by Don Bravaldo.

Published by the Current Accounts Magazine by the Georgia Society of CPAs (May/June 2022 Issue) and the the Andersen Alumni Association's October 2023 Vol.15 No.3 Newsletter

The late Karl Otto Pohl (1929-2014) a former president of the German central bank famously said in 1980, “Inflation is like toothpaste, once it’s out, you can hardly get it back in again. So, the best thing is not to squeeze too hard on the tube”. It certainly feels as though there has been a Tiger Woods-style , strong grip applied to the toothpaste lately when it comes to the current U.S. inflation surge.

Whether the cause was COVID or a variant thereof, the lockdown and re-opening of the economy, supply chain disruptions, excessive government stimulus, or the failure of economic models and a dramatic increase in the money supply, the fact is that nearly everyone—from the Fed to economic forecasters—got it wrong.  

Even if one has yet to return to pre-pandemic spending on large consumer items or travel, we’ve all been to a grocery store and seen the impact on the shelves, with the consumer price index up 8.3 percent in April, on the heels of dramatic increases in February and March (7.9 percent and 8.5 percent, respectively). 

To quote Milton Friedman’s iconic observation, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Inflation makes it harder for businesses to create value. What are the specific factors affecting value, valuation and M&A in mid-2022?

Top of the Cycle

The U.S. economy is at the peak of an M&A cycle in terms of deal activity and record-high valuations. Last year was historic, with $2.9 trillion in M&A transactions, up 55 percent from 2020. Prior to the surge in inflation and Russia’s invasion of Ukraine, market watchers expected domestic activity could eclipse 2021 levels. At this unique, if unexpected juncture, we see four broad drivers influencing valuation. 

The first is multiple compression, the risk of sinking private company valuation multiples. Within private company M&A, the single biggest ratio and resulting multiple is the EBITDA (earnings before interest, taxes, depreciation and amortization) multiple. It is computed as the enterprise value of the private company, divided by EBITDA. As acquirers become wary of a private company’s growth and profitability prospects, they will expect a higher return on their investment, which can only come in the form of a reduced valuation. The negative fallout on profitability can occur from a variety of internal or external forces. For the purposes of this article, the focus is on inflation.  

Many businesses are currently taking advantage of opportunities to grow their top line. Sales and revenue are up, yet despite significant effort and will, the bottom line remains stagnant. While these companies have grown, profitability has in many cases not increased, causing a potential reduction in valuation—multiple compression at work.

The rising cost of borrowing is a second significant driver of acquisition and, in turn, valuation. As most investors expected, the Fed raised short-term interest rates a half percentage point (50 basis points) in mid-May, leaving the range for the federal funds rate at 0.75 – 1.00%. The rate hike was the largest at any one time since May 2000.

Brian Wesbury, chief economist for First Trust Advisors LLC, notes in a recent blog post that at least two more 50 bp hikes are likely to result from meetings scheduled for June and July. Many observers say they expect fed funds rates to climb to near 1.9 percent by the end of 2022. 

That said, the cost of borrowing remains relatively low, an important consideration for both the buy and sell sides. If rates rise excessively, investors will have to contribute significantly larger amounts of equity, making it difficult to generate the kind of return commensurate with the risk of buying a lower middle market-sized company. When buyers find themselves unwilling to pay a higher cost for capital, the only variable remains reducing the valuation offered. 

The flood of capital seeking acquisitions is another factor in the current M&A market frenzy and rise in private company valuations. In 2020, the U.S. private equity sector comprised approximately 4,500 PE firms and 16,000 PE-backed companies. This oversupply of capital and buyers is a big plus for those selling businesses and, to date, shows no sign of retreat. It is, however, important to consider how the situation arose, as some of the same underlying factors contributing to inflation have also fueled the growth in PE. One possible consideration is that, as a result of the long period of abnormally reduced rates, money has poured into PE funds seeking higher returns on capital than could be provided from public market investments such as stocks and bonds. 

Despite the upbeat scenario, we are compelled to assess the horizon for possible storm clouds. According to Harvard Business School finance professor Victoria Ivashina, “Interest rates are an important driver of pension funds’ investment in long-term asset classes, and private equity in particular.” 

She notes that the growth of private equity in the past two decades has been driven less by industry performance, and more by the growth of long-term pools of capital, the maturity of the asset class and a declining interest rate environment. This has served to push capital into the industry. 

Some are predicting a slowdown in funds flowing into the private equity asset class. While it will take years to filter through the long-term deployment of invested capital already raised, there is indeed a chance of a slowdown in PE as a driver of lower middle market M&A activity.

The current tax climate is the fourth determinant. Long-term, business owners and wealthy individuals are unlikely to see the kinds of tax rates now in place for quite some time. Though it may be a year or several years down the road, the U.S. will at some point be forced to raise rates to neutralize spending, balance the budget and contain and service the existing national debt. 

Challenges Persist

Momentum to keep the market hot and valuations high looks to be sustainable for much of this year. That being said, however, investors will need to strategically plan their moves, with mindful timing to avoid missing opportunities and running afoul of unfavorable changes in tax and interest rates. 

Another concern is that, while many business owners are seeing signs of growth, such as increased sales and a robust pipeline, they may fail to react quickly enough to rising input costs, labor, etc. Unless the business owner and management team are aggressive in raising prices, the effect will be reduced profitability and an inevitable erosion of valuation. 

Starting in March 2021, a year into the pandemic, the U.S. economy has experienced rapid increases in inflation affecting businesses and consumers.  According to the Federal Reserve, direct fiscal support in the form of government stimulus during COVID-19 contributed to the rapid rise in inflation, which remains at 40-year highs. Higher wages, energy costs, housing prices and a strong stock market have also played a role. While in mid-2021 the Fed deemed inflation transitory, imbalances between supply and demand across the U.S. economy will take longer to sort through. As a result, inflation will remain the primary threat to the economy in 2022.

In addition to higher wage costs, businesses continue to face an historic labor shortage. The U.S. unemployment rate is near a 20-year low at 3.6%, with more than 10 million private sector job openings unfilled, and approximately 0.5 unemployed persons available per job opening. The labor shortage is a momentous issue for the U.S. economy and, among other fallout, has spurred corporate and financial buyer acquisition of automation.

Manufacturing businesses have been hit doubly, as they have also been affected by supply chain shocks. Diligence will be required to overcome input shortages and the increased costs of logistics. The sourcing of alternative suppliers is under way, and many are re-shoring or near-shoring as they move their supply chains closer to home. With transportation costs and input shortages expected to soften toward the end of the year, manufacturers may find some limited relief as they seek to enhance their profitability before attempting a sale.

Proceed with Caution

Successful business owners anticipate generating a sale event that will provide liquidity to fund a comfortable, even luxurious retirement. Why sell now, the thinking goes, if M&A market valuations have been trending higher for years and their business continues to grow? Five years from now, they conclude, they will be able to sell for significantly more. However, like stock market investors who believe a bull market will endure forever, these owners are blind to the potential of fast-moving, unexpected market turns that could upend that future, successful sale. Waiting too long is a risky strategy. 

The M&A market is expected to remain healthy, even robust, for quite some time. But when it turns, we anticipate it will turn quickly. Historically, recessions are blamed on jolts from black swan events like the housing market crash during the great recession. If, for example, the tragic war in Ukraine escalated into a broader conflict, the effect on public markets could be significant, dampening or even halting M&A opportunities for private businesses. 

Public company valuations are significant drivers of private company valuations, serving as another major valuation guide for buyers. Public markets also fuel capital formation, some earmarked for M&A. As access to public market capital formation halts or tightens, so goes the private company M&A market.

Stay Profitable, Stay the Course

In view of these influences, how can business owners stay nimble and, to the degree possible, remain prepared for a near-term or future sale? Advance planning is the key. The approach we recommend emphasizes best practices, and exit planning and preparation steps including the following:

·      Evaluate your management team and identify key employees for a succession plan. Hire or outsource and fill material gaps existing in your management team.

·      Understand your company’s value. Document historical performance, key performance indicators and future performance through annual budgeting and forecasting.

·      Focus on cash flow optimization, effectively managing capital expenditures on a periodic and scheduled basis, while guiding working capital to average or better-than-average industry benchmarks. 

·      Consider M&A transaction execution risk by mitigating buyer and seller transfer hazards through customer diversification and ensuring that customer experience and operational procedures are readily transferable to a buyer.

We also advise a cautious approach to unsolicited inquiries by competitors, PE investors and strategic buyers. While it is flattering to hear how attractive your business is, a single buyer’s interest is not what M&A success is all about. Sellers are best served by bringing in an advisor who can present multiple offers and manage the process with an eye to the best valuation, and, ultimately, the best deal.