The State of M&A in a Fragile Market
The State of M&A in a Fragile Market
Stout’s Joe Randolph and Harry Gruits are featured in PitchBook’s Q1 2023 US PE Breakdown Report.
This Q&A was published as part of PitchBook’s Q1 2023 US PE Breakdown sponsored by Stout.
Given broader market tumult, where are your clients looking for the most opportunism?
Joe: With deal activity slowing from 2022, companies with cash availability are well-positioned to take advantage of the reduced competition and more attractive valuations. This sets up well for corporate buyers who have faced fierce competition from private equity firms for quality assets over the last several years.
Corporates generally seem to have entered this recessionary environment with stronger balance sheets than they had in previous down markets. While the leveraged buyout model often utilized by private equity firms faces a hurdle with rising interest rates, we still see private equity firms looking at add-ons, searching for proprietary deals, and exploring take-private opportunities.
Acquisition targets that were strategic yesterday may not be strategic today. Having been in a “seller’s market” over the past two years, we are seeing buyers become much more selective and proactive in seeking out strategic fits to their portfolios.
Given the rates of PE penetration in key markets on both geographic and sector bases, how are add-on strategies evolving?
Joe: Private equity firms are getting much more niche with the sectors in which their investments are focused. When looking at add-ons, there seems to be a greater focus placed on value creation beyond the traditional multiple arbitrage opportunities that most private equity firms seek. This can take various forms, but often targets that can add additional capabilities or technologies to an existing platform have been of interest.
For add-ons, private equity firms have been more willing to look at deals with increased complexity and risk. Additionally, they are searching for proprietary deals where they can often get more attractive valuations. We are even beginning to see earnouts return to the discussion as buyers become more focused on valuations.
The focus on value creation even carries over to due diligence. Due diligence has become more focused on analyzing value creation compared with the traditional approach of solely focusing on risk mitigation.
What are the primary concerns that have cropped up among your clients this year that differ from concerns over the past few years?
Joe: COVID is just starting to fade out of focus. We’ve been spending less time normalizing COVID periods now that we have a good sample size of activity after COVID and the CARES Act for most industries – though we certainly still see lasting effects in some industries and sectors.
There is increased concern about a deepening recession, the rising interest rate environment, continued inflation, and the stability of banks and financial institutions. The concerns from last year also still exist relating to the Russia-Ukraine war and U.S.-China relations.
A new concern that seems to be on the rise is the stability of the labor market and the availability of top talent. Private equity firms and their portfolio companies alike are placing increased focus on attracting and retaining talent. This can often come with increased price tags.
PitchBook analysis has noted that current market conditions are potentially prime for take-privates. What is your perspective on those and similar transactions, such as carveouts, given current market conditions?
Harry: A number of economic factors such as inflation and supply chain disruption have put more pressure on public companies when trying to achieve projected earnings. Taking a company private offers flexibility and can significantly reduce compliance costs associated with being public. Private equity recognizes this, as illustrated by an increase in private equity-backed delistings over the past two years per Reuters.1
Carveout transactions present an interesting opportunity for both buyers and sellers in today’s environment. While strategic sellers seek to divest noncore assets to raise capital or realign their strategic focus, buyers with operational expertise and/or existing back-office capabilities can recognize synergies with the right value creation plan. It’s important to remember carveouts are complex and require more time than a traditional divestiture. Therefore, even if sellers don’t plan to divest assets today, it’s important to start early to prepare companies for carveouts.
What are you and your teams watching most closely from a monetary and regulatory perspective as it pertains to either PE directly, or broader business conditions?
Harry: The Federal Reserve’s decision on further interest rate hikes is critical. While further rate hikes were expected based on their last announcement, the collapse of Silicon Valley Bank and others may pause or lessen future rate hikes. Private equity dealmaking has slowed given the interest rate environment, and it’s difficult to see how future rate hikes will change that.
Consumer spending and consumer credit card debt are other factors worth watching. While many expect spending to flatline in 2023, that has not happened, which could continue to put pressure on the Federal Reserve to raise rates. With spending continuing to increase, the level of consumer credit card debt hit an all-time high in February 2023 at just under $1 trillion. Rising interest rates don’t help this dynamic, and as one would expect, delinquencies have also increased. Eventually this will impact companies as consumer purchasing power and activity decreases. The student loan moratorium is also ending in June this year, which will put additional stress on consumers with student loans regardless of what the Supreme Court decides.
Which risks do you think are still not appropriately priced into dealmaking now, and why?
Harry: First, geopolitical uncertainty. The war in Ukraine just had its one-year anniversary. While many companies have realigned their supply chains and exited Russian markets, the risk of a global conflict can’t be ignored. The U.S.’ relationship with China is also highly strained, particularly as it relates to Taiwan. While these conflicts are no secret to sophisticated companies and dealmakers, the impact of any such conflict on the global supply chain would be significant, especially to companies with significant offshore supply concentration tied to these countries. This was witnessed during the pandemic as governments and economies effectively shut down, causing a ripple effect through the highly entangled global supply chain. Supply chain exposure needs to be thoroughly vetted as part of due diligence when evaluating an acquisition target and priced accordingly, not only to understand the exposure, but also to assess alternative sourcing options.
The second risk is a longer-than-expected recession. Many expect a recession to occur in 2023 and abate by the end of the year. However, it’s important to consider the risk of a prolonged recession continuing into 2024 and how that would impact company performance.
- Patturaja Murugaboopathy and Chibuike Oguh, “Private Equity Firms Pounce To Take Companies Private,” Reuters , July, 21, 2022.