Coming off the heels of the strongest year for M&A in over a decade, Q1 realized a retracement of M&A activity, down close to 20% as compared to Q4 of 2021.   

Many dealmakers started the year with high expectations after a spectacular 2021, although ongoing disruptions to supply chains, volatile commodity markets, increasing inflation, and domino effects from the war in Ukraine led to a tempering of optimism. 

While the first quarter of the year saw some investors closing deals previously negotiated in late-2021, many others held tight as levels of uncertainty grew across global markets.   

But despite a pullback in deal flow, M&A activity still looked strong compared to the five-year trend. This continued flurry of deal activity in the face of apparent headwinds further bolsters the idea for many that, at least for the time being, this remains a “sellers’ market.” 

As geopolitical uncertainty grew, some investors viewed the turbulence as an opportunity to secure more reasonable valuations than the lofty multiples paid in 2021. Additionally, high interest rates played a growing role in dampening M&A activity and valuations throughout the quarter. As anyone shopping for groceries these days knows, inflation continued to rise, with the U.S. CPI posting an 8.5% year-over-year increase as of March 31, 2022, the fastest inflation rate since 1981.   

Okay, so everything is more expensive, but how does this impact your company’s value? Here’s a quick Econ 101 refresher: As the Fed looks to stem the rise of inflation, they have announced their intention to hike interest rates. As interest rates go up, the cost of borrowing will follow suit. This increases discount rates applied by investors to future cash flows of companies.  

As discount rates go up, valuation comes down, all else being equal. That last phrase is important because while all signs point to interest rates rising, pushing valuations downward, the abundance of capital on corporate balance sheets and in PE coffers remains at record levels and continues to grow. The obligation (and often requirement) to put this money to work means investors will continue to seek out and pay up for quality companies.   

Deals continued to average 7.5x EBITDA for middle-market companies, in line with prior quarters. While this average does not apply to every industry, data does point to some industries, including Business Services and Manufacturing that we have noted in the charts below, enjoying even higher multiples. 

The desire to find and attract quality companies with better-than-average growth and margins has investors paying premiums often reaching 30% above average. 

While deal activity continues to trend favorably for sellers, many of the investors we speak with anticipate longer hold periods for their portfolio companies. The volatility in various companies’ performance, including supply chain delays, labor irregularities, chip shortages, increased commodity and transportation costs, and even, conversely, the “COVID-19 bump,” makes these businesses’ valuation a challenge. 

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 we head toward the second half of the year, 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.