With current economic conditions like higher interest rates and slowing GDP growth, mergers and acquisitions at the highest levels of corporate finance have seen a slowdown. However, what many may not realize is that one segment of the market — the middle market — continues to see consistent M&A activity.
M&A activity surpassed the two trillion mark in 2021, making it a record breaking year with an increase of 158% in comparison to the preceding year. Middle market companies are defined as those with valuations in the eight and nine figures. Often sold by the founder/owner, on the other side of the transaction might be a competitor looking to expand, a private equity firm, or even an individual investor.
The Middle And Lower Markets Aren’t Seeing the Same Slowdown
Despite the slowdown in large-cap M&A, the activity of the middle market remains healthy. Align Business Advisory Services, a M&A advisory firm for the middle market, believes volatility in the public markets, increasing cost of debt, and large amounts of dry powder are the main drivers of investors coming down market.
It is crucial that investors and funds put this money to work. Smaller businesses are easier to underwrite, as they require less leverage. Additionally, small businesses’ cash flows are more recession resistant. M&A volume will continue to be driven by add-on acquisitions for existing funds’ platforms. Those deals present less risk given the expertise and synergies that exist within the platform company.
Rising rates continue to have a strong impact. Rising rates are constricting the availability of debt financing. Larger transactions not only require more total leverage, but often groups of lenders cooperate to fund a transaction.
In contrast, lower middle market transactions require less total financing and typically only one willing lender. Additionally, buyers can more easily consider increasing the equity to debt ratio of transactions, reserving the option to finance in the future when rates are reduced.
Nimble Entrepreneurial Companies Are Still Growing Fast
The middle market economy tends to be doing better overall with many of those companies continuing to grow. Smaller companies are often more agile because they can adapt to any circumstances rapidly without the need to sort through the layers of bureaucracy confronting large companies.
Small businesses also benefit from the fact that they typically face fewer legal regulations. Larger businesses tend to have additional requirements and more internal processes and policies, which come with time frames, rules, and requirements. These systems can make it impossible to turn on a dime. And in today’s economy, agility is crucial.
“The quest to attain business agility is nothing new for organizations, but the pandemic has meant that the ability to rapidly adapt to market and environmental upheaval in a productive and cost-efficient manner has become business critical,” notes Capgemini in their Business Agility report.
History shows that small and mid market companies in the U.S. have outperformed their larger counterparts through both inflation and rising interest rates. Following periods of economic recession, small-cap companies have generally led the market recovery, outperforming over multiple years.
Certain industries are seeing the most M&A activity as well. For example, as the healthcare industry shifts to value-based care, cost savings and operational synergies reached by consolidating smaller practices become very valuable. Industrial services continue to see demand, as Covid-19 demonstrated the recession-resistant nature of these essential businesses.
Government investments in infrastructure will also provide another area of demand for products and services, propelling growth in this sector as well. Lastly, cybersecurity continues to be a critical need, especially with the growth of remote work. With this growth, interest in this sector is drawing a lot of investor attention.
Investors and entrepreneurs interested in M&A in this market must start by taking inventory of what they have to offer. Consider your funding options and what you know about the company you’re considering before investing. Investors with available funds combined with small businesses that are agile and unencumbered by layers of bureaucracy show promise of continued healthy activity.
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