How M&A Will Respond to the Next Recession

Scott Bushkie is the Managing Partner of Cornerstone Business Services as well as a Founder of Cornerstone International Alliance (CIA). CIA is a global partnership of M&A firms who advise businesses of $5-$150M in revenue. It is also one of Axial’s newest sell-side partners. 

CIA is host to 21 active sell-side Axial member firms, many of whom are leading M&A advisors on the Axial platform. CIA members include Affinity Ventures who was ranked in Axial’s League Tables three out of four quarters in 2019, KeyStone Business Advisors who advised an Axial 2021 Top 20 Deal, and Cornerstone Business Services who has been featured three times thus far in 2022 – twice in the Axial League Tables and once in the Industrials Top 50 – as well as in the League Tables in 2021. And the list goes on.

We look forward to our partnership with CIA, together bringing more high-quality deals to the Axial platform.

The M&A world isn’t quite sure what to expect in the next recession. Private equity players weren’t nearly as dominant through the last market downturns. But today those firms have $1.8 trillion in uncommitted capital they need to put to work. With money to spend, and a timeline to do it, private equity may help keep valuations high.

In 2021, for example, companies with values of $10-25 million were earning 6.1 multiples, on average, in the M&A market, according to GF Data. In 2022 year to date, those companies are getting 6.6 multiples. Those kinds of premiums – and improving valuation trends – are unexpected in times of risk and upheaval, as we have with the war in Ukraine, fuel prices, inflation, and the (potential) looming recession.  

Businesses are earning the highest multiples we’ve seen in decades. If we can see that kind of activity in times of economic uncertainty, dealmakers are optimistic we won’t see a painful drop in the years ahead. 

But even with nearly two trillion dollars of dry powder, private equity won’t continue business as usual. We expect to see more shifts like the following in the months ahead.

Flight to quality

An investment phenomenon, “flight to quality” occurs when investors start shifting out of risky assets during financial downturns (have you seen the price of bitcoin lately?). And while M&A itself is not in a downturn, we will likely see private equity be more selective – focusing on the consistent performers to the exclusion of “big opportunity” entities with unproven potential. 

With a maybe-recession ahead, buyers are looking for companies with predictable performance, solid margins, and low customer concentrations. Unicorns are out. Work horses are in. Or, to use another analogy, buyers will be looking to hit singles and doubles rather than taking the chance on a home run. 

Previously, private equity was targeting minimum returns of 18%-20% for their investors. Today, many PE groups have adjusted projections down to 15%. Expectations for returns have come down in anticipation of a softening market. 

The takeaway for business owners: Get back to basics. Don’t worry about hyper growth. De-risk your company as much as possible. 

Market efficiency

With private equity at the table, we continue to have more buyers than desirable sellers in the market. It’s easier to buy and sell businesses right now, so timelines are shrinking.

Traditionally, it takes 9-11 months to sell a lower middle market business, but there’s a general sense of urgency and competition that’s speeding things up. For example, we’re on track to close a deal just four months after hitting the market. That kind of accelerated activity is only possible when you have multiple motivated buyers at the table. 

Brands are more valuable

Private equity is looking to replicate past success. When they can find a business that fits one of their proven “been there done that” growth models, they’re willing to boost the purchase price.

The direct-to-consumer space is hot right now. If you’re a manufacturer without a branded product, you’re consistently at risk of the retailer going around you and launching their own brand. But with a branded product, people are seeking you out.

Brand recognition lowers the risk profile and increases margin. But that’s not the only reason private equity likes it. Direct-to-consumer companies understand their customers better. They have a better handle on the data, including market sentiment and projections – and data-driven growth is one area in particular where private equity tends to shine. 

Resiliency in M&A

The market will slow down. But good companies sell in any market. Private equity has money to deploy. Meanwhile, strategic buyers will need alternative avenues for growth as long as the tight talent market constrains organic expansion. 

Things will slow down. Good companies sell in any market. Private equity has money they need to deploy, so they have to continue buying. We could see a recession in the next couple of years, but it likely won’t have as big an impact on M&A as the past.