Peeling Back the Curtain

WRITTEN BY

Bailey McCann

ILLUSTRATED BY

Stephan Schmitz

By almost any measure, the past two years have been record-breaking ones for mid-market M&A. The level of activity has surprised many, given the impact of the coronavirus pandemic on the world. Now, as economies begin to reopen, businesses and investors are faced with fresh waves of uncertainty, including ongoing supply chain issues, rising inflation, rising interest rates, increased labor costs and geopolitical concerns. For companies and general partners hoping to transact, these new concerns could put pressure on balance sheets and deal activity overall.

Investors and advisors are now scrutinizing potential acquisitions for how well they managed through the pandemic, how companies are responding to a set of new risks, and whether those that enjoyed a “COVID bump” can maintain their good performance.

If rising costs, rising interest rates and geopolitical shocks continue to build precarity into the economy, it could dampen M&A potential or drive valuations down, advisors say.

Paul Aversano, managing director at consultancy

Alvarez & Marsal, sees both sides. “We’re getting a lot of sell-side work to position companies going to market right now. That has a long lead time, so if I am looking toward the end of the year, there’s a strong pipeline of deals that is still building right now,” he says. If companies and their bankers can position their story well and highlight a runway for growth, the pipeline for the second half of the year should be strong, barring any new macro uncertainty. But if rising costs, rising rates, inflation and geopolitical shocks become more than a series of unfortunate events, there could be trouble. Aversano anticipates the rate of restructurings could start to increase around 18 months from now.

The pandemic had a significant impact on businesses, even if it hasn’t hit valuations or deal flow. In a recent Citizens Financial Group survey of middle-market executives, 58% said the pandemic made it harder for them to do business. But it’s not the only factor. More than half—54%—said labor market challenges, including increased costs and the tight supply of workers, have made it difficult to grow. Commodity prices came in third, with 49% saying those cost increases are a big challenge.

In the first quarter of this year, the conflict in Ukraine also caused some businesses that were considering a sale or other transaction to move to the sidelines. According to data from Bloomberg, at least 100 companies worldwide have delayed or

pulled financing for deals since the start of Russia’s invasion. This includes M&A deals, IPOs and new rounds of financing. The U.S. accounts for the largest share, with 49 companies delaying plans. Taken together, all of these factors are putting pressure on companies as they try to grow.

The impact of these issues is causing something of a bifurcation between industries. Consumer, industrial and manufacturing companies that rely more heavily on in-person workers and commodities have been under constant pressure since the pandemic began.

Meanwhile, companies in industries that could pivot to remote work or saw accelerated demand over the past few years, like technology, business services, media, healthcare and digital education, have all done well. But these businesses too are

Managing Director, Capstone Partners

Source: 2022 M&A Outlook Report, Citizens Financial Group

beginning to face some headwinds when it comes to closing deals. Valuations are high in these sectors and the companies will be under pressure to show they can maintain accelerated revenue growth.

“For most companies, the direct impact of COVID is behind them if they survived. The market valuations will still be impacted when looking back over the past two years, but if they have recovered (or actually benefited), the impact will be less,” explains Sam Hill, managing director at middle-market investment bank Capstone Partners. “There are just a lot of other factors taking precedence now, such as lingering supply chain issues and inflationary dynamics. If a company is still making COVID adjustments, it’s likely from industries that haven’t been able to bounce back.

“Labor costs are overtaking the pandemic now and depending on the industry, supply chain and energy costs are having a bigger impact,” Hill continues. “Interest rates may now become more meaningful and inflation (if unchecked) threatens consumers and the ripple effect may create longer-term issues. In some cases, manufacturers have struggled with passing on costs as quickly as they need to in order to protect profitability.”

Forecasting the future isn’t easy. A recent report from Bain & Co. shows that the biggest factor in deal failure is a misunderstanding of future revenue. Revenue-enhancing strategies like new business models, combined product offerings or updated go-to-market approaches can be challenging to execute in a highly volatile economy. Overestimating the revenue potential from updating a product or service often leads to underperformance down the line.

If a company survived or even thrived over the past few years, that’s a bonus going into a deal process. But the business and its investment bankers have to show that there are continued

opportunities for growth that are defensible. Right now, investors are willing to sign on for stories that include growth of the customer base, future acquisition potential or new product offerings, but the narrative has to be strong and likely include more than one of these growth paths.

For companies that came through the past two years in a weakened state, successful deals are still happening if the business can show opportunities for operational improvements that will lead to better EBITDA numbers in the long term. This can include cutting labor costs, finding new sources of supply for those hit by the recent supply chain crunch, or even steadily improving product delivery times.

Companies that lack either a growth story or a business optimization story could be headed for restructuring. Here, the push has been toward setting up performance improvement plans rather than going into full bankruptcy.

So-called “new economy” industries like business services; healthcare IT; and technology, media and telecom (TMT) continue to lead both in terms of deal flow and valuation. That’s unlikely to change. In the Citizens Bank survey, 52% of executives expect valuations to increase in TMT this year, while 32% expect valuations in business services to rise.

Companies that fall under this umbrella were able to shift to remote work and, in some cases, saw demand increase as businesses sought help with outsourced administrative services, a shift to remote work and virtual communications.

“The balance sheets are very strong across all of the sub-verticals that fall under business services,” says Larry DeAngelo, managing director and head of the Global Business Services Group at Houlihan Lokey. “I think if you see any slowdown, it will be a function of price. But if sponsors think they can grow revenue and create operational efficiencies, many of them are still willing to pay.”

Healthcare, which was one of the fastest growing sectors before the pandemic, continues to accelerate. In the Citizens Bank survey, 68% of executives said they expect that valuations will increase in this sector in 2022. Within the middle market, healthcare IT services companies in particular have seen significant growth in response to the increase in demand for telehealth, electronic visits and delivery of prescriptions by mail. Companies that support remote administrative work also saw an uptick in demand and therefore revenues.

“Healthcare is somewhat unique because it’s not cyclical,” explains Jeffrey Stevenson, managing partner at VSS Capital Partners, an investment firm that makes debt and equity investments in lower middle-market companies, including healthcare IT services. Stevenson anticipates that the demand for these companies will remain high because the demand for healthcare itself grows fairly consistently year-over-year.

Companies with high commodities exposure or those that require a lot of in-person workers have been under pressure since the pandemic began and that’s likely to continue. Companies that rely on energy, like transportation and logistics businesses, are facing new volatility in the energy market due to the situation in Ukraine. Similarly, recent volatility in the metals market is adding pressure to industrials companies that have already been hit by the chip shortage or those that require metals or chemicals as a core part of their operations. Hospitality and aviation, two people-heavy sectors, have also had difficulty fully rebounding as labor costs rise.

Citizens Bank data shows that executives still expect to see valuations rise in consumer (43%), industrials (31%), and transportation and logistics (21%), but getting the price right will be tricky. There is now more scrutiny on balance sheets as the market tries to understand where future growth will come from.

“Supply chain problems have shown up in places a lot of people didn’t necessarily expect,” explains Thomas McConnell, a managing director at Capstone Partners. “The chip shortage has hit a lot of different industries and so you’re seeing big delays in product delivery, which impacts revenue.”

Private equity firm Platinum Equity, for example, recently secured a new financing arrangement for one of its portfolio companies, aerospace supplier Incora. The company has been hard hit by the abrupt changes in demand for airplanes and the inability to easily get parts. In that deal, Platinum was able to get a fresh cash infusion for the company by swapping bonds that were due in 2024 for longer dated issuance. But, according to Bloomberg, it only happened through an aggressive practice known as “priming,” which puts some creditors ahead of others outside of the original terms of a deal. Either way, Platinum has insulated its position at least for the near term, but if

Incora’s fortunes don’t improve soon, it could be difficult for the company to find an exit strategy.

In hospitality, there has been some effort to buy up smaller hotels that have seen a significant drop in revenues over the past two years. Banyan Investment Group raised a $20 million fund at the end of last year to do just that. These transactions often happen at significant discounts, while many of the properties haven’t had consistent investment over the past two years and also cut back on housekeeping and staff. Investors are looking for hotels that can be fixed up reasonably cheaply, have a decent enough growth story as travel resumes, or that could be acquisition targets for strategic buyers.

Banyan recently sold a Kimpton-branded hotel in the Fort Lauderdale, Florida, area for $4 million less than the price it paid for the property in 2020. The hotel was purchased by DiamondRock Hospitality Co., a publicly traded REIT that includes 33 hotels and resorts. DiamondRock owns several other properties throughout the South Florida area. Despite operating at a loss last year, DiamondRock is still doing deals and says it anticipates that travel will steadily return over the near term and is banking on popular destinations like Fort Lauderdale or Destin.

Still, rising labor costs and changes in consumer sentiment could put the brakes on already discounted deals.

Todd McMahon, head of investment banking at Capstone Partners, says the challenges faced by companies like these aren’t insurmountable, but it could take longer to get a deal done. “If a deal is priced to perfection, sponsors start taking a closer look at what’s going on with product delivery and how much labor costs are going to go up. When those become long-term problems, you start seeing impacts to working capital, revenue and profit-

ability. That can limit what a buyer can do when it comes to operational efficiencies or business strategy. Sponsors largely still think the impact is going to be temporary from what we’re seeing, but you could see deals slow down if it starts to look like an ongoing problem.”

Looking ahead, 2022 could prove to be a Rorschach test for the market, even if deal activity remains elevated. So far, private markets have been able to skate around the big macro narratives impacting public companies. Yes, costs are up, but balance sheets are strong and sponsors are still willing to pay ever increasing multiples because they have money to put to work. //

Supply chain problems have shown up in places a lot of people didn’t necessarily expect. The chip shortage has hit a lot of different industries and so you’re seeing big delays in product delivery, which impacts revenue.

THOMAS MCCONNELL Managing Director, Capstone Partners

BAILEY MCCANN is a business writer and author based in New York.