What About Now for M&A?

Cyrus Chin, Philip A. Dunlap

October 26, 2018

2018: A Great Time to Buy or Sell in the Middle Market

2018 is a great time to be a buyer or seller in the middle market. In the first half of 2018, private equity firms completed nearly 1,400 middle market deals with a value totaling $178 billion, beating 2017’s first half performance. As oil prices have stabilized and companies have found creative ways to control costs, we are seeing greater momentum in the economy. Better cost controls should offset the negative impacts of new tariffs, which will eventually increase the cost of doing business in certain sectors of the market.

However, we have seen steady-to-strong growth in the economy for the past six to eight years—this can’t last forever, right? Are we heading for another recession, and if so, when will it hit? Will rising interest rates do anything to slow down M&A and private equity activity? Our belief is that we are in the late stages of a strong economic cycle, so as a business owner or an investor, if you are thinking of selling or buying in the near future, you should be concerned about when—not if—the markets will slow down.

In the near term (through 2019), the deal-making environment should remain healthy. Middle market deals are experiencing higher than normal valuations— up to 1.5x turns on EBITDA higher than historical averages—primarily due to two factors: (1) private equity firms having “dry powder” that they must invest (or risk having to return to their investors), and (2) strategic investors’ willingness to pay more to promote growth and to capitalize on synergies with target companies.

On the flip side, as interest rates rise, and the Fed has indicated it will continue to raise interest rates over the next 12–18 months, the cost of capital will also rise. As a result, the deal-flow for middle market M&A may slow down as private equity buyers will have less leverage to finance new acquisitions. Additionally, because private equity buyers are increasingly spending more time and energy on due diligence than strategic buyers, the time frame for closing deals coupled with the higher cost of capital could make closing deals with private equity buyers more difficult than for strategic buyers.

Finally, the tariffs companies will be facing as a result of doing business in China in 2019 will likely cause companies in certain industries to have lower EBITDA which would lower the purchase price for deals in those industries. As purchase price decreases, getting deals closed in certain industries will be more difficult for sellers and buyers in the latter part of 2019 and beyond.

While the outlook for middle market M&A activity remains strong for the end of 2018 and 2019, business owners and investors should prepare now for a time in the not too distant future when the economy and prospects for middle market deals will be weaker. Business owners should consider that the near term may be the best time to sell. Potential buyers should likewise consider that while valuations are higher now, the ability to close on deals after 2019 may be significantly more difficult. As a result, all parties in the middle market should look to make good strategic decisions regarding M&A in the next 12–15 months.