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What Happens to Lower-Middle-Market M&A During a Recession?

1/29/19 – Keith Carlson

I’ve been asked these questions a lot lately: What happens to the mergers and acquisitions (M&A) market if a recession starts? What happens to purchase price multiples during a recession? If we do enter a slowdown, should I hold off on selling my business?

It seems that the majority of people generally accept the notion that we may enter a slowdown in the next 2-3 years.  So it is only natural that I am receiving these types of questions. As an advisor, it is tough to answer this particular question succinctly, or with certainty, as sound advisors use history and facts to equip ourselves with the best fact-fueled answers for our clients or prospects. The problem is that no two recessions are the same, and the last recession had such dreadful impacts that people may naturally feel terrified by the sheer notion of a new slowdown or recession. That being said, there are some generalities to consider in determining how this cycle could affect the deal-making community and M&A markets. This article will briefly unpack a few of those major influencers. Spoiler alert: If you lower-middle-market business owner and are thinking of selling your business, you should not necessarily ‘run for the hills’ at the threat of an economic contraction. 

Generally speaking, the variables that drive lower-middle-market M&A include: a) lending capacity and appetite, b) cost of capital, c) buyer’s access to equity capital (cash), and d) supply and demand for deals. Let’s take a look at these factors in the context of the current economy, as well as in the context of where many speculate we are heading.

Lending capacity: Unlike the last downturn, any potential slowdown we may be approaching would most likely not be led or ignited by the financial institution community. The last recession brutalized financial institutions so terribly that capital for anyone, let alone buyers, was extremely scarce. For this reason, if we are heading toward a slowdown or recession, it is unlikely that it will greatly impact lending capacity. Any slowdown will undoubtedly affect lending capacity to some extent, but only through banks’ natural tendency to adopt a conservative view during underwriting. This just means they may anticipate earnings softness, which would affect the overall appetite for lending. How does all of this impact M&A? Generally speaking, the less money a would-be buyer can borrow to purchase a business, the less the buyer is willing to actually pay to purchase the business.

Cost of capital: If you have been following the Federal Reserve’s changes to rates, you will know that it has been gradually raising interest rates over the last year (in four straight quarters, to be precise). Although nobody knows what policy the Federal Reserve will set for rates in 2019, 2020 or even 2021, the Fed usually does not continue increasing rates during periods of economic contraction or on what it considers the eve of an economic contraction. During downturns, rate decreases or a no-change strategy usually occurs (e.g., lowering rates or not changing them). How does this impact M&A? Generally speaking, the cheaper the cost of borrowed money, the more a would-be buyer may be willing to pay, assuming he or she bases their valuation levels on expected returns and the desired return remains consistent with historical hurdles.

Buyer’s access to equity capital/cash: If we do in fact enter a period of slowdown, cash surpluses of both strategic buyers (those buying within their industry) and financial buyers will remain strong at the beginning, just as they have through the expansion. Prolonged recent periods of strong earnings have continued to fill company coffers, and private equity funds remain flush with capital ready to invest. Strong cash piles bode well for sellers, creating the motivation to spur activity.

Supply and demand of deals: Recently, many business owners have made a tremendous push to launch a sale process during the prolonged seller-favorable period that we have been experiencing. Nonetheless, owner demographics continue to favor a high-quality deal supply as older business owners such as Baby Boomers continue working through unique succession issues. Moreover, demand will remain strong as strategic buyers continue their quest for growth and disruption and private equity funds face the age-old dilemma of needing to deploy capital within certain timeframes. All this being said, less-than-certain economic outlooks do affect the willingness of sellers to sell, as they do not want to face a reduced purchase price stemming from lower earnings.

In summary, when and if we do enter a slowdown, a) lending capacity could be hampered (by driving premiums down), b) cost of capital will be neutral or will become cheaper (through increasing premiums paid), c) access to capital will be neutral, and d) supply and demand for deals will be somewhat negatively impacted if major uncertainty creeps into the minds of buyers or sellers, although the suspected mild nature of the anticipated slowdown should dull uncertainty to a degree.

Concluding thoughts: Although the combination of these variables appears to paint a slightly more negative outlook in regard to premiums paid in the M&A market, different factors do to offset some of the potential negative consequences. Furthermore, the attributes discussed never fluctuate with the level of volatility encountered in the mega-deal sector (deals of $500 million or more). Why? In most cases, buyers and lenders alike tend to stay much more disciplined in their practices (e.g., willingness to lend, cost at which they lend, and returns they target) in the lower-middle market than in the realm of large corporations. While some contraction will likely occur, it probably will not be so pronounced that it should derail anyone’s plans to sell a business (or buy a business). Thus, if you have been thinking of selling and you believe we are on the eve of a recession or slowdown, you may not get what you would during a period of an M&A market expansion, but you probably also should not feel deterred from making what could be a necessary decision for you, your family, or your business.