Strategic investors take center stage in today’s uncertain M&A environment
Except for a bump in the road during the early months of the pandemic, the M&A environment has been robust for the better part of a decade. Today, at the midpoint of the first quarter of 2023, the M&A environment is a far cry from the frenzy of the past 24-plus months. While signs indicate that inflation is slowing after aggressive rate hikes by the Fed, we find ourselves in an unpredictable and uncertain market that is giving many investors reason to pause.
Sellers, who just a few months ago could count on high exit multiples, are realizing they no longer have the upper hand and their exit options have become limited. Outside of the lower middle market, which until now has been largely unaffected, debt markets remain tight. Investors have started taking a more cautious and risk averse approach as they wait for valuations to come down and interest rates to stabilize. The IPO market is all but stalled.
Many sell-side investment bankers are telling their clients to wait things out if there are no pressing reasons to sell. For those bankers who are taking companies to market, they are now targeting strategics versus private equity – a major shift from what we have seen in recent times.
Going back a decade or so, strategic acquirors had the edge over private equity, tending to pay higher multiples as they factored synergies in their valuations. More importantly, they had the benefit of being patient, long-term investors. This all changed following a flurry of fundraising by private equity. More and more people entered the private equity arena, including family offices and independent sponsors, entrepreneurs and business operators.
Private equity generated solid returns for institutional investors, leading to staggering amounts of dry powder in excess of a trillion dollars. With that came the pressure to deploy capital. Private equity firms turned from pure organic plays and financial reengineering to buy and build strategies. Multiple acquisitions, including small business, were integrated and there was a drive to build value through synergies. Not very different from strategic investors but for one major difference – strategics are largely long-term investors.
Private equity is built for investing and turning over its portfolio. Its playbook includes investment and operating professionals who use technology to streamline the sourcing and execution processes. This puts them at an advantage over strategic investors. In bank-run processes for high quality assets, private equity has been far better positioned to move quickly and help provide certainty of close. Strategics tend to take more time, adopting a more thoughtful process often tied to a larger business plan that doesn’t only include growing by acquisition.
In the market we experienced over the past several years, private equity not only won competitive processes, they also were able to sell and realize returns in a much more compressed time frame. This was due to an abundance of cheap money, high demand for assets, and an emerging trend of recycling assets from one private equity fund to another. The frothy M&A market enabled private equity to invest over a two to three-year period and realize outsized returns. This emboldened them to invest more with far less diligence. Strategic investors, on the other hand, were not only contending with private equity, but were hindered by a buoyant SPAC market. SPACs were offering valuation multiples that made it all but impossible to compete.
It hasn't taken long for market conditions to level the playing field and shift the balance of power back to strategics. Given the cost of debt, coupled with slowing growth rates, private equity firms are generally unable to pay the acquisition prices they did before. They are finding it necessary to shift and reset. This has created a window of opportunity for the strategic buyer who may be willing to pay more, as they view an opportunity in the longer term and are willing to take needed actions to drive synergies and effect economies of scale.
Strategics also tend to have access to more capital in the current market, using their balance sheet and existing lines of credit to close on transactions. Lenders are also more likely to play it safe and lend to strategics who are deep in an industry and understand the market dynamics. As a result, investment bankers are currently favoring them, knowing that they are more likely to drive higher valuations with certainty of close.
The next six months will be especially interesting. Whether the current situation continues is anyone's guess. In the meantime, we should expect strategic investors to shine in a market that is far less competitive.