As the end of 2022 draws near, we want to update our clients and partners on our latest guidance. Overall, the middle market economy remains steady, despite macroeconomic factors and news headlines.
Below we boil it down to four key factors fueling a persistent demand for middle market businesses.
The Middle Market is resilient.
Rising interest rates have had little impact on M&A for transactions valued under $100M. For larger deals, where debt is more of a factor, that’s a different story. Debt financing is harder to come by for those larger deals but is still largely available and relatively stable for smaller transactions.
There are two main reasons that more costly debt hasn’t impacted the middle market. For one, buyers have never been able to put as much debt onto a smaller business like they can for a larger company. Typical guidance puts debt at 2-4x EBITDA.
Secondly, valuations haven’t been historically tied to rates—both as they rise and fall. In the free-money era of the last 10+ years, valuations rose while interest rates stayed flat. Nobody expected zero interest rates to last forever so there was a built in buffer for higher interest rates because there’s always been an expectation that zero was temporary. Of course, that cushion may just be psychological but it helps soften the blow.
Eventually, if rate hikes continue, we might expect a change in valuations. But not at the current moment. In fact, valuations were higher in Q3 2022 than in recent prior quarters, and PE investors demonstrated a willingness to increase the size of their equity checks (as a percentage of total valuation) in order to get deals done.
The looming recession will hit some industries harder than others.
The headlines can be alarming. But generally speaking, many of Caber Hill Advisors’ clients and partners are in industries long considered safer and more recession-resistant than most. Healthcare, in particular, has always been this way.
For example, biannual dentist appointments, the thinking goes, are not a service consumers will cut if they’re tightening family budgets. Similarly, office buildings still need to be cleaned, regardless of economic conditions. Facility services overall are considered necessary – or essential – maintenance services that are not tied to new construction.
One other point on the macroeconomic trends: wages and unemployment hit everyone, but inflation and supply chain challenges don’t impact everyone equally. Some of the strongest examples are the pain felt by companies with any kind of exposure to the COVID-19 disruptions in China or the war in Ukraine. For the American service economy, these events haven’t been as disruptive, and demand remains stable.
PE fundraising levels create a natural buoyancy.
We’ve written about this before and it remains to be true: private equity has money that they have to put to work.
Private equity firms keep raising larger and larger funds from investors who expect a return on that investment. These groups are all chasing the same deals, and the supply of companies that they’re targeting hasn’t changed. And when a PE group makes a deal, typically 33–50% of the purchase price is from equity (the rest is debt).
It’s a combination of factors that add up to a persistent demand for middle market businesses.
Add-ons may represent nearly 3 in 4 deals.
Last year, add-on acquisitions represented about 67.5% of all middle market private equity deals. In 2022, add-ons are expected to reach nearly 73%, continuing a trend over the past decade where add-ons take up a greater share of overall deal volume.
There’s a lot of fragmentation in the lower middle market industries that private equity buyers target. Most of the time, they employ a buy-and-build strategy in these industries, acquiring a larger platform and then growing it via the acquisition of several smaller, add-on acquisitions. Consistent with the notion that once PE firms raise a fund, they have to deploy capital–once they invest in a platform they almost always have to complete several add-on acquisitions in order to achieve their growth goals.
