Middle market M&A still going strong, if a bit slower, Chicago panelists say

News Analysis 4 October

Middle market M&A still going strong, if a bit slower, Chicago panelists say

The overall state of M&A for the middle market in 2022 remains robust, one factor being that many companies need to exit regardless of market conditions, industry experts said. 

“Some clients need to go to market because they don’t have a 10-year plan,” said Suzanne Saxman, partner and M&A chair for Chicago-based Seyfarth Shaw. “You’ve got privately held companies, whether it’s business partners or a founder or a family-owned business, where we don’t see a successor. These are companies that must get out, there’s no other alternative.”

Saxman was part of a panel discussion held last week and organized by the Chicago investment bank Dresner Partners and other members of Mergers Alliance, an international partnership of middle-market focused financial advisory firms.

Saxman, whose law firm represents middle market companies in M&A transactions, also said the labor shortage is partly driving M&A with her middle market clients.

“If you think about it, it’s a lot easier to buy a company than it is to hire 1,000 people or to open a new branch. So, if you can go out and do that from an M&A perspective, why go the slow route?” she said.

Labor was a big theme during the panel discussion. Scott Brown, senior partner with private equity firm Edgewater Funds, said a massive shortage of healthcare workers is continuing to cause wages to rise.

Steven Sherman, managing director with investment bank and advisory firm Loop Capital, said recent layoffs in technology and other industries could serve to temper rising labor costs. “I think the dynamic has shifted,” he said, predicting that the cost of labor will trend down in the near future, which could temper inflation.

Meanwhile, rising interest rates are complicating dealmaking in all sectors, Sherman and others agreed.

“If you’re looking for a leveraged deal, lenders are going to get a lot tougher. A lot of these deals were negotiated months ago and haven’t closed and if you’re a buyer you’re probably going to push for adjustments because of the cost of debt,” he said.

The panelists also discussed how flexible financing and longer holding periods are encouraging more family-owned and closely-held businesses in the middle market to partner with investors.

Scott Rubenstein, a managing director with BMO Harris Bank, said there is no shortage of investors like family offices looking to find founder-led businesses, which represent a large market for investors as Baby Boomers retire.

Private equity firms, including industry giants Blackstone [NYSE:BX] and Apollo Global Management [NYSE:APO], are increasingly setting up hybrid funds aimed at enticing closely-held businesses with minority stakes and other strategies, Rubenstein said.

Brown agreed, saying that about a third of Edgewater’s transactions are non-controlling stakes. The firm is not a long-dated fund, he said, but they’re willing to be more flexible on time horizons when partnering with closely-held businesses.

Brown also said while he feels the M&A market is still robust, inflation has put a bigger focus on the fundamentals of businesses.

“The due diligence bar is higher. I think really good companies will continue to get good valuations but as we think about the debt markets and the risk tolerance, I think that’s pulled back some and in some cases, some folks are sitting on the sidelines,” Brown said.

Slower to close

Panelists agreed that transactions are taking longer to close. They’ve seen an uptick in transactions using representations and warranty insurance, with Saxman calling the due diligence required for the insurance “debilitating.”

Brown said while there seems to be a larger gap between buyer and seller expectations now as compared to last year, businesses that are fundamentally sound are still receiving “astronomical valuations.”

Another factor slowing transactions is regulatory scrutiny, panelists said.

“In the United States, the Biden Administration is really coming down hard and really reviewing M&A,” said Christopher Nolan, managing director at Dresner Partners. “They’ve probably been more aggressive in reviewing transactions in the last year than the Trump administration did in its entire period, and they are coming at it from all angles.”

Nolan said special purpose acquisition companies (SPACs) are still a factor and are on the hunt for “sizeable” family-owned companies. “SPACs come in and say ‘Hey, you can go public without all of the rigamarole,” he said. “It gives the family operators the opportunity to hit the public markets and cash out.”

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