M&A Lower Middle Market Q3 2021 Update
M&A Deal Activity Continued its Record-setting Pace in Q3 2021
North American M&A deal activity remained robust in Q3 2021 following a strong H1 in 2021 and a record-breaking fourth quarter in 2020. YoY deal volume in Q3 increased 28.6% over Q3 2020. Through the first three quarters of 2021, deal volume is on pace to approximate or surpass record highs.
The economic recovery is forging ahead despite inflationary pressures and global supply chain disruption, fueling unprecedented M&A activity. M&A activity across multiple sectors is being driven by digitalization and changes in business and consumer preferences due to COVID. As businesses reopen, travel reemerges, and equity markets continue to post broad gains, corporate executives and investors remain confident in a strong economic recovery.
Although the U.S. economy slowed in Q3 2021 with real GDP increasing at a modest 2%, 2021 is on track to achieve the highest annual GDP growth rate in almost four decades. Inexpensive financing, ample private equity dry powder, strong public company valuations, and diminishing economic uncertainty continue to encourage businesses and investors to grow through acquisition.
Transaction Multiples Reached Historical High
Average transaction multiples in Q3 2021 with Transaction Enterprise Values (TEV) of $10 million to $250 million increased to 7.6x, which was the highest quarterly mark in GF Data’s 16-year history. It again signals strong M&A momentum and transaction valuations, especially for companies that have performed well through COVID.
One of the key factors contributing to higher multiples is the greater percentage of platform acquisitions, which tend to be higher valued than add-ons. This reverses a recent trend in favor of add-on deals. From 2018 to 2020, the platform percentage of total acquisitions ranged from 79.5% in 2018 to 70.0% in 2020. For the first nine months of 2021, the figure bounced back to 74.5%.
While valuations surged across the board, larger companies tended to receive higher valuation multiples. In the $100-$250 million TEV tier, the average was 9.8x. Buyers continued to favor companies with above-average TTM EBITDA margins and sales growth. In the past three quarters, above-average performers accounted for 62% of total reported transactions, while the historical average is 56%. These above-average performers were rewarded with a 28% valuation premium compared to below-average performers.
Debt Leverage Stabilized at Pre-COVID Levels in Q3 2021
Debt leverage has been steadily returning to pre-COVID levels since Q3 2020. Total debt in Q3 surged to 4.1x EBITDA, compared with 3.6x in Q2. The increase of leverage in Q3 is in line with increased valuation. For the first nine months of 2021, total debt averaged 3.9x, up from 3.7x in 2020 and reverted to the same level in 2019. Continued low interest rates across investment-grade and high-yield debt have boosted debt utilization to support M&A transactions.
The average debt leverage in Q3 2021 of 4.1x EBITDA comprised 3.1x senior debt and 1.0x subordinated debt, compared with 2.8x and .8x in Q2 2021, and 3.6x and .3x in Q1 2021, respectively. The lower percentage of senior debt usage reflects add-ons accounting for a lower percentage of the deals, as most add-ons are structured with all senior debt. GF Data noted that add-ons account for 24.5% of the sample transactions in YTD 2021, a drop from an unprecedented high of 30% in 2020.
Outlook
We are bullish on M&A activity during Q4 2021 and Q1 2022. The key M&A drivers remain intact, maintaining deal volumes and values at record levels. There are plenty of opportunities for value creation and growth. Highly sought-after deals that offer innovations and targets with outstanding performance are likely to continue to command a premium in this competitive market. However, recent increased COVID concerns, expected increases in interest rates and inflationary pressures could slow M&A activity at some point in 2022.
Anticipating an increase in capital gains tax in 2022, many buyers and sellers are racing to close deals in 2021. Consequently, Q4 2021 is expected to see record level of M&A volume and transaction values ahead of potential capital gains tax hikes.
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M&A Deal Activity Continued to be Robust in Q2 2021
North American M&A deal activity remained strong in Q2 of 2021, following a strong first quarter in 2021 and a record breaking fourth quarter in 2020. YoY deal volume was 57.6% higher than the volume in Q2 2020. Through the first half of 2021, deal volume is on pace to approximate record highs.
Closed M&A Deals in North America (Q1 2019 – Q2 2021)
Source: Pitchbook and PKF Investment Banking research.
Investor confidence remains high as the equity markets continued to record broad gains. Other factors, such as levels of uncommitted capital, potential increase in capital gain tax rates, low interest rates, reduced uncertainty for buyers and sellers, and increased CEO confidence all contributed to the already heated M&A market. With over $1.5 trillion dry powder in the U.S. equity firms, the US PE deal making notched a record-setting pace through Q2 2021. PE exit activity through H1 2021 is also on track for a record-setting year.
Transaction Multiples Increased
Average transaction multiples in Q2 2021 with Transaction Enterprise Values (TEV) of $10 million to $250 million has rebounded to 7.2x after three quarters in which pricing averaged 6.6x-6.9x. It again signals a strong recovery of the M&A market and transaction valuations, especially for those companies that have performed well through COVID.
Source: GF Data®
Higher performers with above-average TTM EBITDA margins and sales growth continued to be rewarded with premium valuation multiples. In Q2 2021, the buyout targets with above average financial performance were valued at an average of 7.8x, increasing from an average of 7.6x in Q1 2021. This “quality premium” phenomenon has been observed since the second half of 2020, when the reward in valuation for better performance represented over 30% premium, compared to a historic average of 14%. The rest of the buyout targets in Q2 were valued at an average of 5.8x, compared to 5.7x in Q1 2021, indicating a bigger valuation multiple gap between the targets that have strong TTM performance with clear industry sector visibility and companies with weak TTM performance and cloudy visibility.
Quality Premium – Buyouts Only
Source: GF Data®
Debt Leverage Stabilized at Pre-COVID Levels in Q2 2021
Debt levels have been steadily returning to pre-COVID levels since Q3 2020. Total debt utilization is largely unchanged in Q2 2021. Low interest rates across investment-grade and high-yield debt have boosted debt utilization to support M&A transactions.
The average debt leverage in Q2 2021 of 3.7x EBITDA comprised 2.9x senior debt and .8x subordinated debt, compared with 3.6x and .3x in Q1 2021, respectively. The decreased portion in senior debt implies a slowdown in add-ons as most of the add-ons tend to structure the debt with all senior debt. GF Data noted that add-ons account for 23% of the sample transactions in 2021, a drop from an unprecedented high of 30% in 2020.
Total Debt/EBITDA – All Industries by Deal Size
Note: Deals with no debt are eliminated from leverage data, as are significant outliers. Please note that N for 2003-16 encompasses 14 years of activity.
Source: GF Data®
Outlook for Remainder of 2021
The outlook for LMM M&A remains very positive for the second half of 2021. As business reopened and economy recovered, business leaders and investors are more confident and open to develop M&A strategies to accelerate growth and gain scale. The abundance of capital and low interest rates encourage the spending of corporates and financial investors. As a result, highly sought-after deals for innovations and targets with outstanding performance are likely to continue to command a premium under this competitive market.
Anticipating an increase in capital gains tax in 2022, many sellers are racing to close deals in 2021. However, many other companies are waiting to launch an M&A process until Q3 2021 to ensure the disruptions of Q2 2020 are not included in the last 12 months financial metrics, in order to present more normalized performance.
Government spending and increasing consumer expenditure will continue to create optimal environment for business recovery across sectors. We expects a dynamic M&A situation to be continued throughout the second half of 2022.
Contact Us
Robert Murphy
Senior Managing Director
rmurphy@pkfod.com
561.337.5324 | 201.788.6844
M&A Deal Activity Continued its Momentum in Q1 2021
North American M&A deal activity remained robust in Q1 of 2021 following a record-breaking Q4 in 2020. However, year-over-year deal volume was 9.3% lower than Q1 2020.
Closed M&A Deals in North America (Q2 2019 – Q1 2020)
The vaccine rollout is helping to reduce uncertainty for buyers and sellers and CEO confidence levels, as measured by The Conference Board, are at all-time highs. This, along with low interest rates, active credit markets and significant levels of available capital looking for a home, is driving a heated M&A market. Dry powder with U.S. equity firms at the end of 2020 was $1.5 trillion, an increase for the sixth year in a row, and non-financial corporations held $1.7 trillion in cash at the end of 2020, a significant increase from 2019.
Transaction Multiples Remained Strong
Average transaction multiples in Q1 2021 with Total Enterprise Values (TEV) of $10 million to $250 million decreased slightly, with an average of 6.8x EBITDA. This departs from the widely held view that valuations have risen, not fallen, over the past nine months. It is clearly a robust seller’s market, especially for those companies that have performed well through COVID. The 6.8x average does not give the true picture, as strong performing companies are trading at multiples above pre-pandemic levels. The average is being brought down by: companies negatively impacted by COVID trading at lower multiples, higher percentage of add-ons which typically trade a bit below platform acquisitions, and an increased number of deals with earn-outs as the earn-out value is excluded from TEV in the following chart.
Total Enterprise Value (TEV)/EBITDA
Higher performers with above-average trailing twelve month (TTM) EBITDA margins and sales growth are rewarded with premium valuation multiples. In Q1 2021, the buyout targets with above average financial performance were valued at an average of 7.6x, which represents 34% premium, compared to a historic average of 14% while the rest of the buyout targets in Q1 were valued at an average of 5.7x. In this marketplace, there is a stark contrast between the targets that have strong TTM performance with clear industry sector visibility and companies with weak TTM performance and cloudy visibility.
Quality Premium – Buyouts Only
Debt Leverage Reverted to Pre-COVID Levels in Q1 2021
Debt utilization returned to pre-COVID levels in Q1 2021, reflecting a reversion to more normal capital structures as lending institutions regained confidence.
The average debt leverage in Q1 2020 of 4.0x EBITDA comprised 3.7x senior debt and 0.3x subordinated debt, compared with 3.1x and 0.6x in 2020, respectively. The increased share of add-ons attributes to the higher percentage of senior debt as most of the add-ons tend to complete these transactions with a debt structure comprised of all senior debt.
There has been an increase in the use of earn-outs to address financial performance concerns and lack of industry visibility for companies that have not returned to pre-COVID levels.
Total Debt/EBITDA – All Industries by Deal Size
Outlook for Remainder of 2021
Several tailwinds should continue to support robust activity for the remainder of 2021. Deal activity in Q2 and Q3 should be significantly above 2020 levels with strong valuation multiples.
- Business conditions in COVID-impacted sectors improving as vaccination increases.
- Improving economy and government stimulus.
- Low interest rates and supportive debt market for transactions.
- Renewed confidence among corporate buyers to deploy capital and seek growth through acquisitions.
- Record levels of capital with financial and strategic buyers seeking targets.
An infrastructure spending plan, if approved, should help to drive transaction activity and a capital gains tax rate increase for 2022, if approved, could create a frenzied M&A market to finish out the 2021 year.
Contact Us
Robert Murphy
Senior Managing Director
rmurphy@pkfod.com
561.337.5324 | 201.788.6844
M&A Deal Activity Surged in Second Half of 2020
After a precipitous decline in Q2 2020, mergers and acquisitions transactions in North America rose 84% from Q2 to Q4 2020 after experiencing a 38% decline in Q2 and a 22% decline in Q3. The sharp recovery saw the total number of deals in 2020 reach 8,413, only an 11.4% decline from 2019.
Q4 2020 closed as one of the strongest quarters for M&A over the past decade.
Closed M&A Deals in North America (2019-2020)
Source: Factset & PKFIB research. Private company targets only.
Lower middle market M&A activity in Q4 2020 mirrored the pattern of the broader market, showing strong resilience in spite of the challenging economic environment. Activity was particularly robust in several sectors:
• Technology – came out ahead and was the only sector to gain in transaction value over 2019.
• Healthcare – transactions involving both inpatient and outpatient care facilities increased sharply in Q4.
• Financial Services – M&A activity also accelerated in financial services, insurance and related industries.
Transaction Multiples Remained Strong in the Lower Middle Market
Transaction multiples in 2020 for deals with Transaction Enterprise Values (TEV) of $10 million to $250 million finished strong, with an average of 7.1x EBITDA equal to the 2019 average.
Total Enterprise Value (TEV)/EBITDA
Multiples improved in Q4 2020 after a .6x COVID-19 impact in Q3. The decrease of .8x EBITDA in the $100 million to $250 million TEV range can be partially attributed to a tightening of debt leverage in this category. Valuation multiples remained stable as buyer demand for quality deals outstripped supply. Companies that performed well through COVID were in high demand, and companies significantly impacted by COVID held off going to market.
Debt Leverage Decreases in 2020
Total debt leverage decreased on average .3x EBITDA in 2020 compared with 2019. The main reason for the decrease was COVID-19-related uncertainty about the economy and business performance. The average debt leverage in 2020 of 3.7x EBITDA comprised 3.1x senior debt and .6x subordinated debt, compared with 3.2x and .8x in 2019, respectively. The average total debt leverage in Q2 dropped to 3.3x but rebounded to 3.8x in Q4. According to a recent GF Data report, the average senior debt rate across all TEV categories was 5.2% in 2020 and 11.2% for subordinated debt.
Total Debt/EBITDA – All Industries by Deal Size
Favorable Deal Trends in 2021
Market conditions that fueled increased deal flow in Q4 2020 are expected to persist in 2021. These and other growth drivers include:
• Deals interrupted last year continue to re-emerge in 2021.
• Company financial performance has rebounded from the lows in Q2 and Q3 2020.
• Financial buyers and companies seeking growth through acquisitions have a record amount of cash that needs to be deployed.
• Opportunistic buyers are seeking out distressed companies.
• Significant private equity participation in industry consolidations.
• Low interest rates foreseen in 2021 will support a dynamic M&A market.
These salutary trends, coupled with intense buyer demand that continues to exceed the supply of attractive companies, reinforce our forecast for an active M&A market in 2021.
Contact Us
Robert Murphy
Senior Managing Director
rmurphy@pkfod.com
561.337.5324 | 201.788.6844
Business Owners – Are You Prepared if a SPAC Comes Knocking?
If you mentioned the acronym “SPAC” a few years ago you were likely met with a blank stare. While COVID-19 led the headlines in 2020, SPACs became the hottest investment vehicle on Wall Street dominating the initial public offering (IPO) landscape and private equity has played a significant role in the SPAC boom. Private equity’s contribution to the SPAC revolution is important because billions of dollars of capital are being added to an already overflowing investment war chest of “dry powder” estimated to be in excess of $1.5 trillion.
How SPACs Function
SPAC, according to the SEC, stands for special purpose acquisition company and it is a type of “blank check” company. The SPAC basically has no operations but offers securities for cash and places substantially all the offering proceeds into a trust or escrow account for future use in the acquisition of one or more private operating companies. Following its IPO, the SPAC will identify acquisition candidates and attempt to complete one or more business combination transactions after which the company will continue the operations of the acquired company as a public company.
Unlike the traditional IPO process, where a private operating company sells its securities in a manner in which the company and its offered securities are valued through market-based price discovery, the management team (and/or the directors, officers and affiliates) of the SPAC is solely responsible for deciding how to value the private operating company and how much the SPAC will pay for it. Similar to a private equity fund, SPACs generally commit to complete an acquisition within a specified timeframe.
The SPAC Boom
As illustrated below, SPAC IPOs exploded in 2020 with $83 billion raised by 248 SPACs (that’s $14 billion more than what was raised in the previous 16 years combined).
Source: SPACInsider.com & PKF Investment Banking
Through January 25, 2021, an additional 67 SPAC IPOs raised approximately $19.2 billion and there were 71 active filings for SPAC IPOs, indicating that capital raised in 2021 is on pace to far exceed that raised in 2020.
The Road to Being Acquired or Merged into a SPAC
While the availability of capital remains at record levels, the supply of high quality acquisition targets continues to be limited, which is why we foresee a “seller’s market” for companies that have shown resilience or that have flourished during the pandemic. However, merging into or being acquired by a SPAC is not the same as being acquired by another privately-held business or even by a private equity firm.
For private companies, this will mean providing financial statements and other content disclosures that comply with the SEC’s Regulation S-X Rule 3-05 and the US GAAP requirements of a public company, often on an accelerated timeline. Although the SEC issued new rules effective January 1, 2021 to simplify the requirements of Regulation S-X, many business owners and financial departments will still find the financial reporting and disclosure requirements quite onerous.
When it comes to the preparation and inclusion of financial information in a proxy or registration statement related to a merger with a SPAC, the following presents just a few items that may potentially be required:
- Audited financial statements of the acquisition Target for one or more years;
- Audits must be conducted in accordance with PCAOB standards, which may require additional work if previously audited in accordance with AICPA standards;
- Retrospective revision of financial statements if private company accounting alternatives were utilized (e.g., amortization of goodwill);
- Audited financial statements for any significant acquisitions by the Target entity during the prior one or two years;
- Adoption of new accounting standards at the same time as public companies;
- Complete “carve-out” financial statements of the acquired business if the Target is a division of another business;
- Pro forma financial information, including transaction accounting adjustments (i.e., purchase price allocation and fair value of identified intangible assets).
Back to the Future
Business succession can be a complex journey with many twists and turns which is why having a well thought out exit plan is essential. An effective plan should include an evaluation of potential exit strategies as there are different exit channels and each channel rewards different value drivers. In a competitive M&A environment, speed to close and depth of financial reporting are often important factors, and this will be particularly true with SPACs.
Based on the recent boom in fundraising, SPACs represent another possible exit channel in a crowded M&A market that could help sustain high valuation multiples for business owners seeking a liquidity event. Any sales process can feel overwhelming to a closely-held business. However, as briefly illustrated above, merging with a SPAC requires an even higher degree of coordination between buyers and sellers and a prudent business owner should give serious thought to how prepared their business is to be acquired by a SPAC, especially if the SPAC offers the highest purchase price.
So, before a SPAC comes knocking, do your homework and assess whether you can confidently answer the bell.
Contact Us
Robert Murphy
Senior Managing Director
rmurphy@pkfod.com
561.337.5324 | 201.788.6844