2021 was a significant year for business owners who chose to exit via a sale of their privately held businesses. The government’s response to the COVID-19 pandemic pumped billions of dollars into the economy, helping to drive a robust mergers and acquisitions market led by aging baby boomers preparing to retire and concerned about the prospect that the Biden administration was potentially eliminating the favorable capital gains tax. This article is written to provide an exit planning market update following this historic M&A cycle against some economic headwinds and challenges in today’s market. The article focuses on five issues that are intended to help business owners and exit planners/consultants build perspective on where the exit planning marketplace stands as of August 2022.
2021 was a significant year for business owners who chose to exit via a sale of their privately held businesses. The government’s response to the COVID-19 pandemic pumped billions of dollars into the economy, helping to drive a robust mergers and acquisitions market led by aging baby boomers preparing to retire and concerned about the prospect that the Biden administration was potentially eliminating the favorable capital gains tax. This article is written to provide an exit planning market update following this historic M&A cycle against some economic headwinds and challenges in today’s market. The focus is on five issues that are intended to help business owners and exit planners/consultants build perspective on where the exit planning marketplace stands as of August 2022, including:
We take each of these items in order and present current market survey data from several sources. For members of the International Exit Planning Association (IEPA), there is also a recorded panel discussion including partners in leading private equity groups (recorded July 19, 2022) that amplifies many of these points and adds context to the overall article.
I. Buyer Interest Remains Strong but More Selective
The 2021 M&A super cycle for business sale transactions was created by a ‘perfect storm’ of events following the global pandemic in 2020. Government stimulation, the sentiment of the great resignation impacting business owners, the aging of baby boomer owners, and the threat of the elimination of capital gains taxes by the Biden Administration created an unprecedented level of business exit activity throughout 2021. This activity was accompanied by record high levels of valuations and prices being paid for businesses.
Naturally, some of the factors impacting valuations today are the economic slide in the 2nd quarter of 2022 caused by concerns over inflation which may create a recession, leading to a drop in stock market values, rising interest rates, and continued concern over global impacts from the war in Ukraine. There are also persistent supply chain and labor issues creating cost/expense challenges to the analysis and forecast of virtually any business today.
As of August 2022, following the record activity in 2021, the outlook on multiples/valuations going forward has leveled off, with a majority of investors projecting a slight drop in company valuations when comparing 2021 actual prices paid versus a forecast for 2022 transactions. What this likely means for many business owners is that while the robust nature of high valuations in 2021 has subsided, the overall buying activity and buyer interest has not reduced. That said, buyers are becoming a bit more selective. The remaining points in this article help provide perspective on what issues buyers consider important in today’s market and, therefore, some guidance as to how and why valuations are, overall, trending lower.
II. There Remains a Strong Market for Strong Companies
In virtually any market conditions, strong companies will trade. Strong companies can be characterized as those with increasing revenues, high profit margins, solid management/leadership teams, steady/recurring revenue, solid financials, good operations, and a forecast for growth that is supported by the leadership team. That said, when market conditions are great, opportunities for some lower quality companies to trade also exist. So, while today’s market is strong for solid companies, recent data shows an increase in selectivity amongst buyers. The average deal that closed in the first half of 2022 is showing stronger growth, higher EBITDA, and better margins relative to last year, and when compared to peer groups.
As a part of the increased selectivity amongst investors, 2021 witnessed a dynamic whereby the top tier businesses were coming to market providing investors/buyers with a lot of quality deals to choose from. This marketplace activity also crowded out less desirable businesses that may not have received much attention when compared to the strength of businesses being brought to market in 2021. By contrast, 2022 is showing a sustained pace in the quantity of deal flow but the overall quality of businesses has dropped when compared to 2021.
Unprecedented demand for advisory services in 2021 was a contributing factor to the market dynamic whereby larger, higher quality deals crowded out other opportunities. Even as intermediaries/investment bankers reached capacity, companies continued seeking advisors, creating a bandwidth constriction that kept some players out of the market. This paved the way for a robust first half of 2022 as companies that had been forced to wait returned to the market.
While the volume of companies being brought to market is high, it is the solid businesses that are getting the most attention. Some of the observations below explain some of the diligence and criteria that buyers are using in being more selective.
Observation #1: COVID-19 ‘Pop’ Does Not a Marketable TTM Make
Most companies are valued based on Trailing 12 Month (TTM) EBITDA (cash flow) figures. In today’s market, investors are taking a hard look at any ‘COVID-19 pop’ in the business, to determine if improved revenue and EBITDA is sustainable and under writable. What this means is that buyers/investors are taking a hard look at a number of items that may have simply been more acceptable risks in 2021.
As part of being more selective, investors are more carefully scrutinizing the sustainability of earnings of a business, particularly as the forecasts are dependent upon—and built off of—financial performance that included an increase because of factors relating to COVID-19. A large component of this additional diligence is the fact that many businesses experienced a ‘COVID-19 pop’, which was the pent-up spending and demand that did not happen in 2020 because of the global pandemic and consequent economic shut down. Investors are asking many questions about whether the level of demand that any company experienced in 2021 is sustainable going forward. Part of this analysis also includes the impact to a company from the injection of equity through the forgivable loans of the Payroll Protection Plan.
Exit planning advisors and business owners can take from this commentary that if a business owner’s company had a strong 2021, and continues to have a strong financial performance in 2022, it should not be assumed that the company will necessarily trade off of these higher profit levels. Rather, a portion of the analysis that needs to be made in order to defend the higher levels of profitability goes to the underlying sources of demand and innovation that support a forecast to show sustained support for that level of business activity going forward.
For example, a facilities maintenance company serving commercial real estate properties may have had both a ‘COVID-19 pop’ from pent up demand for cleaner work environments following the shut-downs and underutilization of commercial properties. In addition, these businesses may have also had an increase in special cleaning services related to concerns over the COVID-19 virus. Both of these factors may not necessarily continue into the future at the levels seen in 2021. In this case, the ‘COVID-19 pop’ may be presenting a higher-than-historical profitability for the business, but, if that level of profitability is not sustainable, then the value of that business may not necessarily be based on the current level of earnings. Investors are doing more diligence on these issues and looking for greater support for the longer-term implications and sustainability of these activities. This is a shift from 2021 when investors were forced to accept certain assumptions and ‘close into certain risks’ to compete in a highly active market environment.
Observation #2: Labor Availability, Supply Chain, and Overall Cost Issues
Economic and political factors such as interest rate changes and the war in Ukraine are having an impact on businesses, but they are taking a backseat to operational factors, i.e., labor shortages, supply chain challenges, and increased cost of goods.
A recent survey conducted by the Alliance of Mergers and Acquisitions Associates (AM&AA), lists factors that are the largest in current/2022 transactions. While global macro-economic factors are significant contributors to the overall business market environment, respondents indicated that labor shortages, supply chain issues, and cost of goods/raw materials were larger factors impacting the valuation and sale of businesses in 2022. These fundamental operational issues are the granular ones that impact the day-to-day running of the business and it is these issues that are having a greater impact on valuations and transactions than the macro-economic factors.
In analyzing the viability of maximizing value in a sale process, business owners and exit planners/consultants should consider the impact of labor, supply chain, and cost of materials on any business as major items to evaluate and be prepared to explain to any investors/buyers. For example, one of the items that may be significant in this analysis is vendor concentration or where there may be bottlenecks in the supply chain to a company. Investors/buyers are scrutinizing secondary and tertiary suppliers, valuing redundancies in ways that were not as prevalent a few years ago. Another example is to look at the level of inventories that companies are holding, driving up the cost of raw materials to be able to continue to service customers. Buyers will be looking for candid answers as to how long lower margins may persist without necessarily defaulting to 2019 levels without significant explanation.
On the labor front, buyers are recognizing that, with the great resignation, people may simply not exist to fill roles that exist on a ‘future organizational chart’ that plots the path to future growth. Of course, in a tight labor market like we have today, there are too many job openings for skilled labor and not enough qualified candidates to fill them. In fact, in some parts of the country, labor is not even available. And, if that labor is available, investors are asking how much more it will cost in wages and benefits to attract and retain this talent. To position a company for maximum value in today’s market, it may make sense for an exiting owner to think through how to reduce the dependency on human capital with potential technology enablement that can work to reduce the need for man hours.
Observation #3: Inflation and Rising Interest Rates are NOT the Dominant Issue Today
It is easy to have concerns that increased interest rates (due to rising inflation) will cause the value of a company to be lower. However, for businesses with cash flow/EBITDA of approximately $2mm to $10mm (i.e., the ‘lower middle market’), the impact of interest rate hikes is blunted at this end of the market because of the lower use of debt to complete these transactions. However, as banks trend towards pull back on their willingness to lend, pricing may be impacted across the board.
It has been more than 40 years since inflation has been as prevalent as it is today, so the operating environment will present some challenges in the short-term and perhaps in the mid-term. Business operators need to think through the implications of inflation in a way that is, in most cases, the first time they are doing so in their working career. Therefore, similar to many of the items discussed so far in this article regarding market factors impacting valuations, having solid answers and projections for the impact of inflation on a business is a critical operational component of analyzing a business, but it will likely be less of an issue relating to the pricing of a transaction from a deal structuring perspective.
In fact, the larger transactions will feel the impact of higher interest rates much more significantly. However, for businesses valued between $10mm and $100mm, the impact of higher interest rates is less significant and should not serve as a significant deterrent to a business owner seeking a partial or full exit. The reason that this is true is because there is less debt capacity, overall in ‘smaller’ transactions where there tends not to be a lot of leverage.
While the ‘lower middle market’ may be less impacted by increased interest rates, there may be a larger impact if lenders become less willing to deploy their debt capital. If this happens, investors may be less concerned about the cost of the debt and more about the availability of that debt to support certain transactions which would likely drive overall valuations lower.
III. Opportunities Exist in the Form of Varying Types of Transaction Options
Moving to our third major point of this article, we want to address the exit and transaction options that may be available to business owners who are thinking about an exit. All too often business owners think that an exit transaction is a ‘binary’ proposition; meaning that the owner will either be ‘all in’ or ‘out of the business’. Rather, today’s marketplace has an assortment of transaction options that are being presented against the backdrop of the opportunities and challenges in today’s marketplace to let business owners know that the decision to begin planning for an exit does not need to wait until that business owner is entirely ready to stop working. Additionally, the marketplace of buyers is very creative in addressing the exit goals of owners and structuring partnerships and deal structures in a way that allow professional capital to access quality, private businesses that are also aligned with an owners’ goals.
In short, a business exit does not have to be an all-or-nothing proposition. For example, a recapitalization transaction allows an owner to have a growth-oriented partner while that owner retains a portion of equity. Simply put, a growth-oriented partner that has a proven track record of growing business value, may be the ideal partner for a business owner to take chips off the table without completely retiring, and still have that owner retain a slice of a potentially much bigger pie as the company value grows.
While some business owners in today’s environment are ready to ‘exit’ (many of whom are baby boomers), the reality is many more enjoy working in their businesses and are not ready to stop working and retire. IEPA survey data shows an overall increase in the last few years of business owners’ mental readiness for an exit. Recapitalization transactions are suitable (perhaps preferable) to an owner with a ‘low mental readiness’ for an exit because that owner does not want to stop working (or participating in the upside equity value of the business) but would like to take some chips off the table through a liquidity event but still stay on in their role in the business.
Private equity groups today are actively seeking out these types of transactions/partnerships. And, given the market changes and challenges, a recapitalization transaction demonstrates to private equity group investors that the business owner believes in the future of the company and is willing to share the risk. The evidence of a business owner willing to share the risk in the future is the opportunity for a business owner to reinvest millions of dollars of equity value in the business with a new partner.
Survey data shows that roll-over equity continues to be a large component of private equity group transactions. Exit planners and business owners should consider this preferred form of transacting against the landscape of the changes that are happening in the marketplace. This is particularly true if a business owner wants a partner to assist with (and share the risk with) the issues that we identified already, namely, competing in a war for talent and navigating supply chain and inventory expense issues that appear to be remaining for the short-term. Business owners who are tired, but not ready to retire, may find that a partnership of this kind provides the ideal scenario for a gradual, full exit from the business.
By contrast, for the business owner who simply wants out entirely and does not have a large management team (or maybe lost a few key managers in todays’ war for talent), there is a very active market for add-ons to platform companies owned by private equity. In short, platform deals typically begin at $2mm in EBITDA and higher. Lower than $2mm in EBITDA are typically add-on transactions. Business owners who are thinking about selling entirely and not taking on a partner can consider the fact that add-on acquisitions are still very vibrant and another viable transaction opportunity that may be more aligned with that owners’ goals.
In summary, if a business owner or exit planner believes that the marketplace is trending more towards a weaker market than a stronger market, it is helpful to remember that exiting a business is not a binary concept; that there are many ways to structure a transaction to allow a business owner to accept capital and a partnership, while diversifying themselves personally but still remaining active and relevant in the business.
IV. Business Owner Sentiment and Market Timing Suggest a Steady Pace of Continued Owner Exits into the Foreseeable Future
Historically, there have been forces that impact particular industries. In the recent past, however, we are seeing headwinds and tailwinds that impact ALL owner’s personal health, financial security, and age of the business owner.
There is a trend of pragmatism in recent survey data that indicate that business owner sentiment around exit planning has shifted from reactionary to proactive. In 2021, business owners largely reacted to the prospect that the potential taxes on their sale would double if President Biden succeeded in eliminating the preferential capital gains tax rate. In 2022, the activity of sellers are becoming more proactive than reactive. Survey data suggests that business owners are giving more and more consideration to not only their age, but also to factors such as personal diversification and wealth preservation in considering how to navigate todays’ challenging economic environment.
Baby boomer owners were reminded through COVID-19 that their businesses are fragile and value can go away quickly. Data suggests the business owners are now thinking more practically about their overall wealth planning in the context of their illiquid business wealth.
What exit planners and business owners can take from this marketplace statistic is the fact that there will continue to be a steady stream of owners who are looking for an exit. However, what should also be factored into these considerations is the overall timing and whether or not a protracted recession could remove the opportunity not only to exit a business in the near-term, but perhaps to be able to exit that business for a number of years. Today’s marketplace is strong even if it is trending towards being more selective. Owners and exit planners should consider these factors as part of the overall exit planning and decision-making process.
V. Exit Planning Continues to be the Difference-Maker for Successful External Exits
This article was written to provide perspective and insight in a time of heightened uncertainty in the U.S. and globally. Deciding when and how to exit a business is a complex process that most business owners are ill-prepared to handle alone. While it is difficult to time the market for an exit, is it less difficult to be prepared. And survey data and empirical evidence show that owners who are better prepared are able to more successfully execute an exit either via a sale (or partnership with) a third party or for to complete an internal transaction with managers and/or family members.
At the IEPA, we have long held the belief that it is never too early for business owners to begin planning for how and when they will exit their privately-held company. The IEPA trains, certifies, and supports your professional advisors in helping you with this complex task. If you actively engage to become more knowledgeable and aware, you will increase your chances of success. For most business owners, the exit from their business is the largest financial and emotional transaction of their lives, with far-reaching implications for many stakeholders to your business.
This article features changes in the marketplace that may or may not impact the success of your future business exit. In summary, despite rising interest rates and a possible recession, the market is still very active. That said, there are many headwinds developing that are slowing down the torrent pace of exits that occurred in 2021. Because we are in uncharted waters with the pandemic, the trillions of dollars in government spending in the last few years, and international upheaval, it is hard to say with certainty where the economy is heading. What can be said is that historical cycles have been long in the economic and M&A market, so business owners are encouraged to answer this question in contemplating what to do next: “Do you want to sit on the sidelines for many years while the cycle plays out, or are you ready to take action in the near-term?” We close this article with this question because it goes to the heart of what you do next that could make a significant difference in the outcome that not only you experience with your exit, but also what happens to your overall wealth and your business.
We hope that you found the information in this article helpful to thinking about today’s market environment and what is available for you to assist with any exit decisions that may be pending.
John M. Leonetti, Esq., M.S. Finance, CM&AA, and a Certified Business Exit Consultant®, is the founder and CEO of the International Exit Planning Association. He is a nationally recognized leader in the exit planning field and has been interviewed on ABC News Now, NECN, and numerous national radio programs, including being quoted in the Wall Street Journal on a number of occasions. In addition, Mr. Leonetti is the author of the highly publicized book Exiting Your Business, Protecting Your Wealth: A Strategic Guide for Owners and their Advisors. His book has been the hot topic for many national industry and business owner publications. The IEPA also offers the Certified Business Exit Consultant® professional designation program for advisors who want to assist business owners with their exit planning.
Mr. Leonetti may be contacted at (781) 821-2608 or by e-mail to firstname.lastname@example.org.