Navigating Middle Market M&A in a High-Rate and Inflationary Environment

Navigating Middle Market M&A in a High-Rate and Inflationary Environment
Topics Succession Planning

Despite the highest inflation rates seen in 40 years, central banks’ efforts to temper inflation by raising interest rates, the ongoing Ukraine conflict, bearish conditions in the public markets, and the lingering supply chain issue created by pandemic uncertainty and response, it is likely that 2022 will see a lot of middle market merger and acquisition activity.

Buying Options

A business owner may expect the latest uncertainty to temper prices offered for the sale of their business relative to 2021. Prospective buyers may now offer lower prices, or they may offer alternative payment structures that extend the time where a business owner continues to share in the risk of business ownership after the conclusion of a transaction. These time periods are frequently called earn-outs and necessitate that a seller perform reverse due diligence on any prospective buyer. For the life of any earn-out period, the seller’s and buyer’s financial fates are intertwined.

One of the reasons that prospective buyers may not be able to offer the same prices in 2022 as they did in 2021 is the cost of debt. Just like a home buyer, business buyers are sensitive to interest rates. When rates rise, buyers may not be able to afford as much debt as they could when interest rates were lower.

Unlike a home buyer, business buyers can also turn to alternative forms of financing, like private debt. Private debt is more flexible than bank lending, but it is also more expensive to compensate the private lender for their added risk. If the business buyer is a financial sponsor like a private equity fund, the added expense of private debt is likely to place downward pressure on private equity limited partners’ (investors) returns and general partners’ (fund managers) compensation – neither outcome is desirable from the fund manager’s perspective.

Competition in the Market

The competition among buyers chasing a limited supply of high-quality companies in the market remains fierce.

Many strategic buyers have strong balance sheets and have amassed large cash reserves. In an inflationary environment the buying power of cash reserves is being eroded when not put to productive use.

Financial buyers have amassed unprecedented capital reserves in recent years from their investors. Private equity fund managers are obliged and incentivized through fee structures to deploy those dollars by their investors. Capital reserves, or dry powder, creates opportunity as well as pressure. Investors expect, and in most cases mandate, that their investment will be committed in a timely manner. The invested capital cannot remain on the sidelines if the private equity fund wants to be fully compensated or raise their next fund. This cumulative pressure to find deals is advantageous for the business owner seeking a buyer for their company.

Business Options

Taking current dynamics into account, a business owner who is contemplating selling their business now, or soon, should focus on optimizing their internal processes, governance and financial performance. A variety of factors affect a company’s market value, including growth rates, industry dynamics, and size of the company, among others. It is important to align one’s business with these value drivers. The most critical value driver is growth—growth in revenue, growth in cash flows and profitability. Business owners need to develop strategies to grow their businesses to position for maximum shareholder value and sale value.

No matter the economic environment, the optimal time to exit is when a firm is enjoying a period of quarter over quarter and year over year growth. If an owner can demonstrate a history of growth and position sustainable growth over time, he or she can demand a high company valuation and favorable deal terms in almost any economic scenario.

Don’t Try to Go it Alone

Planning to sell a business is just what it sounds like—a process that takes time, effort and expert advice. Positioning a business for sale, negotiating deal terms, and preparing oneself financially for a sale are steps that are unique to the process of ownership transition.

Opportunistic business buyers shrewdly target business owners who have not built a team who can proficiently advise them through a sale process. Lack of preparation on the part of the business seller creates opportunities for buyers to negotiate terms that favor the buyer to the detriment of the seller.

At a minimum, a business seller should be working with an attorney experienced with mergers and acquisitions, a CPA with valuation expertise, multidisciplinary financial advisors who can advise on the personal financial impact of various types of sale outcomes, and an investment banker or business broker who can negotiate deal terms.

Business owners should never enter negotiations that may lead to the sale of their business prior to significant business planning and personal financial preparation. They must also equip themselves with a team who can advise on every step of the sale process if they wish to achieve the best possible financial outcome.

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