As we near the end of the fourth quarter of 2024, the middle market M&A landscape feels unfulfilled, as if it already had one foot out the door before the year started. While the year started off with great promise of deals and M&A activity matching an Eddie Van Halen guitar lick—full of energy, intense solos (a couple large deals), a few surprising twists and a lot of sizzle; the rest of the year proved to be a lot like Van Halen sans David Lee Roth—a lot of promise with unmet expectations (sorry for any Van Hagar fans but I am a VH originalist—it’s DLR or no one). Now before any of you hardcore Van Hagar fans start to assail my taste, let me tell you why this year (at least thus far) can’t be love; but why love will (likely) come walking in, in 2025.
So This is Love…
Enthusiasm Rebounds; Deal Volume Rumored to Follow
After a cautious first half of the year, middle-market activity took a “jump” forward with sector specific activity (e.g., two such sectors: healthcare and quick service restaurants (fast food joints)).[1] Moreover, investment bankers I’ve spoken with have indicated that their pipeline, which has been modestly robust, has finally started to move towards LOI stage; with indications of interest and/or real interest (as opposed to tire kicking) picking up.[2]
The numbers also prove that deal flow has increased, as private equity deal activity reached $309.8 billion during the first half of 2024, a 24.1% increase from the same period in 2023.[3] However, digging through those numbers, much of the activity was in the upper echelon of private equity funds with deal sizes in the billions. The percentage increase year over year (2024/2023) is positive, but 2023 was one of the worst deal markets in modern deal making history.
Nonetheless, as I wrote recently, one of the (anecdotal) indicators as to how you know sentiment is changing is reflected by how many people attend industry sector events.[4] Here is my “man on the street” reporting: I spoke at and participated in an event that was fully attended by both capital providers, private equity and independent sponsors and everyone is ready to deal (Monty Hall would be proud). This is a good sign; albeit only one-half of the bid/ask equation—the other half, the “sellers” were absent—likely grinding to increase valuation.
And therein lies the rub. The bid-ask spread is still steep and what we need to see happen is valuation stabilization, which likely isn’t going to happen without a catalyst event (transactions in the upper middle or 1bn dollar and up space) or the beginning of the 2025 golf season—when sellers are once again reminded by their buddy who sold his company for 20x trailing EBITDA in 2022 right before teeing off on hole #2 (people don’t discuss that stuff on #1 because everyone is laser focused on #1 to avoid the dreaded first tee shanks).
The catalysts? Other than sentiment, the drivers for deal flow will likely be lower (or normalized), inflation and neutral to favorable credit conditions. These factors should serve as the perfect foundation for expansion and sustained growth. I am not of the belief that interest rates need to decline for deal activity to heat up; instead, rates need to stabilize, normalize and remain constant so as to avoid buyers saying “I’ll wait” until rates come down to take on cheaper debt.
The foregoing will lead to buyers, like a spandex David Lee Roth high leg kick (with urgency), to engage sellers about exit strategies or capital infusions.
Eruption
Over the last few years private equity has received a lot of attention in its ability to raise and deploy capital in record numbers. Private equity firms have been revving their engines like the iconic opening riff of Panama, aggressively pursuing deals moving farther down through the middle market. With dry powder at record levels (globally, as 2023 dry powder equaled $3.9 trillion globally, and $1.1 trillion in the US), private equity firms shifted gears to accelerate deal activity, focusing on sectors like healthcare, technology, and consumer goods[5].
To that extent, with the amount of dry powder building up, fundraising has been lower than previous years and the reasoning is simple: LPs are telling sponsors, “finish what you started” before you ask for seconds. Therefore, relying on my knowledge of human behavior (my 51 trips around the sun has taught me a few things), it is my belief that private equity will start harvesting deals (i.e., looking to sell portfolio companies), thereby creating an equal force reaction on the buy side which will cause a deployment of capital and deals will start to run (not with the devil) sometime in Q4 but more likely Q1 of 2025. (By the way, shameless plug for independent sponsors: smaller endowments and family offices have turned to independent sponsors in greater numbers over the last few years out of desire to direct invest in transactions, more transparency into platforms AND a shorter runway for return of capital. If you want to learn more about independent sponsors sign up for the Earnout Magazine Summit in January of 2025 in Miami).
Want more evidence of the foregoing? According to Bloomberg Law, for the first time since 2020, and for just the second time in the last five years, there was a Q2-to-Q3 increase in global M&A deal volumes in 2024.[6] Although, later in the Bloomberg article there is a cautionary statement that M&A will face headwinds through the end of the year; resulting in the absence of the usual Santa Claus end-of-year rally in mergers and acquisitions. I agree with this assertion because one of the reasons deal activity picked up in 2024 was a result of elongated time to close transactions. In other words, many of the deals that have closed this year were hangover deals from 2023.
Further, because of recession uncertainty[7] and interest rate uncertainty (waiting for rates to drop to access better financing terms), the deal pipeline hollowed out throughout the year. Accordingly, at this stage of the deal cycle (at least from what investment bankers are saying), the pipeline is filling and that means Q1 and Q2 of next year should prove to be a stronger deal market than we have seen in a number of years. Also, and this doesn’t affect the middle and lower middle market, but the regulatory environment has been difficult and this has caused multinationals to press the pause button to see how the election unfolds.[8]
Fair Warning
The Fed’s decision to maintain interest rates at current levels continues to be the elephant in the room. And while we await the Federal Reserve (Baroque) parlour dance (minuet anyone?), interest rates remain at a 15 year high. While not a complete dealbreaker, financing middle-market transactions has become a bit more challenging. While many private credit funds have filled this void with capital that is not necessarily overly expensive, for many borrowers, it was all but a mere two years ago that cost of capital was a few hundred basis points and until we move further from that memory, accessing (at least non-lifeline capital) leverage will remain tepid. As a result of the increased cost of debt, reluctance of sellers to lower pricing (and sell side bankers) and the push to deploy dry powder, buyers will increasingly use (i) equity (or equity-like instruments) in a deal (even if that is asking sellers to rollover more equity); and (ii) seek more deal concessions from sellers (especially if valuations remain neutral) by being more creative with financing solutions—e.g., deferred payments, earnouts, and seller notes are becoming more common; dealmakers are finding ways to keep the music playing.
“Right Now” – Timing Is Everything
Alacrity is everything when it comes to a deal market. The urgency and immediacy of the moment—will begin to take place in Q4 2024 and will take hold in 2025 (especially if there is regulatory pullback/relief). Buyers and sellers alike are realizing that the window for getting deals done is now. The convergence of improving economic conditions, normalized business fundamentals and stabilized interest rates means the environment is ripe for action. Dealmakers are starting to sense that if you want to secure quality assets you’d better move quickly and capitalize on synergies, hoping to create the type of long-term value that feels like a guitar solo you never want to end.
[1] Although it was more of a slight skip than a cougar’s leap but deal flow moved. In case you’re wondering: the cougar currently holds the highest jump on record for any mammal according to the Guinness Book of Records, a cougar jumped 23 ft straight up from a standstill. (for fun facts about cougars: https://factanimal.com/cougar/).
[2] Of course (almost) every banker is going to tell you that “things are great” and we are so busy.
[3] To be fair, the deal market was DOA in 2023 so any uptick isn’t saying much or as the late Jim Morrison wrote, I’ve been down so very ***damn long…it looks like up to me.
[7] How many times did someone with a lot of advanced degrees call a forthcoming recession—my favorite was dip and rip—mostly because of it alliteration.
