During Q3 2022, deal activity for US middle-market companies stopped going down and stabilized well above pre- COVID-19 pandemic levels, but half of peak levels reached in Q4 2021.
With ample dry powder on hand, PE firms are well-equipped to continue to seek out deals in a market that has become cheaper by the quarter thanks to falling prices and lower public valuations.
More details can be found in Pitchbook’s Q3 2022 US PE Middle Market Report, sponsored by Antares Capital and LBMC.
Lisa Nix: In this current environment, pressure on valuations is real with sellers proposing more run-rate and pro forma adjustments that make up a significant portion of adjusted earnings. As a result, more of the financial due diligence effort is being focused on pro forma earnings utilizing historical trending to inform forecasts and run-rate revenue and expense adjustments. To mitigate or address the potential valuation gap, buy-side clients are requesting increased assistance with not only stress testing seller pro forma adjustments, but surprisingly with performing analysis and scenario modeling on their own synergy and forecast adjustments, which are integral to their investment decision. Since the 2021 deal frenzy, clients have become more selective and more disciplined earlier in the deal process, requesting additional buy-side due diligence assistance in the pre-Letter of Intent (LOI) or pre-exclusivity phase of a transaction. With the economic uncertainties weighing on deal valuations and the continuance of compressed deal timelines, it is important now more than ever for a buyer to utilize external advisor(s) to assist in their evaluation of a seller.
LN: From a buy-side perspective, one of the most underrated and often underestimated concerns is the cost and effort that will be required for financial transformation with some middle- market selling companies. The lack of investment in financial systems, controls, data analytics and processes is common in the middle market and becomes an operational challenge early after the deal closing. Timely and accurate financial reporting, albeit critically important, goes much beyond a company producing financial statements in accordance with US GAAP. The development of a scalable, cloud-based data architecture— if one does not exist—that lays the groundwork for comprehensive financial and operational reporting and analysis,
becomes necessary for a buyer to deploy successful integration strategies and realize pre-closing deal synergies. Continuing to assimilate and integrate new or disparate data sources as the company evolves, developing data driven reporting to support real-time financial and operational decision-making, and extending capabilities for future acquisitions will also become business-critical priorities. Clients are requesting data analytics and analyses employed during the due-diligence process to extend post-close as they develop and build out these capabilities internally. Conversely, sellers are typically not highlighting deficiencies in their financial systems, and the burden rests with buyers to make this assessment during the diligence process.
John Mark McDougal: Everyone is stretching right now, with a compressed labor market and supply chain woes, to find new ways to solve old problems. Most of the problems themselves have not changed that much, only the severity of their near-term impact, particularly in cases such as the labor market and supply chain. Having “blue ribbon” technology, reporting, and processes in these crunch times where significant decisions are needed quickly increases an organization’s probability of success. Companies should focus on maximizing areas of strength to address both expected and unexpected challenges.
JMM: This question has a lot of differentiation based on industries and even geographies, but a few things are clear— all eyes are on interest rates, adjusted inflation numbers, and jobs reports. In speaking with clients the last few months, our business-to-consumer clients are monitoring order levels and discretionary spending very closely. The consumer is spending based on a variety of factors, one of them being their personal outlook based on the news they see. While earnings have been holding up in many sectors, continual economic headwinds eventually make people want to halt some spending, or at least defer it, and that’s when you’ll see the “pullback.” The auto industry continues to be plagued by supply chain disruption as well as labor issues. Last, but not least, healthcare is what you would expect—a continued stable force in uncertain times.
Brad Bonde: Given the recent substantial shift in interest rates and potential for a recession on the horizon, many PE groups have narrowed their assumptions as part of underwriting and projections, the exception being premium assets with proven management teams and high cash flows that still command strong valuations. The second tier of assets, which have managed costs and grown revenues but have some volatility in their earnings profile, is experiencing more negotiation throughout diligence. Investors are taking a longer look at potential complications to ensure they have sufficient risk mitigation structures in place. Valuations have stabilized or decreased in many sectors, and investors are attempting to factor in continued talent challenges and inflationary risks in their assessment of investments.
We are not seeing investors frequently stretch or be willing to pay for synergy and optimization for companies with significant levels of addbacks and pro-forma growth projections in their value proposition. We have observed more clients trying to bridge financial results between what was reflected during quality of earnings and the results that are being identified subsequent to closing. This is primarily driven in situations where investors may have stretched in their valuations during the breakneck pace of the past two years.
BB: When everyone has capital to put to work, other factors may come into play in a seller’s decision-making process. When investors are reluctant to pay a premium that just a short time ago would have been attained, sellers may be more willing to roll equity to participate in additional upside or hope to capture additional return in an improved economic market while still taking some chips off the table. Sellers may also consider feedback that bankers and peers may offer in relation to their experiences during diligence while making a decision. Investors that may have a reputation for lengthy and onerous diligence and propose significant changes to LOIs may be at a disadvantage.
Investors should plan to budget more growth funding into their acquisitions shortly after closing. These short-term nonrecurring costs may help drive returns to offset higher costs of capital.
In addition, when operating in an environment with economic uncertainty, key differentiators in driving returns include the ability to optimize processes and accelerate the time it takes to generate financial insights. When companies have immature financial teams, processes, and systems, higher emphasis on the post-closing steps throughout diligence becomes more important to a successful acquisition. These steps are necessary to consider when holding periods may extend longer than originally anticipated in the current market.
