Roundtable on Trends in Mergers and Acquisitions - Crain's Chicago Business

From left: Brian Flanagan, John Koenigsknecht and George Thies

As the nation comes down from a historic spike in M&A activity, Crain’s Content Studio asked three market experts to tell us what they’ve observed in recent years, what they’re seeing today and whether they have any predictions for the future.
Brian Flanagan
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Brian Flanagan is a lead managing director within Thompson Flanagan’s Private Equity Practice. In 2021, Thompson Flanagan was acquired by NFP, a leading property and casualty broker, benefits consultant, wealth manager, and retirement plan advisor. Flanagan previously served as president of Thompson Flanagan’s executive liability practice, overseeing management liability, property and casualty, and reps and warranties. Additionally, from 1995 to 2000, he was a senior vice president in Marsh’s FINPRO department in New York City, brokering directors and officers insurance on behalf of financial institution clients.
John Koenigsknecht
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John Koenigsknecht is the chair of Neal Gerber Eisenberg’s Corporate & Securities practice group and co-chair of its cross-border & international practice group. He counsels public and private companies across the United States and regularly acts as U.S. counsel for international clients on complicated corporate transactions, capital market transactions and governance matters. He is also the Global Chair of the Mergers and Acquisition Special Business Team for Interlaw and President of the Board of Directors of CommunityHealth NFP.
George Thies
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George Thies, is a managing director at Riveron with over 15 years of experience in public accounting and transaction services, including leading financial due diligence on over 200 M&A transactions. George has worked with both public and private companies across a variety of industries including food and beverage, manufacturing, distribution, software, professional services, construction and consumer products. He has advised private, corporate, and financial buyers and sellers with buy-side and sell-side due diligence; financial statement analysis; carve-outs / stand-alone analyses; financial modeling and post-closing working capital adjustments.
With high-interest rates and debt being more expensive, do you see the spike in M&A continuing? What kind of pace of transaction activity do you expect for the rest of the year?
John Koenigsknecht: The M&A market in 2021 moved along at a record-setting pace, but with higher interest rates, inflation, global conflict, and supply chain instability, among other issues, M&A activity did slow in the first half of 2022, particularly in the first quarter. While the second half of 2022 is expected to remain relatively strong, particularly when compared to the 2020 market, some experts are pointing toward scenarios in which the M&A market could experience a cool-down for just those reasons. Although there is now increased market uncertainty, many expect activity to remain positive, just not as strong as its recent historic heights. We also anticipate seeing a shift back to more balanced deal terms as it becomes a bit less of a seller-friendly market.
George Thies: Rising interest rates are one of several factors that may bring M&A activity down from all-time highs in 2021. However, 2021 levels were not sustainable over an extended period and while the increasing cost of leverage is likely to have an influence on multiples and moderate deal volume, there is still a lot of dry powder to be deployed, and deals will continue to be completed despite a less favorable interest rate environment.
Brian Flanagan: Refinitiv reported that private equity deal activity is down 25% year-to-date. And the overall market for M&A is down 39% year-to-date. For larger deals, the debt market is very challenging. Many clients have stated that the “debt markets are frozen” as lenders look for more clarity on the state of the economy. For middle-market firms, the higher interest rate environment has not been that big of an impediment. Most middle-market firms continue to plow ahead at a measured pace. We usually see a spike in deal activity at the end of the year. We expect a bit of a pick-up, but nowhere near the pace of 2021.
How are inflation, supply-chain issues and the Russia-Ukraine war influencing deal volume?
Koenigsknecht: Inflation and interest rates have climbed significantly in 2022, and that, put simply, has made capital more expensive. With that said, we have seen that a significant part of the M&A activity continues to be attributable to private equity being active in the market. Looking at the second quarter of 2022, we’ve had about eight consecutive quarters in which deal value has outpaced historic deal-value levels. Sufficient M&A activity exists in the marketplace, and should produce enough turnover for investors to be active for the rest of the year.
Flanagan: Right now, most firms that invest in consumer businesses are taking a very cautious approach with their investments. That said, firms that invest in healthcare, technology and infrastructure seem to be moving forward at a relatively healthy pace. Supply chain issues seem to be abating somewhat, but it has certainly been a challenge for companies to keep up with demand. We are now hearing about companies facing a supply glut as the tightening of monetary policy, and the end of COVID-19 relief, has run out of steam. The Russia-Ukraine conflict seems to be adding anxiety for investors, but I have not heard many claims that it is curbing their dealmaking since most middle market investors are making (predominantly) North American acquisitions.
Are current interest-rate hikes deterring business owners from exiting their businesses?
Koenigsknecht: Divestitures appear to be on the rise, but not in the sense of unveiling an exit strategy. Businesses are divesting marginal assets to create capital to make acquisitions aligned with their long-term objectives. It should also be noted that SPAC activity in the M&A marketplace has declined, in large part due to increased regulatory scrutiny, changes in the use of financial projections by private targets going through de-SPAC transactions, and increased reporting requirements.
Thies: While increasing interest rates are beginning to impact multiples, there is still plenty of buyer demand. However, expectations around valuations may need to be realigned with the current macroeconomic environment for current processes to close. There is always some level of expectation gap between buyers and sellers, but given record multiples in recent history and the impact of rising interest rates on highly leveraged PE deals, there may be a reset needed.
Flanagan: I don’t think so. I would say that investors are much more cautious about the businesses they are investing in because of all the uncertainty in the world. The EBIDTA multiples over the past 10 years continued to increase seemingly every year. The supply of “good” companies has certainly been thin relative to the number of investors willing to invest in those companies. This seems to be the driving force in the EBIDTA multiple expansion. It appears that those multiples have plateaued in the past few months as investors reevaluate their appetite and portfolio. Private equity firms continue to get great treatment in Washington.
What do you think we will need to see in the next six months with the economy for deal activity to continue with confidence?
Thies: Uncertainty in general is a barrier to deal activity, and the more visibility we have into where the economy is headed, the more confidently deals can proceed. Optimally, we would see inflation levels remediate, which would in turn signal a slowdown, and potential reversion, in interest rate hikes that would support strong deal flow.
Flanagan: We will need to see the credit markets continue to be healthy. If they shut down the way we saw in 2008-2010, deal activity will go down dramatically. It would be nice to see the stock market recover as well. Many limited partners are negatively affected by the “denominator effect” when the stock market “corrects” the way it has this year. The denominator effect skews many institutional portfolio allocations. If certain investors want to have 12% of their investments towards illiquid investments and the stock market goes down, they find they have a larger allocation towards private equity than they allocated towards the investment strategy. When the denominator effect kicks in, investors need to shed private equity assets. And, of course, an easing of inflation would be welcomed by all.
After the now legendary “COVID bump” in valuations, have those gains leveled off now or not? And are they accounted for as the normal course of business?
Koenigsknecht: Valuations have come down some from 2021 levels. There’s nothing normal about the economic and societal challenges and transformations businesses have faced over the last few years and the uncertainties they continue to face. But when those valuations come down and stay down, there will be opportunities for greater returns to be discovered. The market and deal terms have adjusted to COVID-19 risks, and many companies have already divested and continue to divest non-core businesses. From a legal perspective, we have already seen the impact of the pandemic flow through the documents, such as in force majeure clauses, but it will be interesting to see how this continues to play out over time in the definitions of material adverse effect and in review by the courts.
Thies: In general, valuations seem to have leveled off or are coming down some from those that came out of the COVID recovery in 2021. With respect to the impact of COVID-19 on the operations and financial results of target companies, there are many factors to consider when evaluating normal course vs. temporary impacts due to pent up demand, federal stimulus, shutdowns, and furloughs, etc. Given the impact of COVID-19 varied greatly across industries, regions, and employee groups, it is necessary to evaluate each individual target and consider pro forma adjustments to normalize historical results on a case-by-case basis.
Flanagan: It appears that valuations certainly peaked in 2021. Many investors are reluctant to overspend given the macroeconomic issues we have discussed. These issues are coupled with sellers not being willing to come down on their price expectations. There seems to be a disconnect between what sellers and buyers feel a business is worth — which is another reason the deal pace has come down this year.
With a cool down in multiples, are we entering a buyer’s market? If yes, what should sellers keep in mind?
Koenigsknecht: It is true that M&A multiples did cool down, but if you look at the second quarter of 2022, they are nearly where they were for the first quarter of 2021. It may take some time before this is widely known or for the market to react. So it may be hasty to say that we are entering a buyer’s market. We are probably looking at a more balanced market, at least in the short term. With that in mind, it could be a mistake to approach transactions too conservatively. M&A investors still have significant capital to be deployed, and those advising them may want to revise their strategies to take advantage of these new opportunities and valuations.
Thies: As both borrowing costs and macroeconomic risks increase there will be less room for error from both buyers and lenders perspectives, which will reinforce the importance of sell-side diligence. It will be imperative to come into a process with clean numbers and avoid surprises to prevent re-trading and dead or stalled deals given there is going to be even greater scrutiny around the financials and less willingness to absorb multiple expansions that could result from findings in the buyer’s diligence process.
Flanagan: We don’t see that multiples have come down much. You might see that more in the public to private space where stocks might look cheap on a relative basis. It is certainly possible for some of the companies that merged with a SPAC to be taken private again as many of those stocks have been punished in the public markets. In this market, buyers see a lot more uncertainty, and most sellers still have not reduced their expectations on what their business is worth.
What are the best areas of opportunity for private equity investors right now? Are you seeing particular interest in certain sectors or industries?
Koenigsknecht: Private equity has been and continues to be an important player in the M&A market. Practitioners in the United States know that there is significant capital in the private equity market that can be deployed in the second half of 2022. Although it recently has shown a decrease in volume, the technology sector is still a significant driver when it comes to the percentage of market share, and we’ve seen some of that at our firm. Private equity investors may also begin to focus on areas such as renewable energy, life sciences/health care, or financial services, where there has been some growth in market share and which could continue to heat up.
Thies: While there is a greater level of unpredictability than in recent periods there may be opportunity for PE investors in the form multiples coming back down to more attractive levels. While there is no single set of industries, we see PE investors focused on in aggregate, economic headwinds and increasing borrowing costs will make focused attention on the investment thesis important throughout the transaction cycle from careful diligence, to value creation through synergy capture and effective post-close integration. As a result, PE investors are likely to emphasize industries and sectors where they have existing expertise, platforms that are expanding through roll-up strategies, and where there is opportunity for synergy and supply chain integration across the portfolio.
Flanagan: Healthcare remains very resilient and attractive to many investors. The healthcare sector has proven to be a solid performer even in uncertain times. While we are not seeing as many “platform” investments as we did last year, we are seeing a healthy amount of “add-ons” in this environment as companies look to make strategic smaller acquisitions. While these might not be as sexy as new platforms, they certainly can be very accretive to earnings throughout the ownership of a given company.
Have you seen an increase in due diligence required to complete deals? Other than the QofE, what is the most critical, insightful and necessary part of doing due diligence on a target?
Koenigsknecht: Diligence is critical in any deal, and it is essential to have skilled legal and financial advisors engaged early in the process. It goes directly to deal certainty, risk allocation, valuation/pricing, deal structuring and the expected transition after close. In the current market, there is an increased emphasis on reliable revenue streams of the target going forward. We have noticed purchasers requesting a more granular legal review of revenue-generating contracts and their sensitivity to supply chain disruption issues. In addition, we have seen more focus on retaining key talent at target companies.
Thies: At a high-level, diligence requirements haven’t necessarily increased but there is greater focus on certain factors given the evolving economic conditions. For instance, as target companies are faced with increasing labor and other input costs, it is important to understand the sustainability of historical margins, how effectively rising costs have been passed on to customers and to ensure the financials are reflective of current cost levels on a pro forma basis. In addition to the QofE, it is critical to evaluate net working capital for both purchase agreement related target setting as well as capital requirements. Supply chain issues and rising costs have increased working capital needs and lengthened the cash conversion cycle for many companies. As a result, buyers need to take a close look at the timing of cash flows and assess the impacts of inflation and other business challenges on pro forma net working capital to ensure appropriate financing levels.
Flanagan: For us, there is a high focus on the cost. We have been in a very challenging insurance cycle where premiums have risen for the past two and a half years. Insurance companies are struggling to be profitable given many of the obstacles they face: climate change creating more catastrophic events, inflation driving up the cost of replacing and fixing cars and homes, and the continued complexity and cost of litigation. Luckily for most buyers, the insurance market has started to soften, and prices have started to come down in most lines of business. The big outlier would be for cyber liability insurance, where prices continue to rise with the unprecedented rise of bad actors infiltrating companies’ systems and creating havoc — and claims for underwriters.
What do you think corporations should consider in this deal economy in relation to their M&A strategy?
Koenigsknecht: Current public opinion and investor preferences regarding environmental, social and governance (ESG) are creating new expectations and opportunities for corporations that have strategically planned for these issues. Corporations that are perceived to fit into this category are becoming more attractive investments, including to a growing number of funds and investors that are specifically formed to focus on ESG initiatives at target companies. Another important consideration that could affect M&A timetables is the intensified regulatory scrutiny of these transactions, which can add unanticipated complexities toward closing deals and extend deal timelines beyond those originally anticipated. Finally, if you’re a company considering improving your supply chain and thereby reducing costs through M&A transactions, expect continued competition for targets in this area in the coming quarters.
Thies: With borrowing costs increasing and in anticipation of an economic slowdown, corporations may seek to fortify their balance sheets and focus on core operations. As a result, it may be a strategic time for carve-outs and divestitures of non-core business units which are likely to remain viable given the level of PE dry powder.
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