Interest Rates and a Banking Crisis Bolsters Lower-Middle-Market M&A

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It has been one year since The Federal Reserve began raising interest rates, 500 basis points to date, in hopes to taper inflation, but it has only been a few weeks since two regional banks (Silicon Valley Bank and Signature Bank) have collapsed, and a rapid acquisition of a third (Credit Suisse) took place. The increase in lending cost from the Fed raises, the economic uncertainty of a pending recession and high inflation, and the instability in the banking system would ordinarily suggest M&A buyers and their lenders would pause and only make the most selective transactions. However, this posture may not apply the same across M&A bulge, middle, and lower middle markets.

Just as we’ve seen the public do in the traditional “bank run” on SVB and Signature, we may see a flight to quality in the current M&A markets, or perhaps better said, “a flight to safety and certainty.” Larger transactions not only require more total leverage, but often groups of lenders to cooperate to fund a transaction. Lower-middle-market transactions, by definition, require less total financing and typically only one willing lender. Often lower-middle-market transactions are easier to “understand” as buyers and lenders underwrite risk. Additionally, buyers can more easily consider increasing the equity-to-debt ratio of transactions, reserving the option to refinance in the future when rates are reduced (and most believe the Fed’s plan is to do so).

Meanwhile, Private Equity dry powder remains at an all-time high. According to S&P Global Private Equity dry powder measured nearly $2.0 trillion at the end 2022. This capital stands ready to deploy, and buyers are likely to move into the lower middle market, particularly as they continue to bolt-on acquisitions of existing platforms, which by nature carry less risk given the expertise and synergies that exist with the platform company. As mentioned above, buyers at smaller transaction sizes can consider writing larger equity checks to mitigate impact on higher rates, particularly to secure quality assets at nominal valuations.

We believe the current economic environment will drive a disproportionate share of M&A activity toward the lower middle market, providing a compelling avenue for business owners to de-risk themselves and enjoy the rewards of their efforts.

If you are considering selling a portion of your business, let’s have a chat about your options in today’s economic climate.