High Prices Raise Stakes for Deal Success

Economic headwinds have done little to dampen the high prices paid for middle-market companies, a fact that has made dealmakers acutely focused on how they’ll create value after a transaction.

Panelists at ACG Chicago’s Midwest Capital Connection on Sept. 28 discussed deal activity and pricing in today’s M&A market and how having the right advisory team and an effective talent strategy can help ensure a transaction’s success.

Cresting Multiples

During a record year for middle-market M&A in 2021, purchase price multiples reached 7.6x in Q3 and Q4, according to GF Data, which tracks deals with $10 million to $500 million of enterprise value, using information reported by 350 private equity firms that subscribe to its database.

Despite headwinds this year in the form of inflation, rising interest rates and Russia’s invasion of Ukraine, multiples have remained high, falling only slightly to 7.5x in Q1 and 7.4x in Q2, said Graeme Frazier, co-founder of GF Data, and Bob Dunn, GF’s managing director, at the conference.

Deal volume, however, dropped significantly in the first half of 2022 among GF’s private equity subscribers. They reported just 55 transactions in Q2 this year, compared with 93 in Q2 2021 and 168 transactions in Q4 last year.

Related content: Highest Multiples Seen in Decades Keep Mid-Market Dealmakers Optimistic

Of the deals that came to market, Dunn and Frazier point to a growing bifurcation between those involving high performers and all other businesses, as the former group makes up a greater share of transactions.

GF generally defines companies with above-average performance as those with both 10% EBITDA margins and 10% revenue growth over the past 12 months. Historically, about 57% of leveraged buyout transactions tracked by GF involve these so-called high performers, but by 2021 that figure was 66%.

The data also reveals a split in valuations, where high-performing businesses garnered an 8x multiple on average while the rest of the companies commanded only a 6.1x multiple.

Based on the data, Dunn suspects that “more companies are choosing to wait on the sidelines,” because of supply chain issues, the impact of the conflict in Ukraine, employment issues or something else. “Any of the myriad problems that we’ve all been struggling with over the last year or so has pushed these companies to either hold off or take a smaller multiple,” he said.

If current conditions persist, multiples will likely decrease and the advantage could shift to buyers, according to Frazier and Dunn. It’s a trend that’s underscored by recent deal terms tracked by GF, which reveal lower indemnification caps for strong businesses and other concessions to buyers.

“It shows this split in the market that’s occurring where the higher quality deals don’t show the cyclical characteristics and other things that are going to change the multiple, because there’s so much capital being put to work right now,” Frazier said. “Those deals are still commanding high multiples. The question is, ‘Will the other deals get done and, if so, at what multiple?’”

Any of the myriad problems that we’ve all been struggling with over the last year or so has pushed these companies to either hold off or take a smaller multiple.

Bob Dunn

GF Data

Building the Advisory Bench

To prepare clients for what to expect in terms of multiples, advisors want to get at an estimated purchase price right away. At the start of a process, “the first thing we do is get all the documents—what we call ‘the shoe box’—so we can analyze the enterprise value at the outset,” said Mike Norton, director at investment bank Houlihan Capital. “The last thing we want is for IOI’s to come in and for them to be way off.”

Speaking on a panel titled Building Your Winning Advisory Team, Norton said his firm will then take the “shoe box” of documents and turn them into presentation materials for clients. Founder-owned middle-market companies are often not well versed in M&A and need to bring in experienced advisors to counsel them through the deal process. “Our role is to be the quarterback for the transaction: we’re with it every step of the way,” Norton said. “Our goal is to prepare the company for the market—to take what they have and turn it into deal speak.”

Peter Spier, partner at law firm Quarles & Brady, cautioned against companies hiring “the guy you know” for legal M&A advice. “Maybe it’s a friend of someone they worked with for 20 years on business formation and other aspects,” but if they don’t specialize in M&A, they’re not a good fit for the job. “Often [these lawyers] just see dollar signs, but the right thing to do would be to tell the client to look for an M&A expert,” Spier said.

Michael Vaccarella, partner at consulting firm Wipfli agreed: “You have to make sure these advisors do M&A a lot of the time rather than dabble in it.”

Moderator Steve Baker, partners at CE2 Partners, asked panelists, “if an owner comes to you about selling a business, what’s the first thing they should do? A lot of the time they don’t know who to call.” Vaccarella replied: “Keep running the business like you have been, don’t run the business like you’re selling.”

Prioritizing People

As acquirers continue to pay high prices for assets, they remain focused on ensuring the deal delivers on its expected returns.

One major risk to deal success is corporate culture and the ability to attract and retain talent—something employers too often get wrong during and after a transaction, according to a panel at the conference.

“I think it’s very easy to focus on the numbers and the clients, and everything else going on, and kind of forget the employees during that process,” said Elaine Hugar, president at DPG Management, which provides human resources and executive recruiting services. “Sometimes you see kind of a storm brewing, because you haven’t paid attention to (employees).”

Panelists emphasized communicating in multiple formats about the vision for the future and where everyone in the organization fits.

“You have to meet people where they are,” said Jennifer Fondrevay, founder and chief humanity officer of consultancy Day1 Ready. “It’s not just one town hall and a memo. You have to go beyond that for people to really understand their role in the vision.”

It’s not just one town hall and a memo. You have to go beyond that for people to really understand their role in the vision.

Jennifer Fondrevay

Day1 Ready

As part of the acquisition process, having a plan for retaining key employees is also critical, said Jennifer Guzman, vice president of experience at EmPower HR, who noted that it’s more difficult and costlier to rehire and retrain for a role than it is to keep a key employee. Rather than wasting time quibbling over reasonable compensation increases, she recommends moving quickly and proactively offering incentives to stay. “It’s going to cost you significantly more money to replace that role if that role walks out the door,” she said. “Don’t cut off your nose to spite your face.”

As buyers determine who to retain or who to let go after an acquisition, it’s important to understand any staffing nuances—such as who is on leave or who is part of a collective bargaining arrangement, for example—to avoid unforeseen repercussions, according to Sean Herring, a principal at law firm Jackson Lewis.

Related content: Post-Transaction Integration: It’s All About the People

There are also legal pitfalls to be aware of. For instance, a company looking to shed high earners must understand that decision is likely to disproportionally affect employees over 40, Herring noted.

When a company does proceed with layoffs, it should be aware of how it treats employees on their way out the door. Using compassion and even offering services like outplacement to help them land their next job can go a long way. Those leaving are less likely to speak negatively of their experience, and current employees will notice.

“When you treat (employees) very well on the way out the door, boy does that pay you back for the employees who are staying. And that word comes back, because you know they’re all talking to each other,” said Hugar. “They understand it, usually, if you do it right.”