The on-going economic challenges have led to decreased deal activity in 2023, as many buyers and sellers are adopting a more cautious approach. Valuation adjustments have become more apparent as companies reassess their financials and risk profiles. There is also a shift in industry focus, with some sectors being more affected than others.
Additionally, increased emphasis on due diligence and risk management has become imperative to manage uncertainties and mitigate potential risks. We are also seeing the deal structures evolving to adapt to the changing economic landscape.
Amidst these changes, a focus on strategic and operational synergies has become crucial for M&A success. In this update, we will delve into these key areas in detail to provide insights into the dynamics of lower-middle-market M&A during a recessionary environment.
Decreased Deal Activity
One of the notable trends in 2023 is a decrease in M&A deal activity. Several factors contribute to this trend, including economic uncertainty, reduced access to capital, and cautiousness among buyers and sellers. Uncertainty about the economic environment, reduced access to capital, and cautiousness among buyers and sellers are leading to a decrease in the volume of transactions. Businesses are hesitant to pursue acquisitions due to concerns about the stability of the economy and their own financial position.
Many businesses are facing challenges in accurately forecasting their future financial performance due to factors such as decreased consumer spending, lower demand for products or services, and general economic volatility. This uncertainty impacts their willingness to engage in M&A transactions as they may be hesitant to make significant strategic decisions, including acquisitions or divestitures, in an uncertain economic environment.
Additionally, access to capital is becoming more limited as lenders and investors become more risk-averse. Banks and financial institutions have tightened their lending criteria, making it harder for businesses to secure financing for M&A transactions. Private equity firms and other investors are becoming more cautious in deploying their capital, leading to reduced availability of funding for lower-middle-market M&A deals. This reduced access to capital has hindered the ability of buyers and sellers to finance and close M&A transactions, leading to a decrease in deal activity.
Furthermore, both buyers and sellers are becoming more cautious in their approach to M&A. Buyers are concerned about the financial health and stability of target companies, and are conducting more thorough due diligence to assess the risks and uncertainties associated with the acquisition. Sellers, on the other hand, are hesitant to sell their businesses at discounted valuations, as they hope for a recovery in the economic conditions to achieve higher prices. This cautiousness on both sides of the transaction have resulted in longer deal timelines, increased negotiations, and a decreased willingness to close transactions, leading to reduced deal activity.
Lastly, on-going recessionary pressure has been negatively impacting the financial performance of businesses. Lower revenues, reduced profitability, and increased financial challenges impact the attractiveness of businesses as M&A targets. Buyers are more cautious about acquiring businesses with weakened financials, and sellers are hesitant to pursue M&A transactions if their financial performance has been adversely affected by the recession.
Valuation Adjustments
Another trend in 2023 is the adjustments seen in target company valuation due to changes in the financial performance, working capital, risk premium, synergy estimates, as well as the decreasing in overall market multiples paid for similar transactions.
On-going recessionary pressure has adversely impacted the earnings and revenue of many companies. Many lower middle market companies today are experiencing reduced sales, lower profitability, or increased costs. As a result, earnings and revenue adjustments are made to reflect the current and expected financial performance, which result in a lower valuation for the target companies.
Another valuation adjustment is due to changes in companies’ working capital requirements, such as increased inventory levels, delayed collections from customers, or stretched payment terms with suppliers. These changes are impacting the target company's liquidity and financial health. As such, working capital adjustments are made to reflect these changes and ensure that the target company's working capital is appropriately valued at the time of the transaction.
Moreover, economic uncertainty, reduced access to capital, and market volatility are increasing the perceived risk associated with the target company, and buyers now require a higher rate of return or discount rate to account for the increased risk. This has resulted in a risk premium adjustment being applied to the valuation of the target company.
Additionally, the expected synergies have also been impacted. Cost savings from synergies may be delayed or not realized due to reduced demand or operational challenges in integrating the two companies, impacting the overall valuation and deal price.
Lastly, most comparable companies or transactions are now trading at lower multiples compared to where they were in 2021 and 2022. It is impacting the valuation of many target companies today as the valuation is often based on market multiples, such as enterprise value-to-EBITDA (EV/EBITDA) multiples.
Shift in Industry Focus
Lower-middle-market M&A activity in 2023 has shifted towards industries that are more resilient or even thriving in the economic downturn. Industries such as healthcare, consumer staples, utilities are often considered defensive or recession-resistant. We are seeing a shift towards these defensive industries, as they are perceived to have more stable cash flows, lower risk, and the potential for continued demand even during economic downturns. M&A transactions in these industries continue to attract investment interest, and valuations may be relatively more stable compared to other sectors.
There is an increased focus on industry consolidation as companies seek to strengthen their positions in the market and achieve cost efficiencies. Strategic buyers are more aggressive in pursuing acquisitions to solidify their market position and gain a competitive advantage, while smaller players are seeking partnerships to survive in a challenging economic environment.
It’s worth noting that technology and innovation-driven industries may continue to receive attention in M&A transactions. Companies in industries such as software, e-commerce, cloud computing, and digital services may be better positioned to adapt to changing market conditions. Strategic buyers or investors may be interested in acquiring technology assets or innovative companies that can provide long-term growth opportunities and enhance their competitive advantage.
Increased Emphasis on Due Diligence and Risk Management
Buyers and sellers today are placing greater emphasis on conducting thorough due diligence and managing risks associated with M&A transactions. We are seeing an increased scrutiny on financials, operations, and market outlook, as parties are seeking to mitigate risks and uncertainties in a more challenging economic environment. As economic conditions become uncertain, investors and acquirers are becoming more cautious and diligent in evaluating the risks associated with potential deals.
Financial due diligence becomes more critical as companies may face financial challenges such as declining revenues, cash flow issues, increased debt levels, and deteriorating financial ratios. Buyers may conduct a thorough review of the target company's financial statements, historical performance, cash flow projections, debt levels, and other financial metrics to assess the financial health of the target and identify any potential risks or red flags. This may involve engaging financial experts to analyze financial data, review accounting practices, and assess the accuracy of financial projections.
Operational due diligence focuses on evaluating the operational aspects of the target company, including its operations, supply chain, manufacturing processes, IT systems, human resources, and other operational functions. During a recession, operational risks may increase, and companies may face challenges such as supply chain disruptions, reduced capacity utilization, labor issues, and cost pressures. Buyers are focused on assessing the target company's operational resilience, ability to adapt to changing market conditions, and potential operational risks that may impact the post-merger integration process.
Market due diligence involves evaluating the target company's market position, competitive landscape, customer base, and growth prospects. During a recession, market dynamics may change rapidly, and companies may face challenges such as declining demand, increased competition, and changing customer preferences. Buyers may conduct a thorough market analysis to assess the target company's market outlook, competitive positioning, customer retention, and growth potential in a recessionary environment. This may involve market research, customer surveys, competitive analysis, and other market intelligence activities.
Legal and regulatory due diligence becomes even more crucial during a recession as companies may face heightened legal and regulatory risks. Buyers may engage legal experts to review the target company's legal and regulatory compliance, contracts, litigation history, intellectual property, and other legal matters. This may also involve assessing the target company's exposure to potential legal and regulatory risks arising from economic challenges, such as bankruptcy filings, labor disputes, contract cancellations, and regulatory changes.
Lastly but not least, risk management becomes a key focus during a recession as companies seek to mitigate potential risks and uncertainties associated with M&A transactions. This may involve identifying, assessing, and mitigating risks related to financial, operational, market, legal, regulatory, and other aspects of the deal. Buyers may implement risk mitigation strategies, such as negotiating favorable deal terms, obtaining representations and warranties insurance, escrow arrangements, earn-outs, and other risk-sharing mechanisms to protect against potential risks.
Changes in Deal Structures
In a challenging economic environment, we are seeing more buyers and sellers negotiating different deal terms, such as earn-outs, contingent payments, or deferred payments, to mitigate risks and uncertainties. Creative deal structures are being used to bridge valuation gaps or manage potential risks associated with the economic downturn. Earn-outs and contingent consideration arrangements are becoming more prevalent in 2023 as a way to bridge valuation gaps and manage uncertainties. Earn-outs are structured as future payments contingent upon the target company achieving certain financial or operational milestones post-closing. This allows buyers to mitigate risks associated with uncertain future performance and align the interests of the buyer and seller. Earn-outs can be used to bridge valuation gaps when buyers are cautious about the target company's future performance.
In a recession, buyers may face challenges in securing financing or may be more cautious about taking on additional debt. As a result, deferred payments and seller financing arrangements are also becoming more common in deal structures. Deferred payments involve spreading out the purchase price over a longer period of time, reducing the upfront cash payment by the buyer. Seller financing involves the seller providing financing to the buyer, either through a loan or equity participation, to help bridge the financing gap. These structures can provide flexibility to both buyers and sellers in managing the financial aspects of the deal.
Many companies today are also considering alternative deal structures such as joint ventures or strategic alliances as a way to share risks and costs while pursuing growth opportunities. Joint ventures and strategic alliances can allow companies to pool resources, share expertise, and access new markets or technologies without the need for a full acquisition. These structures can provide more flexibility and lower financial commitments compared to traditional M&A transactions, making them attractive during uncertain economic conditions.
Focus on Strategic and Operational Synergies
Buyers today are placing more emphasis on achieving strategic and operational synergies from M&A transactions. Cost savings, efficiency improvements, and revenue enhancement opportunities are closely evaluated to drive value creation and offset the impact of economic challenges. For example, companies are more focused on cost reduction and operational efficiencies to weather the economic downturn. M&A transactions may prioritize identifying and capturing cost synergies, such as eliminating duplicate functions, streamlining operations, and reducing overhead expenses. Cost synergies can help improve profitability and strengthen the financial position of the combined entity during challenging economic conditions.
Companies may also focus on revenue synergies as they seek to expand their customer base, enter new markets, or diversify their product or service offerings to drive revenue growth. M&A transactions may prioritize identifying and leveraging cross-selling opportunities, expanding distribution channels, and accessing new customer segments or geographies to generate additional revenue streams. Revenue synergies can help offset declining sales in existing markets and provide new growth avenues during a recession.
Operational integration is another critical area to achieving strategic and operational synergies in M&A transactions. During a recession, companies may need to expedite the integration process to capture synergies quickly and realize cost savings or revenue enhancements. This may involve aligning organizational structures, integrating IT systems, consolidating facilities, and implementing shared services or supply chain optimizations. Operational integration efforts may be accelerated during a recession to capture synergies sooner and generate value more quickly.
Another area of focus is the strategic fit between the buyer and the target company, as companies seek to strengthen their competitive position and adapt to changing market dynamics. M&A transactions may prioritize evaluating the strategic fit between the buyer and the target company in terms of their business models, customer base, product or service offerings, and market positioning. A strong strategic fit can provide synergistic opportunities for the combined entity to achieve competitive advantages and navigate the challenges of a recession.
Furthermore, risk management becomes paramount as companies navigate heightened uncertainties and potential challenges. M&A transactions may place increased emphasis on identifying and mitigating risks associated with the deal, such as financial risks, operational risks, legal and regulatory risks, and market risks. Robust risk management practices may be put in place to assess and manage risks proactively, ensuring that the combined entity is well-positioned to weather the challenges of a recession.
Lastly, monitoring the progress of post-merger integration is crucial to ensure that strategic and operational synergies are being realized. Companies may closely monitor the integration progress to identify any gaps or challenges and take corrective actions promptly. Post-integration monitoring may involve regular reviews of integration plans, key performance indicators, and milestones to ensure that the synergies identified in the deal are being captured effectively.
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