Aldrich Capital Middle Market M&A Update–First Quarter 2023

Middle-market M&A activity started the year subdued as buyers continued to err on the side of caution. Middle market public and private company transaction deal value and volume for Q1 2023 decreased from Q4 of 2022 to continue an ongoing decline. Compared to Q4, values and volume decreased by 20.3% and 9.6%, respectively. Q1 2023 value and volume fell 28.8% and 25.2%, respectively over Q1 2022. During Q1 2023, the M&A environment was still active; however, rising interest rates and economic uncertainty have reduced the supply of deals and hurt overall multiples. Capital availability was still quite high, and the economy maintained its strength, fueling the M&A market even with lower volumes.

There is no getting around the effect of rising interest rates on business valuations. If a buyer pays more to service its debt, there is less available to pay the sellers. The falling public market reduces a buyer’s estimated exit value. Still, we have seen that the lower middle market is somewhat insulated from these forces.

The looming recession and the fatigue of business owners, due in part to supply chain issues and labor shortages, are certainly the most significant factors driving deal flow in the lower middle market. As shown below, lower middle-market multiples across most business categories have remained in line with recent averages.

Corporate strategics with strong balance sheets are competing more broadly with private equity as each continues to focus on quality business acquisition to create value, albeit at a slower, more selective pace than the last 18 months. Still, an encouraging sign for business owners weighing their options in 2023.

While we have certainly seen a slowdown in acquisitions, some sectors continue to garner interest, despite economic headwinds. For example, there is a high level of interest in deals involving commercial services companies such as those providing facilities support, HVAC, cleaning, and environmental services. Elevator maintenance and fire sprinkler companies are just two examples. These businesses possess a captive customer base and are ideal targets for consolidation as investors can establish a platform that consolidates operations across different regions.

Buyers are interested in other non-cyclical sectors, including tech-enabled business services, healthcare, and food services. These companies tend to have consistent demand and generate good cash flow. In the food services space, for example, people will still need to eat lunch even if the S&P is down by thirty percent! Additionally, we are seeing renewed interest in agriculture, aerospace, and defense. Investors are looking for industries with strong cash flow, in niche markets, are more mature, and tend to perform well even under adverse business conditions.

Lastly, as previously mentioned, we still anticipate continued M&A activity at the lower end of the middle market. This is partly fueled by an older generation of business owners eager to exit. Many of the industries mentioned are led by baby boomers now looking to retire, a secular trend that will bring companies to market. Coupled with nearly $4+ trillion in private equity coffers that need to be deployed, 2023 can still turn into a great year for sellers in the middle market.

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.

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.