Well, we can’t say we didn’t see it coming. Inflation is here, and it’s likely to get worse before it gets better. This will have two effects on deal making: 1) With inflation, acquirers will demonstrate more caution when committing capital. Until now, the LBM M&A market had been more or less in equilibrium between buyers and sellers. But it has swung oh so slightly to be a buyer’s market. When pricing deals, we are hearing phrases like this: “We would have paid slightly more, but with inflation, the future is cloudier than even a few months ago.” And 2) inflation will impact how buyers finance deals, and how an acquirer’s cash is balanced with senior and subordinate debt to assemble the funds needed to close the deal. That’s because money is more expensive to borrow.
For deal values in the $10 million—$25 million range, in 2022 YTD, as inflation hit 8.6% and interest rates increased on senior debt— less senior debt was used to pay for acquisitions (37.4% of the deal value vs. 54% in 2021), while more sub debt was used (12.1% vs. 10.4% in 2021). This means that more equity (acquirer’s cash) was required, (50.5% vs. 35.6% in 2021). Deals in 2022 are simply getting more expensive to fund with less senior debt, more costly sub debt, and more equity needed to bridge the funding gaps. This is even true for so-called “all-cash” acquirers. Even if an acquirer offers “all cash” at close—an attractive feature that makes the acquirer stand out among bidders—the “all-cash buyer” is probably bundling up multiple deals and financing them later on. (This is just like when you bid all cash for a house, only to leverage the asset later with some debt.)
With private equity groups using more of their own cash to close the deal, they still depend on debt to 1) Lower their cash-risk profile, since the debt payments for the deal-specific loans are invested by the acquired company going forward; those debt payments are not paid by the private equity group out of their checking account. And 2) The private equity group’s own success is gauged by the return on their committed capital. Ergo, the more debt they put in place, the less cash they use, and the better they look in the debt-to-cash deal profile. This also means that the private equity group earns back their at-risk cash as quickly as possible.
Where does that leave us today? Private equity groups, which do most of the buying of today’s LBM companies—and even cross-town strategics that are making acquisition bids— are 1) Being slightly more prudent in their selection of target companies, seeking companies with higher EBITDAs ($2 million+), focusing on top performers with relatively high EBITDA margins (10% or greater), and companies that are showing strong Y/O/Y growth (10%+). And 2) They are paying slightly less for them. Not a lot less. But less. Whereas a 5X was a fairly dependable multiple of EBITDA to expect in a typical deal, we are now seeing some slippage of that multiple, especially for smaller companies (sub $15mm in sales). Offers are coming in that are 4.8X, or 4.5X for companies with EBITDAs under, say, $2mm.
Here are the purchase-price implications of that downturn in multiples. A company with a $2mm EBITDA that would have achieved $10mm in purchase price in a 5X market (5X $2mm) may now get $9.6mm (4.8X $2mm). The EBITDA multiplier that rewarded you on the way up in a seller’s market is punishing in a buyer’s market.
All of this could be largely cured if the interest rates ticked down, even a little bit, to signal a downward trend instead of an upward trend. That said, private equity groups have a mandate to put their money to work and deals will surely get done; they get done in any market, under every condition. Quality, premium performers with trailing-twelve-month EBITDA margins and revenue growth of 10% or greater will still command excellent interest and premium valuations. And as always happens, we will cycle out of a down market and use the lessons learned to grow even more valuable companies in the future.