Middle Market Should Look to 2022 With Caution As Headwinds Loom

Capital markets for mid-market companies in 2021 were marked by ever-increasing valuations, which were of course driven in part by abundant access to capital. In short, the past few years have seen a phenomenal time for the middle market to either raise money or exit to a buyer. As 2022 gets underway with a number of economic headwinds looming, the impacts on valuations could be significant. If nothing else, we are seeing the beginning of a far more cautionary environment which could slow down the pace of M&A deal flow for the near future.

Middle Market M&A’s Top Threats in 2022:

A number of issues threaten to undermine the fundamentals of middle market companies in the new year as well as their cost of capital. Namely, we believe the following concerns will create the greatest turbulence in capital markets:

● Supply chain disruptions will continue to hamstring business operations and constrain profitability. Policies such as China’s Zero COVID policy will make localized shutdowns of various regions that are important to manufacturing a recurring trend for the majority of the year. Supply chain issues could also become exacerbated around the world due to increasing disruptions from climate change.

● As the Federal Reserve ramps up its tightening through rate increases and the tapering of asset purchases, the cost of capital for operations as well as acquisitions will sharply increase.

● Adding to the increasing cost of capital in credit markets will be the transition from LIBOR to SOFR rates over the coming years. The transition to this more volatile measure will create more unpredictability in capital costs and add additional strains to capital markets.

● As inflation continues unabated for at least the first half of 2022, the spread between the Consumer Price Index (CPI) and the Producer Price Index (PPI) will continue to widen. This means operational costs will continue to increase with little ability to pass those prices on to customers, leading to margin compression.

What This Means for Middle Market Transactions

● There is still time to take advantage of favorable markets, but the window is shrinking. While it’s clear that 2021 was a far better environment for M&A as well as fundraising, it is still advisable for firms seeking a sale to move quickly to take advantage of a still-relatively stable market before conditions likely deteriorate sharply later in the year.

● A deceleration of economic growth is going to hit valuations hard. Asset markets have had a remarkable run and values are frothy as a result. It is unlikely that 2022’s economy will give businesses an opportunity for their fundamentals to catch up to currently sky-high valuations. We will likely see a collapse in valuations across the board.

● For firms raising capital (for acquisitions or otherwise), raise prior to the transition to SOFR. A number of monetary and fundamental factors outlined above are going to lead to a materially higher borrowing cost that could uniquely impact the middle market this year.

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