Inflation and interest rate concerns are changing how middle-market M&A deals are getting done, favoring certain sectors over others and providing more opportunities for direct lenders and strategic buyers. With worries increasing around current macroeconomic conditions, deal dynamics are also starting to shift, with more deferred compensation and deferred payment mechanisms, says David Gibbons, senior partner in the M&A practice at Hogan Lovells law firm. Read the full story below:

“The inflation factor lowers real returns, and the increased cost of the debt further lowers that. So we’re in a period here where investors and targets have to bridge between where they are on valuations,” Gibbons says.

In this environment, earnouts are more routinely considered to bridge valuation gaps, he says, with a deferred payment of the purchase price of a deal and the payment contingent upon achieving performance milestones. Depending on the industry and type of deal, earnouts can be based on profits, revenues, sales volumes or developments—the filing of new drug applications by a biotech company or approval to investigate its new drug by the U.S. Food and Drug Administration, for example.

“It varies across industries and you’re seeing dealmakers, bankers, lawyers and business development types being more creative” to bridge valuation gaps between buyers and sellers, Gibbons says. “The cost of financing and to returns because of inflation is necessarily making that a broader divide.”

Before inflation and rising interest rates became a concern, potential M&A deals had more buyers and more competitive buying processes. Typically there were no valuation gaps between buyers and sellers, and contingent purchases weren’t necessary because multiple buyers were willing to pay a seller’s price.

Some Sectors Hindered, Others Not

In this inflationary environment, M&A activity in retail and consumer industries is expected to fall off. Real estate M&A is another area hurt by inflation as capitalization rates go up and valuations drop “precipitously,” Gibbons says. Deal activity in industries with an enormous need for capital will also be hindered, such as biotech, where large amounts of leverage are needed to keep companies going for long periods to get drugs approved and commercialized.

Deal activity continues to be robust in technology and specific tech areas like cybersecurity, Gibbons says, with cybersecurity becoming top of mind for company directors because of the war in Ukraine and new tensions in the Middle East and China. Also, dealmaking in the energy sector remains strong, despite the typically high cost of funding development projects, because of the Ukraine war, energy prices, fossil fuel legislation and new alternative energy tax incentives.

Software sector M&A is another area that has been protected from inflation, says A.J. Rohde, senior partner at Thoma Bravo and co-leader of the firm’s investments in middle-market software and technology companies. Software companies tend to do well during cycles when companies buy software to increase their levels of automation to cut employment costs.

“Our worlds are pretty unaffected by the macro backdrop that we’re in,” Rohde says. “No one is immune from enterprises curtailing their spending, but oftentimes an enterprise will look at its entire cost base, most of which is headcount, and they’ll look for ways to automate that.”

In the current market there has been a flight to quality, says Peter Tsang, co-chief investment officer of the Riverside Company’s Capital Appreciation Fund, which targets middle-market companies in North America. Deal activity hit a high-water mark in 2021, with a slight decline in the first half of 2022, while overall deal quality — the growth potential and financial metrics of companies acquired in M&A transactions — was not as strong in the first half of 2021, though it improved in June and July.

But high-quality businesses continue to receive significant attention from buyers, even if the auction processes are less heated, Tsang says. In general, investment bankers have been casting a wider net for potential buyers in the current environment to try to ensure that a sale will be completed. Riverside’s view is that macroeconomic conditions are important, but they have little effect on any one particular deal in the middle market, Tsang says.

“Doing deals in the middle market is more of a micro business than a macro business,” he says. “We are not buying businesses with multi-billion dollars of revenue or buying an index of hundreds of different market companies; we are literally investing in one company at a time. The focus is on finding the really good quality businesses where a firm has a thesis to stand behind.”

Inflation and rising interest rates have made add-on acquisitions more expensive, but not prohibitively so, Tsang says. “We don’t know exactly where interest rates will go over the next 12 months. But so far, lenders are still willing to do business.”

Alternative Lending Sources

Direct lenders —funds that lend into the debt side of middle-market deals — have also become more active in the current interest rate/inflation environment, Gibbons says. He cites several reasons:
They’re unregulated
• They’re sitting on pools of capital so they can act quickly
• They’re adept at taking on more risk than traditional lenders
• They can protect themselves from inflation by charging a floating interest rate

“They play in a space that’s conducive to middle-market PE,” where deals are often too small for traditional bank lenders, or too large for one bank lender to take the risk but too small for a syndicate of bank lenders, he says.

And, for the first time, he’s recently seen strategic buyers relying on direct lending to fund acquisitions.

Strategics Strong

Many strategic buyers have remained active in making middle-market deals as part of a cash deployment strategy.

“We still see lots of smaller deals getting done by strategics who are doing it not just as a pure financial investment,” Gibbons says. Those with strong balance sheets probably aren’t out trying to raise capital to finance their deals, and they can rely on pre-existing lines of credit if necessary.

Strategic buyers have been particularly active in the software sector, says Thoma Bravo’s Rohde. “Strategic buyers, if they’re in a healthy position and have cash, they’re actually trying to take advantage of this market window.”

Often, the strategic buyers have come from outside the software or technology sectors, especially under the current market dislocation and inflationary pressures. “It forces big companies to look inward at their own business and how they can transform their business. And not surprisingly, they look to software to automate what they’re doing,” Rohde says. If they have boards of directors that are supportive of M&A, software acquisitions can be part of a plan to digitally transform themselves.”

The macroeconomic conditions have also fostered more take-private dealmaking in the software sector, says Rohde. “In this market, a significant portion of our pipeline are public companies that we think have been unfairly treated by the public markets in light of this sector rotation you’re seeing.”