M&A activity returns to its historical trend, awaits catalyst for takeoff

The past five years have been characterized by dramatic shifts in M&A activity. The onset of the pandemic brought about a pause that would be followed by two years of an off-the-chart growth spike, then a reset, due in part to a rapid rise in interest rates. While current deal activity is down from 2021 and 2022 levels, it is reasonable, reflects a normal cycle, and lies in wait for the catalyst to reignite it.

Recently, I participated in a panel at the M&A Science’s 2024 Spring Summit with colleagues Charles Sapnas and Chris Mellen and the following summarizes our conversation.

Market Volumes & Multiples

Data for M&A involving U.S. private companies for 2023 is still being compiled, but in 2022, acquisitions were at around $345 billion. That compares to $1.248 trillion in 2021—an outlier year that reflects the pent-up demand for deals following the pandemic—and is closer to the average of about $360 billion between 2013 and 2020, a return to a longer-term trend line and cycle.

The EBITDA multiples at which deals are getting done vary greatly based on industry (services, technology and healthcare are generally higher than consumer/retail), the size of the deal (bigger companies generally earn higher multiples), and the nature of the deal (so-called platform deals, where a purchaser is buying a stand-alone business versus a smaller add-on business or business unit to combine with an existing portfolio company tend to be higher). But to generalize, multiples are higher today than in the past, with the typical private company changing hands at about 7.5 times EBITDA over the last year or so, versus about 6.5 times in the decade-and-a-half preceding the pandemic. Multiples for good companies remain strong.

Higher Interest Rates

The more normative level of deal activity in 2022—which is expected to continue to be reflected in the 2023 numbers—comes against the backdrop of a sharp increase in short term interest rates that is probably the biggest single issue on which dealmakers are focused. The Fed’s tightening that began in early 2022—and the resulting uncertainty about whether it can time a reversal just right and pull off the elusive “soft-landing” that has evaded monetary policymakers in the past is shaping everything from the types of deals getting done to their structure to the outlook for exits and deals going forward.

Deal Structures in a Higher Interest Rate Environment

Perhaps unsurprisingly, sellers of private companies’ expectations for price are heavily informed by the blockbuster 2021 deal environment, whereas buyers take a longer view that also reflects the higher interest rate environment and concerns about a potential economic slowdown. The gap in expectations is being bridged in several ways, all of which result in sellers maintaining some skin in the game after the deal closes:

Earnouts. Contingent consideration, or earnouts—where, in addition to an upfront payment, a buyer agrees to pay additional consideration upon the achievement of certain performance milestones (usually EBITDA-related)—aren’t new, but they tend to show up more and represent a greater percentage of the purchase price, in periods of greater economic uncertainty.
Seller financing. More private deals than usual include seller financing, where a company owner finances part of an acquisition of their business with an unsecured, subordinated note. Seller financing notes typically carry a below market fixed rate of 5 to 8% and mature in five years, which neatly coincides with the typical holding period for many private equity investors.
Rollover equity. When markets are uncertain, as they are now, deals often feature more rollover equity, whereby part of the seller’s consideration comes in the form of equity in the ongoing enterprise. For some recent private deals, rollover equity represented as much as 40% of the acquired company’s total value.

The Outlook for Deals

Most market practitioners expect a solid volume of deals in the second half of 2024. The anticipated easing in short-term interest rates may or may not materialize as quickly as some had hoped, but most are convinced that the tightening is over.

It’s also the case that demographics are destiny. In the early 2000s, there were heady predictions of an unprecedented wave of private company sales. Tens of thousands of Boomer business owners, as the theory went, were ready to cash out and retire. A global financial crisis followed by a pandemic may have delayed exit plans for entrepreneurs, but as they've aged, the need to find an exit has become more urgent.

Despite challenges, the outlook for deal-making remains positive, with opportunities for growth and value creation on the horizon. In navigating the complexities of M&A, stakeholders must remain agile, leveraging expertise and collaboration to seize the potential of a dynamic and evolving market. And be ready for the next boom in M&A.