The long-term impacts of the COVID-19 pandemic are still being felt across the mergers and acquisitions market as both buyers and sellers look to determine the true value of businesses.
After some businesses saw boosts to both revenues and margins following the need to increase product pricing, those looking to buy companies are left trying to figure out whether those increased revenues will remain sustainable into the future and how much they should pay.
“Buyers are not taking EBITDA at face value as they did historically,” said Ann Hanna, managing director and co-founder of Milwaukee-based Taureau Group LLC. “Buyers are saying, ‘Well wait a minute. When commodity prices come back down, are we going to have to give these price increases back?’”
There are two factors affecting EBITDA, which stands for earnings before interest, taxes, depreciation and amortization. The first factor has been the significant increases in commodity prices that have given some businesses a boost in both revenue and margins. The second is strong post-pandemic demand in 2021 and 2022, which has also caused many companies to experience increased revenue and margins compared to years past.
Hanna said that strategic buyers currently have an advantage over financial buyers, like private equity firms, because they generally pay with cash and aren’t as impacted by rising interest rates. When interest rates were lower, financial buyers had the advantage of being able to pay higher values.
“We still have a lot of money out there. We don’t have fewer financial buyers, but what we do have is a slight suppression on the values that they can pay,” said Hanna.
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2021 and the first half of 2022 were record months for M&A deals, said Robert Jansen, managing director of Milwaukee-based Bridgewood Advisors Inc. Since then, the number of deals being done has shifted back to normal levels as concerns over inflation, interest rates and labor challenges continue.
“With all that said, I tend to be a bit of a contrarian and Bridgewood has had some incredible wins bringing high-quality companies to market while other M&A firms are in a holding pattern,” said Jansen.
He believes demand is still there and valuations for healthy businesses will remain strong. Jansen said for many business owners, it’s still a good time to sell and capture top value.
Despite this outlook, macroeconomic concerns remain at large within the M&A market. Axios Pro Deals Sentiment Report for 2022 surveyed thousands of readers who work in the dealmaking sector to gauge their sentiments on the current M&A landscape. The report found that today’s political and macroeconomic environment continues to be the biggest concern for respondents looking to make a deal in the coming months.
“Readers across the entire deal spectrum universally expect lower valuations on every type of deal,” according to the report.
While Hanna acknowledges these headwinds, she also believes their impact may have been overstated. Demand for M&A deals remains strong, she said.
“I believe the real story is what has happened to EBITDA in this market,” said Hanna, explaining that buyers are questioning the sustainability of higher valuations and could be “discounting” the measure of EBITDA in their determinations of how much money to spend on an acquisition.
Deal structures may look a bit different
Jansen explained in the current M&A environment, buyers are emphasizing diligence and testing scenarios, so it becomes that much more important for companies to demonstrate their sustainability.
To address some of the ongoing discrepancies in the valuation of companies, he predicts firms may look to implement different deal structures. Those deals could include the use of seller paper or earnouts, in which the buyer agrees to make additional payments to the seller based on the future performance of the company.
“I expect we’ll see certain deal structure, such as earnouts, becoming more common to bridge various gaps in valuation, forecast expectations and holes in the capital structure,” said Jansen.
He said financing for deals has become increasingly important given higher interest rates and the availability of debt capital, which may sideline certain private equity firms and position corporate buyers to outmaneuver private equity when competing for acquisitions.
For Milwaukee-based investment banking firm TKO Miller, some of the hardest deals over the past several years have involved businesses that performed especially well, as those companies then had to justify their value to buyers.
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“Those deals can be the hardest to work out if you don’t have a good story or narrative as to how they’re going to be sustainable,” said Nick Kozik, director at the firm.
TKO Miller has had to adjust how it pitches to clients and prioritizes transparency in how it is evaluating businesses.
“It’s very important to set the value expectations and be up front about them,” said Kozik.
Aside from the ongoing dilemma of valuations, he believes it is still a good time to sell a business as there are fewer deals currently on the market. This means that a company that may have fallen closer to the bottom of the pack a year or two ago looks even more attractive today.
“This year has really picked up again quite a bit. I would say for a sub $150 million to $200 million deal, you’re probably looking at a very small discount compared to absolute peak valuations in 2021,” said Kozik.
The sectors that are most attractive to buyers right now include utility and HVAC services, food manufacturing, industrial automation, and veterinary and health care services. Companies in the technology and home construction and remodeling sectors have seen the sharpest decline in interest from buyers. Businesses in the metals space also continue to be popular purchases as well as packaging and medical device companies. Kozik said businesses that operate out of necessity will continue to perform strongly.
“If you want to sell this year, the earlier you can get into the market the better, because you’re getting ahead of any potential downturn. We’re trying to get people who are interested in selling into the market now while there’s sort of a lull,” said Kozik.
He expects more deals to come to market in the second half of the year and that there will be an additional pullback across the board for valuations within the next 12 to 18 months.
However, both Kozik and Hanna believe there is still plenty of demand for businesses and plenty of money available to complete deals. This, coupled with the ongoing trend of Baby Boomers looking to sell their businesses as they retire, means there are many deals to be completed.
“There’s not really an asset class that can get the returns that private equity can get right now, and I think as long as that’s the case and as long as there’s still money chasing private deals, I think those valuations, at least in well-performing sectors, hold up,” said Kozik.