Where Do We Go From Here?

Apr 16, 2023

Hi there. Welcome to the latest edition of The Lower Middle Market. We’re the only news source tracking lower middle market M&A. Our goal is to keep you up to date on what’s happening in the market by highlighting the latest news, transactions, and activity in less than 5 minutes.

Happy Sunday! We’re writing this on a lazy Sunday or at least lazier than last Sunday’s combo Easter celebration/Master’s final. Speaking of which, if you didn’t have a chance to read through this thread on Augusta National, you should. It’s fascinating:

https://twitter.com/JoePompliano/status/1644365793293918208?s=20

Moving on, here’s what we have for you today:

LMM market update
QoE dragging deals down
Insights on the recent Code Advisors acquisition by The Raine Group

Market Update

Over the last year and some change, the M&A market has been in flux. 2022 marked a shift from mega deals to smaller deals. As the cost of capital shot through the roof, many investors experienced a flight to safety. Add-on acquisitions became a focus. Raising funds focused on smaller companies became a logical next step. The recent regional bank scare sent shockwaves throughout financial markets. And the case for an extended recession looks to be back on the table as investors and lenders proceed with caution.

So where do we go from here? Let’s take a look at some recent market commentary and thought leadership from top M&A professionals in the market:

Sell-side m&a advisory firm, Northern Edge Advisors predicts a gradual recovery in 2023 as excess liquidity drives acquisition growth. Key themes from their insights include:

Borrowing is considerably more expensive due to higher interest rates, with tightening expected to ease by mid-2023
Private equity firms are sitting on unprecedented dry powder, which they will seek to use on attractive opportunities
The difficult operating environment will drive an increase in companies jettisoning non-core assets
Some deals will be voluntary while other companies will be forced to sell assets, creating opportunities for buyers to expand product lines, services, or supply chains at a reduced rate
Buyers increasingly focus on smaller, more affordable deals, versus large-scale acquisitions, due to economic uncertainty

M&A Firm, Generational Equity, expects lower middle market deals to thrive, against the backdrop of a rough market for larger middle market deals.

Emily Rouleau of Bloomberg has a slightly different take and thinks all areas in the M&A market will take longer to bounce back due to economic uncertainties. Of note, small deals (EV < $100mm) recently experienced their worst quarter (by deal volume) in at least five years.

John Ferrara, Founder of Capstone Partners, sees the second half of the year and into 2024 as providing breathing room in capital markets. He sees a robust level of pent-up demand waiting to hit the market and creating a healthy pipeline of M&A transaction activity.

Whenever attempting to project the future we’re always reminded of the famous Buffett quote “forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” With that being said, at minimum, it’s useful to understand what the consensus thinking is along with potential base case scenarios.

QoE Dragging Deals Down

In the current high-cost-of-capital environment, due diligence takes an even higher priority for buyers in examining targets. We came across this article by Mark Borkowski of Mercantile Mergers & Acquisitions on the subject of Quality of Earnings. In recent years, Quality of Earnings (QoE) reports have increasingly played a pivotal role during the due diligence process. Traditionally, buyers have paid for QoE reports, but more and more sellers are paying for the reports to be prepared before a Letter of Intent has been signed. This seems like a healthy and important trend for targets in a) avoiding a potential deal killer and b) helping the seller better understand potential red flags before going to market. As a result, targets should be prepared, with financials and operations ready to face greater scrutiny.

On the topic of due diligence, here’s a recent buy-side perspective on the cost of QoE for lower middle market deals: