average cost of debt year over year has doubled from 5% to about 10%, and lenders are more cautious on platform investments. That's not preventing M&A, but it's definitely a factor that the market has to account for. And industrials have been a bright spot due to their asset bases. The positive macroeconomic trends and the just general reinventing of US manufacturing.
Alex Eskra: I agree, Ron. It'll be really interesting to see how Q2 shakes out along with the rest of the year.
Ron Miller: Alex, thanks again for your time today. And listeners, thanks for tuning in.
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