Economic fundamentals in place for investors

It's been an amazing couple of years for the mergers and acquisitions market. Despite inflation, rising interest rates, uncertainty over the economy's direction, and an ongoing war in Ukraine, the M&A market has experienced a wave of activity.

In the U.S., states began to shut down in mid-March of 2020 to prevent the spread of Covid-19. At the time, M&A market activity had dropped significantly, according to GlobalData, a U.K.-based data, and analytics firm. The number of announced M&A deals fell from 2,349 in February 2020 to 1,984 in March 2020 globally, whereas the corresponding deal value decreased from $151.2 billion to $129.9 billion.

By the time the world reopened in 2021, the M&A markets were set to explode. In 2021, the total global deal value reached $5.9 trillion as investors flushed with cash entered the market, according to Boston-based Bain & Company, a management consulting firm.

M&A activity slowed down a bit in 2022, with aggregate deal value down by about 20%, according to Bain & Company's Global M&A report released in July. In the first quarter of 2022, deal value totaled $599 billion, a decrease from Q4 2021's $970 billion. In Q2 2022, deal values totaled $702 billion in April and May.

Since February 2022, inflation has risen sharply, and central banks worldwide have raised interest rates, causing the cost of capital to increase. But the fundamentals driving the robust M&A market still exist.

First, capital is generally available for deals. Most businesses still have strong cash flows and balance sheets. Meanwhile, the pockets of private equity investors are as deep as they've ever been. The volatility the markets have seen in the first five months of 2022 will likely continue throughout the year amid continuing inflation, recession fears, supply chain constraints, geopolitical tensions, increasing scrutiny, and Covid-19's unpredictable path, according to Bain & Company.

Trends in the M&A market

Within the M&A market, one trend Bain & Company thinks the industry may see more of is the shift toward “scope and capability” deals. A company seeks access to new markets or other complementary services in a scope deal. Companies attempt to increase their market share in a scale deal in a specific industry. More of these arrangements may take place as C-suite executives work to redefine their businesses as a generational shift occurs, the digital economy grows, and the end of the carbon economy nears.

A longer-term trend is a decline in inter-regional M&A. According to Bain & Company, if countries and economic blocs keep raising barriers, it will continue to change the nature of M&A. If tensions ease, more inter-regional may occur.

Three sectors that David Clark, vice president of ArkMalibu, an Ohio-based M&A advisors firm, says his company has been focused on are the transportation, distribution, and staffing industry. The firm believes that there will be much consolidation in those spaces.

“We believe there's going be plenty of opportunities for us to sell businesses within those three industries,” he told Advisors Magazine.

Clark noted that there are three performance indicators for whether the M&A market will be hot or cold: earnings growth – where buyers are looking to take advantage of higher earnings to sell – the amount of capital buyers have to put to work, and how easy is it to borrow money to go out and make acquisitions. The M&A market currently has all three options going for it.

Perspectives on the M&A market

Clark said that from where he stands, the M&A market has been bullish since the end of 2020. He characterized the market as volatile, especially over the last six months, describing it as going through a healthy reset after the growth seen in 2021.

ArkMalibu, a sell-side-only investment bank, focuses on the transportation, distribution, and staffing industries. Clark anticipates there's room for consolidation in those industries and that there will be plenty of opportunities for ArkMalibu to sell businesses. Most clients are one-time sellers, family-owned, or founder-owned companies.

“What we're seeing as earnings go up is that multiples of those are valuations on those earnings. The good news is that earnings growth is outpacing multiple compression,” Clark told Advisors Magazine.

Multiple compression occurs when a company's earnings increase but its stock price does not move in response. If a company posts flat earnings, the stock price could fall or drop faster than the earnings. As a result, the price-to-earnings ratio is reduced.

“A lot of people are saying, oh, the M&A market is getting worse because multiples are coming down,” Clark added. “Well, but earnings are outpacing that multiple compression, so it's still a good time to sell your stock and get a good valuation.”

Robert Kirkpatrick's take on the M&A market is that it will remain bullish for his sector. Kirkpatrick, the managing partner of Broadside Advisors LLC, the D.C.-based M&A and financial advisory firm founded in 2016, specializes in mechanical, electrical, and facility services.

“It was a strong market up until March and April 2020,” Kirkpatrick said. “These are essential businesses, and whether people are occupying the buildings or not, they must do maintenance work on them.”

There was a five-month period where work slowed down, which made the M&A market a little skittish about what was happening, but by late summer, the market picked back up. Investors were interested in doing deals again, according to Kirkpatrick.

“It didn't come back at discounted valuations. It came back at the same or higher,” Kirkpatrick said.

The sector Kirkpatrick focuses on is particularly enticing for investors, and investment in the facility services market continues to grow, according to Kirkpatrick.

“Investors see a steady business, with steady growth and relatively good margins, depending on specifics. For the longest time, the valuations were at a standard range, but recently they seem to have grown extensively,” said Kirkpatrick.

“It's pretty nice knowing that if I invest in a company that has $3 million in EBITDA this year because of the service model that they do, they probably will have $3 million or more next year,” Kirkpatrick added. “They're not worried about the guys that do big work with general contractors and might be doing $3 million this year, $6 million next, or $100 million the year after that.”

Deborah Smith, Co-Founder, and CEO of The CenterCap Group LLC, thinks too much uncertainty can impact any industry.

“The longer inflation, interest rates, uncertainty, recession, lasts, the more likely it'll have a negative impact on the real estate sector,” Smith told Advisors Magazine.

The CenterCap Group is an East Coast-based investment bank with offices in Connecticut and Florida operating in the real estate sector. Smith leads the firm's Strategic Capital and M&A and Execution efforts.

“On the real estate side, there will be assets that are stressed as opposed to distressed, at least for now. And it'll be very market-specific and properties specific. The more complicated the asset, the more complicated the capital stack, the more likely it will have issues,” Smith said.

On the corporate side, most investors are focused on growth, according to Smith.

“At the corporate level, where people decide to buy and sell an asset is a decision different than how I should grow my business. It's a different decision-making tool. And unless you're relying on debt, which many companies aren't when acquiring another company, the decision is a little bit different.”

As to whether the Fed's efforts to combat inflation are having an impact on the real estate's M&A market, Smith doesn't see it.

“We do not see a slowdown from that perspective. This year is going to be our busiest year, which was only exceeded by last year,” Smith said. “The markets for us are still very active, and that’s whether it's foreign capital coming in or domestics looking to figure out how to grow.”

“What we are seeing is that there is a pricing gap because interest rates have moved, and there's a discrepancy between sellers and buyers, “Smith said. “I think there is a bit of a hold as the market recalibrates.”

M&A markets thy name is resiliency

Looking forward, the experts Advisors Magazine spoke to expect another strong year for deal-making because the economic fundamentals are robust. As Clark noted, there will be plenty of M&A activity in the next six months.

“At the end of the day, even if the number of deals starts coming down. There are still going to be assets that are ready to go to market. Assets that are going to sell for compelling valuation,” Clark said. “There's going to be plenty of deals to go around with the high amounts of capital ready to be put to work from those buyers are leading indicators of why we're confident.”

There will be plenty of M&A opportunities in the next couple of years, even if there is a slowdown due to a recession.

“Capital is at record levels and will be coming up materially over the next 12-18 months as buyers are still hungry for deals, he said. “As the access to lenders becomes more disappointed to the types of investments that they fund and it's more expensive to go out and get that so if it was more expensive to borrow money to acquire companies, that typically indicates that there could be a slowdown in M&A activity.”

Kirkpatrick expects a little rationalization of multiples in the future, but he doesn't expect the market to have a severe contraction in terms of deals getting done. A recession, according to Kirkpatrick, will pull the market back slightly, but the facility services market has been steady for the last 25 years.

“The underlying economics of the business is good, and investors want to put money into those good solid, foundational businesses,” said Kirkpatrick.