The market for small-to-medium company mergers and acquisitions may be down in 2023, but it’s definitely not out. Although 2023 may not reach the same levels as 2021’s record volume or even 2022’s more subdued activity, we are optimistic about volumes and valuations in the coming year and expect it to be a good year by recent historical standards.
According to Pitchbook, the number of middle-market transactions by private equity firms—which account for the lion’s share of market activity—totaled 1,610 through the first half of 2022, which would project to more than 3,000 deals for the full year, assuming the usual yearend rush to close. By comparison, there were 4,078 deals by PE firms in 2021, easily the most on record and up from an average 2,600 in each of the three previous years. We would expect 2023 volume to come in at around 2018-2020 levels.
Despite all of the challenges facing the financial markets and economy in 2022—falling stock and bond prices, higher inflation, rising interest rates, fears of a recession, continued supply side challenges, the ongoing Russia-Ukraine war—middle market M&A probably outperformed most expectations. Indeed, most of the decline in M&A volume in 2022 was concentrated among the largest deals, while declines in smaller deals were more modest.
And if 2023 activity is only a bit below the prior year’s, it shapes up as a fairly decent year ahead. There are several reasons behind our cautious optimism.
- Interest rates: Most projections call for the Federal Reserve to end its rate-rising program when its fed funds rate target hits 5% to 5.25%. After the Fed raised the rate another 50 basis points on December 14, that put the fed funds rate at 4.25% to 4.50%, meaning that most of the rate-rising process is already behind us. That at least gives businesses some confidence in what to plan for in 2023.
- Inflation: November’s year-on-year increase in the consumer price index fell to 7.1% from 7.7% a month earlier and down sharply from June’s 9.1% peak. If that progress continues, that could persuade the Fed to moderate or even halt its rate hikes, leading to a possible “soft landing” for the economy in the coming year.
- The economy: Despite fears of recession, the U.S. economy remains strong. Recession is not a given. U.S. GDP growth rebounded to an annual rate of 2.9% in the third quarter following two straight quarters of negative growth, the traditional definition of a recession. While that may indicate that the economy is heating up more than the Fed would like, possibly stoking inflation, it may also be moderate enough to ease the Fed’s worries.
- Supply chains: The post-pandemic increase in supply chain bottlenecks, caused by a severe imbalance between pent-up demand and supply and transport shortages, have eased greatly in the past year. We expect that trend to continue in 2023 as China relaxes its draconian Covid restrictions while companies look to on-shore or near-shore their supply lines.
- Washington: With Democrats controlling the Senate and Republicans controlling the House, political gridlock may result, meaning it’s likely that there will be no action on potential capital gains tax increases or regulatory changes that could incumber businesses.
- PE dry powder: This may be the biggest reason for our fairly optimistic outlook. According to widely-quoted estimates, PE firms are sitting on between $2 trillion and $3 trillion of unspent capital, with about a quarter of the total held by middle-market firms. And they are eager to spend it—PE groups typically are required to invest their money in the first 24 to 36 months, regardless of the economic environment. Most of this money has been raised fairly recently, mainly from institutional investors such as pension funds, large endowments, and universities. So there is a lot of “hot” money available for investment.
- Valuations: Valuations have come done slightly, but these have also created more opportunities for acquirers. Well-run companies still command premium prices.
- Competition: Many companies need to invest in themselves to stay competitive, particularly in technology but also in people. That could spur capital raises and acquisitions.
Business owners continuously face the “stay-or-sell” decision. The many uncertainties hanging over the economy in 2023 may make that dilemma more challenging than usual. However, if the decision is to “sell,” we believe well-run companies will be able to find a surfeit of buyers at satisfactory valuations.
Interested in learning more? Please contact John Grady, FOCUS Managing Director, at [email protected]