Winning M&A Strategies During Tough Market Conditions

What was a pessimistic tone broadly in markets entering 2023 transitioned to one of optimism heading into 2024, with higher probabilities cast for a “soft landing.” The general economy, particularly consumers, will eventually face the reality of higher rates as the burden of the increased cost of capital sets in and COVID-era savings are depleted, but for now operating conditions remain robust.

In the financing ecosystem, the consensus seems to be that base rates are going to be higher for longer as macro conditions continue to demonstrate evidence of strength. Further, rates are expected to remain higher than in the last decade even if we enter a stretch of rate cuts. This is important for a few critical reasons. Debt capacity has fundamentally changed for operating companies, higher hurdle rates on investments are likely here to stay, and near-zero rates (ZIRP policies) will no longer be the general engine propelling all market participants.

Coping with Continuously High Rates

At ButcherJoseph, we spend a significant portion of our year focused on debt capital advisory efforts on behalf of our clients. When base rates increase by 5% or more, there is a direct impact to fixed charge coverage levels and ultimate leverage detachment points. However, operating companies across most end markets continue to demonstrate revenue and profitability growth. Issuers with strong fundamentals continue to raise their debt capital needs at competitive terms, albeit at lower leverage levels than before the rate hike cycle. We have seen strong competition from debt capital providers (banks and non-banks) for quality issuers. Over the past year, capital providers have focused on sustainability of earnings and the impact to company fundamentals in various economic conditions. As always, companies with recurring and nondiscretionary aspects to their business are viewed favorably.

As leverage levels have recessed, general partners are faced with prospects of lower returns at status quo valuations.

Financial engineering is critical to private equity returns. As leverage levels have recessed, general partners are faced with prospects of lower returns at status quo valuations. Our sell-side practice has experienced downward valuation pressure in buyers’ reaction to the financing environment, but quality assets continue to command premium valuations, a similar story to the credit markets. Quality assets typically have the earnings growth profile to justify the valuation and satisfy GP return requirements. In comparing our processes in recent months to prior years, we have found there are fewer buyers who recognize an investment thesis or are willing to execute on it.

In the era of near-zero rates, most buyers could justify an investment. Cheap capital was abundant and hurdle rates were low, which revealed itself through record deal activity and valuations. There were multiple buyers (at competitive valuations) for nearly every business. Today, I would argue bankers are value-add again, as dealmaking requires thorough research on buyers and a delicate hand in marketing and execution of sale transactions.

Getting Deals Done Despite the Noise

A large part of our sell-side practice is focused on sale transactions for founder-owned business. Despite the headline news and uncertainty, our founder-owned deal pipeline is robust. Nearly all founder-owned businesses transact for reasons other than market timing. Founders look to realize value and prepare for an ownership transition of their businesses due to life events, typically because they want to enjoy some form of retirement.

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We are at the front end of the baby boomer retirement curve, which will only add to the demand for business buyers in the coming years. Many large sponsors have recognized the opportunity in the lower-to-middle market and have developed strategies to take advantage of it. We expect the trend to continue in the coming years and believe the underlying demographic trends to be a secular tailwind for general deal activity in the middle market.

Another trend we have picked up on is the use of employee ownership as an exit vehicle for sponsor-owned companies. In an environment where there are fewer natural buyers willing to pay premium valuations, sponsors have leveraged employee ownership structures (ESOPs) to realize and lock in a return on their investment. Our sponsor clients have used ESOPs in situations where the sponsor has invested in a quality business that does not have a readily identifiable pool of buyers and for portfolio companies that have management teams who are not particularly excited to interact with another sponsor. ESOPs also provide tax advantages and can alleviate general stakeholder concerns related to a sale event. Certain characteristics of the sponsors’ capital source are required for an employee ownership structure to be an effective exit vehicle.

Though deal activity is down relative to the record years of 2021 and 2022, we are optimistic on the dealmaking environment going forward. Today, debt capital markets for middle-market issuers remain competitive given the strength of underlying fundamentals. And even though there is uncertainty in the longer-term macroeconomic outlook, sponsors will have the opportunity to invest in founder-owned companies as underlying demographics continue to take hold in the coming years.