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We ushered in 2023 amid a very uncertain economic environment. With high inflation, rising interest rates, and an up-and-down stock market, it’s time for investors to rethink their investment strategies and spend time understanding how the next year or two will shape their returns and investment thesis.
Let’s first look back a couple of years. Government stimulus, a low-interest-rate environment, and a surging stock market created an endless supply of capital on favorable terms to investors. Consequently, 2021 M&A activity reached new highs as we saw a huge volume of transactions (both public and private) involving middle-market and lower-middle-market deals.
Investors, investment bankers, and third-party professionals could barely keep pace with the activity. Throughout the first half of 2022, activity remained robust, despite signals that the market was entering a downturn. The second half of 2022 proved especially challenging as credit markets froze, traditional capital sources took a pause, and many transactions were pushed to the back burner. We experienced a fallout in the once-robust SPAC market as that sector found itself with little or no access to PIPE financing, and sellers hesitant about a public market environment where a significant amount of their proceeds would be tied up in public equities. We expect that the SPAC market will continue to experience significant headwinds in 2023, with many more bankruptcies and winddowns to come.
Valuations are still high and will likely be adjusted downward. However, we are seeing lags in both buyer and seller expectations creating misalignment between the parties. While alternative and private credit in the lower middle market is still available, it comes at a much higher cost as lenders are more careful and diligent with their underwriting processes. This seems to be a common theme throughout the environment – the approach to due diligence is changing.
Reassessing due diligence for 2023
Both the buy-side and the sell-side due diligence process feel different from what we experienced during the height of the pandemic and into 2022, where the processes generally happened in a compressed time, ramping up before clients secured exclusivity. This pushed buyers to rely more heavily on sell-side due diligence findings.
Processes have now slowed. Buyers have returned to a pre-pandemic structure where, unless a process is very competitive, they will not spend significant dollars until they are awarded exclusivity. Also, the diligence process is becoming phased, with business/commercial diligence leading the way, followed by financial, tax, legal, and other work streams.
It used to be that pro forma adjustments, mostly positive for the seller, positioned the business using a 12-month run-rate. Some sell-side processes went so far as to incorporate pro forma adjustments based on future events/transactions that may or may not be contractual. Let’s face it, the latter adjustments belong as “EBITDA other considerations” and should be reflected in the financial projections. Today, these adjustments are being discounted heavily in valuations, with sellers being asked to have more skin in the game through earn-out structures or seller notes.
We are seeing far more scrutiny with synergies adjustments, even in refinancing transactions. Lenders want to see support and, where possible, a trend showing that synergies are being realized. Previously, much of the discussion around synergies was taken at face value.
Very little time is being spent on post-COVID adjustments, with the impacts of closures, government stimulus, etc., now in the rearview mirror. Buyers are focusing on current and future trends.
At the peak of the M&A frenzy, investment bankers – in their rush to bring companies to market – didn’t want sellers to spend the time to have critical baseline financial information available. Now, we’re seeing more sellers hiring accounting advisory professionals, interim CFOs/controllers, and others to clean up the financials and get them close to GAAP. This process allows the sell-side due diligence team to hit the ground running, leading to more efficient processes and creating less stress as buyers, too, ramp up their diligence process. However, it does delay the market launch.
Every dollar counts. Materiality thresholds are lower as power shifts to buyers. Bankers no longer have the leverage to pit multiple parties against one another. Recurring and non-recurring adjustments are being heavily analyzed, with close attention to the nature of the adjustments and year-over-year trends. There is greater understanding that there will always be a level of recurring non-recurring adjustments that should be factored into the analysis.
For many investors, management teams as well as key employees are being integrated into their investment thesis. Background checks that raise questions are another reason to take pause. Buyers, instead of pushing this to post-closing, are now using this to force change as a condition of closing. Until recently, sensitivities and fear of losing a transaction by making management team changes were prevalent. But that was when you had multiple parties vying for the same asset, so open conversations were few and far between.
In conclusion
So, what does this all mean for deal-making in 2023 and the due diligence that goes along with it? It means there is more opportunity for investors to be disciplined and patient. It means investors need to be cognizant of, and find opportunities to take advantage of, the changing market dynamics we are seeing. It’s time for both buyers and sellers to get back to fundamentals. Looking forward to seeing how this will all play out.Subject matter expertise
Claudine Cohen
Managing Principal, Value360 Practice
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This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.