Aldrich Capital Middle Market M&A Update—Third Quarter 2022

As buyers became more cautious during Q3 2022, Middle-market M&A activity slowed. The third quarter has undoubtedly faced challenges within the financial markets. In September, the United States Federal Reserve raised interest rates for the fifth time this year as inflation continued to run near its highest levels since the 1980s.  

The third interest rate hike of 75 basis points caused more ripples in the stock market. Increased interest rates led to lower economic growth expectations, as companies’ future earnings are discounted at higher rates and decline as a result. As interest rates continue to rise, many buyers may not be in a hurry to complete transactions, preferring to take their time and find the best deals.  

While the macroeconomic backdrop will impact each industry and sector in the middle market, valuations remained strong for the highest-quality companies (growing end markets, strong and durable profit margins, good management teams, and customer diversification). The graph below shows that deal volume was down in Q3 and year-to-date by 4.2% and 36.7%, respectively.  

However, it’s not as bad as it may sound. Remember, 2021 was an outlier and a really good one at that. The combined forces of fiscal and monetary stimulus unleashed a torrent of deal activity for most of 2020 and all of 2021, with certain areas of capital markets doubling from pre-COVID-19 levels.  

A fairer comparison would be to benchmark today’s activity to the three-year period heading into the COVID “bump.” However, even on that basis, Q3 activity is flat to slightly up when compared with the “old” normal of 2017 to 2019, which, at the time, was considered a blistering pace for U.S. dealmaking. 

As discussed last quarter, strategic and private equity buyers remain willing and able to get deals done. Dry powder (cash) for private equity firms remains elevated, compelling these firms to invest. And with valuations remaining relatively unchanged for quality companies in the lower middle market, business owners seeking retirement after two years of disruption and continued uncertainty should continue to find interested parties for the foreseeable future.  

The following chart represents middle-market transaction values for select business categories. Each category will react differently to the macroeconomic backdrop, but ultimately M&A is company–specific. For example, a profitable company growing in an attractive sector will have a much easier time transacting at a higher valuation than lesser–quality companies. 

Showing meaningful performance trends to the market is critical to maximizing value upon a sale. Establishing these trends will take time. For those business owners contemplating a transaction over the next several years, failing to plan early may mean significant value left behind. 

As 2022 comes to a close, if you have any questions regarding the trends specific to your industry or need help preparing for an eventual ownership transition, please reach out to your Aldrich Advisor.