A case for lower multiples? What should sellers do in an uncertain market?
With global uncertainty, inflation/stagflation and rising Interest rates, the sands may be shifting from a sellers’ market to more of a buyers’ market.
While acquisitions reached all-time highs along with buyers being willing to acquire at high multiples, the landscape may be changing for the remainder of 2022. Most economists would agree we are approaching an economic cycle of slower growth.
What then specifically will pressure sale multiples and prices?
Cost of Capital – The cost of capital is rising. The fed has been signaled and now acted on not only monetary tightening but multiple and frequent interest rate increases. Most Middle-market M&A deals are partially funded with some portion of debt (typically 40%-60%) Giving investors higher returns overall on their equity investments.
The fact that rates are rising may have a negative effect on multiples as buyers “price-in” higher costs of capital.
Inflation / Stagflation – If buyers pay “market rate” often goosed up by Investment bankers like ourselves running global broad auctions for the sale of your company, the only way they win (achieve adequate returns on equity over time) is if they grow the company post-acquisition. In the current environment, growth may be hampered due to inflationary pressures, cost increases or stagflation. Certainly, the tight labor market and those increased costs have a positive effect on keeping stagflation at bay, however those winds may be changing. Companies may not see the demand for additional labor in a slowing growth environment.
Market Uncertainty – It is often said that “markets hate uncertainty”. And while this is true of stock markets in general, it is also true for private company M&A. Global instability, lingering supply chain issues, and many companies’ inability to accurately forecast or articulate if recent growth was due to a “covid-bump” and a return to normal is imminent there is a good deal of market uncertainty. In uncertain times we see buyers building-in additional structures (Earn-outs or other contingent compensation mechanisms) to share risk or de-risk their investments. While multiples and valuations may come down slowly, buyers are beginning to evaluate the current risk premium in the market and adjust pricing but moreover terms accordingly.
Alternative Asset classes - investors have increasing avenues to place their capital – Previously lackluster sectors or investment classes in this environment will start to become more attractive vs. private equity potentially. Investors will have more choices to place their capital and balance risk and return dynamics i.e., Bond markets, alternative debt markets etc.
Stock market dynamics – I would be remiss if I did not mention the turbulence in the US stock markets as well as ripple effects in most global indices. Certainly, a more conservative view of slowing markets would dictate most strategic acquirers will be conserving cash and perhaps like many they have seen their market capitalization (available dry powder) shrink as of late. This environment and related volatility and uncertainty favor those sellers that are top of their investment class so to speak. In other words, only the best companies will be purchased in this environment and others will be discounted to adjust for the risk, albeit not in their company per se but for market risk in general.
Three widely subscribed CEO confidence indexes we follow, indicate the sentiment of Middle market and lower middle market CEOs are trending down amid the uncertainty.
- Conference Board Measure of CEO Confidence™ declined for the third consecutive quarter in Q1 2022. The measure now stands at 57, down from 65 in Q4 2021. While still in positive territory, the Measure is now down 25 points from the all-time high of 82 recorded in Q2 2021.
- WSJ / Vistage Small Business CEO Survey - 99.3 Down from a high of 109.7 in August of 2021
- Marcum – Hofstra CEO Survey - Business outlook score dropped from 86.9 to 82.1 Y-o-Y.
So, what are sellers to do?
- Move quickly. If you are preparing for sale or sitting on the fence, perhaps take advantage of buyers’ propensity of buying historical earnings. If your past performance is market-leading capitalized on that historical performance. Many entrepreneurs are saying “we had a record year”. The propensity of ever-optimistic entrepreneurs is “the party will last forever”. If you read the list above there is a case for lower multiples and more cautious investors.
- Mitigate future risk - Focus investment and resources on de-risking ort de-risked areas of your business. Know the drivers of value and risk assess your business while focusing on those areas that are de-risked or have shorter sales cycles to accomplish future growth. Perhaps shift from long-term market development to shorter-term singles and doubles for maximized opportunities in the present market.
- Aqui-Hire - Dedicate additional resources or pick up key hires to beat industry growth rates and take share. A client of ours recruited away a competitive team responsible for several million dollars in sales as a talent aqui-hire strategy to take share and de-risk future growth.
- Increase prices where you can nimbly - Build price increases into your strategy so as not to suffer short-term margin compression. For once the media mantra of supply chain issues, rising costs, commodity price increase, inflation etc. may work in your favor. We see more sympathy for suppliers from their customers, still, enabling companies to raise prices as demand is still strong across many sectors. Do not lose this opportunity while sentiment still exists.
- Better financial acuity and metrics / KPIs - Beef up your financial acuity and visibility to gross margins and costs and well as pricing performance in the market. Buyers will be particularly keen on drilling down into short-term profitability as a leading indicator of future performance. Be prepared to win this strategic conversation and anticipate where you need to go.
- Position expertly - Have your investment banking team really work hard to position your company in the market and competitive landscape as well as help you de-risk and make your proforma earnings more defensible. An uncertain growth plan, or un-defensible proforma will hurt valuations so your strategic thinking, preparation and execution has never been more important during these uncertain times.
While many will be focused on a good defense when considering selling. In times like these, a good offense and proper positioning are the best defense. Get proactive and prepare now as you assess your personal and business readiness for a sale or liquidity event.
If you are at the initial stages of considering a liquidity event and are interested in other tangible ways to prepare personally and professionally, see our previous blog post here to start taking action to always been a position to achieve liquidity when you decide to and on your terms. Click to here to read blog.
By: Craig Dickens, CDI Global