Aldrich Capital Middle Market M&A Updates—Third Quarter 2023

In Q3 2023, the middle-market M&A landscape witnessed a mix of challenges and opportunities. The quarter started with hopeful signs of recovery in equity and debt underwriting and relative stability following a brief banking crisis. However, as the quarter unfolded, new threats emerged, including the potential for a US government shutdown and less favorable interest-rate prospects from central banks. These developments have instilled a sense of caution among M&A dealmakers.

Q3 2023 brought substantial headwinds to global M&A activity, with a significant dip in deal value. Compared to the previous quarter, global M&A value plummeted by close to 20%, marking the lowest quarterly total in nearly a decade and striking an almost 50% decrease from the peak of two years ago. Despite a minor drop in the number of deals, year-to-date deal value is down by 22.5%.

In response to these challenges, dealmakers have pivoted toward smaller transactions and adopted a more cautious approach to substantial “megadeals.” Private equity’s share of M&A deals contracted to 33%, a decline from its Q4 2021 peak and the second consecutive year of decrease after a decade of expansion. The reduced access to leverage is evident in the significant drop in the debt-to-enterprise value (EV) ratio for US leveraged buyouts in 2023. peak and the second consecutive year of decrease after a decade of expansion. The reduced access to leverage is evident in the significant drop in the debt-to-enterprise value (EV) ratio for US leveraged buyouts in 2023.

Nevertheless, conditions for a future M&A market rebound persist. A substantial reservoir of unspent private-equity dry powder and substantial corporate cash reserves suggest the potential for a recovery in M&A activity.

Revenue and EBITDA valuations have trended down for both large-cap and middle-market companies since their peak in March 2021.  While broad market valuations have followed this trend since January of 2023, middle-market companies have seen EBITDA multiples hang in around 8.0x.  Furthermore, select sectors, such as healthcare and business services, have seen EBITDA multiples expand over that period.

The fluctuation in multiples underscores the delicate balance between market conditions and corporate performance in the ever-evolving landscape of middle-market M&A. Market conditions provide guidance and will impact investors’ thoughts related to valuation; as we have mentioned in the past, however, valuation is distinct to each company. A company experiencing growth and earnings better than peers coupled with a continued path to growth and profitability should command a valuation premium when going to market.

The third quarter of 2023 brought an uptick in middle-market public and private company transaction deal value and volume when compared to the preceding quarter. Volume was up 1.2% from Q2. However, compared to Q3 2022, values saw a substantial decline of nearly 30%, and volume experienced a drop of 21%. Despite the challenges posed by rising interest rates and economic uncertainty, the M&A environment remained active, buoyed by high capital availability and a robust economy, even though deal volumes were somewhat reduced.

Strategic acquirers took the lead in middle market M&A activity in Q3, accounting for over 90% of deal flow, while financial buyers represented less than 10%. This marked the highest quarter for strategic activity and the lowest for financial activity over the past five quarters.

In Q3 2023, middle-market M&A sector trends closely resembled those of the same period in 2022, with information technology exhibiting significant growth. Healthcare emerged as the leading sector, followed by information technology and industrials, while consumer discretionary deals declined. Over the past year, external factors have continued to drive trends. These factors include interest rates, global economic conditions, political challenges, and COVID-induced supply chain disruptions, just to name a few.

Despite the challenges, signs of recovery are emerging. Forward indicators, such as investment banking backlog comparisons, displayed positivity in Q2, with some setbacks in Q3. Private equity firms have reported a reduction in bid-ask spreads, indicating the potential for increased deal volumes.

Many analysts conclude that the current period of weak M&A activity is poised to transform into an eventual recovery. The initially anticipated recovery in Q4 2023 has been postponed to Q1 2024 due to recent developments. However, many analysts remain optimistic that the tide will turn, suggesting the potential for a market rebound.

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 leaving significant value 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.