Signs of a Rebound Despite Lingering Headwinds
The environment for business sales has hardly been accommodative through the second quarter of 2024. A challenging set of economic and financial factors were carried over from 2023 and have lingered to the detriment of deal making in the first-half of the year. Namely, elevated interest rates have limited the affordability of capital for businesses and acquirers alike, leading to a tight financing market and hindering the ability of acquirers to meet elevated seller valuations. Adding to the economic challenge, domestic and global political developments have introduced a fresh set of uncertainty for sellers and buyers.
But as interest rates have stabilized in the first half of the year, and as the Federal Reserve signals that rate cuts are imminent, there are signs of positive shifts in the deal market. According to M&A data provider PitchBook, North American deal volume is up 6.2% year-over-year through the first six months of 2024.
Despite a less than supportive backdrop for mergers and acquisitions in 2024, low levels of activity in 2023 have created an environment ripe for an uptick in activity. Sellers who delayed sale processes are prepared to bring deals to market, and acquirers are sitting on cash piles that are ready to be deployed. Layer in declining rates and the ingredients for increased deal activity are present.
Digging Into Q2 2024 Lower Middle Market Deal Activity
As deal activity increases we desire to maintain a pulse on relevant process details, especially among lower middle market businesses, our area of focus at 37th & Moss. Data for private business transactions are notoriously difficult to track, and in our experience the lower end of the market is most nebulous. Thus, the IBBA Market Pulse survey remains one of our preferred sources of relevant detail on transactions under $50 million. Below we’ll explore a handful of takeaways from the Q2 2024 survey, and in doing so we hope to educate buyers and sellers regarding current trends in small business acquisitions.
About the Q2 2024 Survey
Completed between July 1 and July 15, 2024
Responses gathered from 322 business brokers and merger & acquisition advisors
Covers 222 transactions that were completed in the second quarter of 2024
Transactions split into two segments:
Main Street: Less than $2 million purchase price
Lower Middle Market: $2 million to $50 million purchase price
Election Impact on Lower-Middle-Market Business Sales
About one-fourth of sellers indicate that deals will remain sidelined until uncertainty related to the November 2024 US election is resolved. Among businesses in the $2 million to $50 million range, 26% of sellers will wait for the election before going to market. Among businesses below $2 million in value, a nearly identical 25% of respondents indicated that a company sale process would commence after the election.
Valuation Multiples: A Trend Reflecting Challenging M&A Conditions
Second quarter transaction multiples for each of the four segments below continued to show a downward slope in 2024 relative to the high watermark set in 2021. The Federal Reserve’s rate hikes began in March 2022 (Q1 2022). While interest rates are not the only variable in the valuation equation, logic holds that an increase in cost of capital results in an increased acquirer investment return requirement, which leads to a lower valuation as a means of offsetting the elevated cost of capital. In other words, when rates go up, valuations face downward pressure.
For transactions in the $5 million to $50 million range, Q2 2024 valuations moved higher by a half-turn versus Q2 2023 from 4.8X to 5.3X. The $5 million to $50 million segment is the only segment that showed positive year-over-year multiple growth. Perhaps a sign that risk appetites are loosening among lenders and equity providers, and that investors find the stability of larger businesses to be of appeal amidst economic and geopolitical uncertainty.
Offers Per Deal - Another Sign of Up-Market Demand
Further to the point of demand for deals in the $5 million to $50 million range, the number of offers per deal in this segment were double the offers per deal in the $2 million to $5 million segment in Q2 2024. While transactions above $5 million have historically received more offers than those below $5 million, the sequential growth in offers per deal from Q4 2023 to Q2 2024 shows a clear pick-up in demand for deals above $5 million relative to deals below $5 million.
Use of Earnouts in Lower-Middle-Market Deals
The percentage of deals with earnouts in Q2 2024 reverted from the Q4 2023 high of 10%, but remained above the three year average of 4%. As risk appetites among lenders increase and rates face a flat or downward trajectory, the emphasis on earnouts could decline. But, as it stands today, rates remain elevated and given the challenge this creates for acquirer returns, motivated sellers are likely to continue to find earnouts to be a useful structure for bridging valuation gaps.
Number of Months to Close - A Favorable Decline in Q2 2024
Among transactions in the $5 million to $50 million range, the number of months from process start to deal close improved sequentially to 9 months from a Q1 2024 value of 13 months. This trend corroborates the uptick in offers for deals in this segment (i.e. more deal demand equals less time in market), and could be an indication that financing support, or other post-LOI diligence steps, are yielding outcomes that are conducive to smoother transactions.
Is the Tide Turning?
There are certainly signs that deal activity in the lower middle market is increasing, yet cautious optimism is warranted given geopolitical volatility and lingering economic uncertainty. We’ve written at length on our resources page about the challenges of economic forecasting, and we recognize that predicting the future is impossible. But pent up demand from sellers who elected to remain on the sidelines during the past six quarters, coupled with record investor cash piles, creates a backdrop that could bode well for deal activity. A declining interest rate environment may be the spark that favorably shifts risk appetites and removes one of the largest impediments to a successful backdrop for sellers and buyers.
