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December 11, 2023

Deals & Co.: Navigating the Ripple Effect of Merger & Acquisition Trends in 2023

Deals & Co.: Navigating the Ripple Effect of Merger & Acquisition Trends in 2023
  • Broader merger & acquisition (“M&A") activities in 2023 face headwinds with a decline in volumes, reaching $575 billion in Q1 from $1.1 trillion in the same period in 2022, attributed to recession fears, inflation, and market volatility.
  • Distressed M&A surges as companies, grappling with economic challenges, opt for restructuring through divestment, anticipating a persistent trend amid low growth, a looming recession, and supply chain disruptions.
  • Cash-rich companies strategically leverage their financial strength, gaining a competitive advantage in acquiring strategic assets, particularly in the resilient middle market, where they deploy cash for strategic acquisitions.
  • The middle market remains a hotbed of M&A activity in 2023, resilient against a larger market slowdown, as cash-rich funds capitalize on reduced valuations and nimble entrepreneurial companies outperform larger counterparts.
  • Independent sponsors emerge as a compelling alternative, attracting attention for their flexibility, agility, and diverse deal sourcing, with an anticipated increase in investor allocations to independent sponsor transactions.
 
Broader M&A Market Trends

The broader M&A market is experiencing a notable decline, with recession and inflation fears contributing to a challenging financial environment. In the first quarter of 2023 alone, M&A volumes plummeted to $575 billion, down from $1.1 trillion in Q1 of 2022. The Federal Reserve's decision to raise interest rates further deterred borrowing and investment, impacting M&A volumes significantly. Market volatility, particularly visible in the financial sector, contributed to uncertainty among investors and dealmakers.

Distressed Deals on the Rise: Against the backdrop of economic challenges, 2023 has seen a surge in distressed M&A activity. Grappling with revenue challenges and debt repayment struggles, companies are opting for restructuring through divestment as a viable path forward. Experts predict this trend will persist due to low growth, a looming recession, and ongoing supply chain disruptions. Zombie companies, which managed to barely stay afloat by repeatedly refinancing at lower rates throughout the 2010s, are likely to face a reckoning when their next round of promissory notes comes due. Refinancing won't be an option, as they can scarcely meet payments even at current lower rates.

Buyers are drawn to these transactions due to the exceptional opportunities they offer, recognizing the potential value in acquiring distressed assets amid less competitive traditional M&A processes. Conversely, contending with financial distress or the looming threat of insolvency, sellers find appeal in the prospect of divestment and restructuring as a viable path forward.

However, these transactions pose challenges for buyers. Distressed deals often adopt an "as is, where is" nature, providing minimal time for due diligence and resulting in escalated costs as buyers navigate critical issues and material risks.

Despite these hurdles, the allure of distressed deals lies in their potential value, ultimately making them worthwhile for both buyers and sellers.

Competitive Advantage for Cash-Rich Companies: In the prevailing market conditions, companies with deep capital reserves have gained a competitive advantage. These cash-rich firms have leveraged their financial strength to execute strategic acquisitions, capitalizing on reduced valuations to secure a strategic advantage within their sector. This has spurred significant growth in the middle market space, where bigger, cash-rich funds have taken advantage of lower valuations to purchase bolt-on companies to principal investments.

The Middle Market Stays Hot: In the face of higher interest rates and a slowdown in GDP growth impacting M&A at the corporate finance summit, an intriguing trend emerges—the resilient surge in middle market activity throughout 2023. Despite an overall slowdown in large-cap M&A, the middle market, comprised of companies with valuations in the eight and nine figures, remains a beacon of consistent M&A activity. The unique advantages of cash-rich funds and companies in navigating a high-rate environment are underscored as they strategically position themselves in the middle market space, capitalizing on the ease of underwriting smaller businesses with lower leverage requirements and more recession-resistant cash flows. As larger transactions face constraints due to rising rates and funding challenges, the lower middle market transactions are thriving, requiring less total financing and offering increased flexibility in adjusting equity-to-debt ratios.

In this landscape, nimble entrepreneurial companies are proving their resilience, given their agility, fewer legal regulations, and historic track record of outperforming larger counterparts in the face of economic challenges. As investors and entrepreneurs navigate this dynamic middle market, the key lies in strategic agility, efficient adaptation, and keen understanding of the sectors experiencing the most robust M&A activity.

Independent Sponsors in 2023: Independent sponsors continue to attract attention as a compelling alternative to conventional private equity funds. The model offers flexibility, agility, direct involvement, and diverse deal sourcing, making it an attractive proposition for investors seeking tailored investment strategies and swift decision-making processes. As a result, investor allocations to independent sponsor transactions are expected to increase further. The market deal terms are evolving, reflecting the sector's ongoing maturation and integration into the broader M&A landscape.