Fueled by a rebound in post-pandemic financial performance and a continuing low-interest- rate environment, global M&A activity reached an all-time peak in 2021, exceeding $5 trillion in transaction value, according to PitchBook’s Q1 2023 Global M&A Report.
However, since mid-2022, rising inflation, interest rates and economic uncertainty have led many acquirers and sellers to reduce transaction activity. Private equity (PE) investors especially have felt the effects of the rapid changes in the macroeconomic environment. In the first six months of 2023, the volume of U.S.-based PE M&A transactions declined by 31 percent versus the same period in 2022, or nearly twice the 16 percent decline in M&A volume for U.S.-based corporate acquirers during the same period.1
What has caused the reduction in PE-related transaction activity? One cause of reduced transaction activity is the recent surge in the cost of transaction financing. Average U.S. debt financing yields for new leveraged loans increased by more than 500 basis points in Q1 2023 relative to Q1 2022.2 Rising interest rates negatively affect projected equity returns in two ways: 1) decreasing free cash flow available for debt repayment or for reinvestment in the business and reducing the amount of funded debt available and 2) increasing the amount of equity necessary to finance an acquisition. Consequently, buyers using debt financing must reduce the purchase price of an acquisition to maintain equity returns similar to what they underwrote in 2021 and early 2022.
A second cause is a recent decline in overall market transaction valuation multiples resulting from higher-cost transaction financing and uncertainty concerning earnings volatility associated with rising inflation and a potential economic recession. Since reaching a peak average valuation multiple of 10.5x EBITDA in 2021, North American- and European-based EBITDA multiples have declined to an average 8.8x in Q1 2023, representing a 16 percent decline, according to PitchBook.4 Private equity investors are active buyers and sellers of businesses, and many firms have chosen to extend the investment periods of their existing portfolio companies that they otherwise would be ready to exit through an M&A transaction, waiting until the macroeconomic conditions improve and support higher-valuation multiples.
What can acquirers expect going forward? While private equity M&A activity is down, history suggests we are witnessing a temporary downturn. Long-term fundamentals for private equity activity remain strong, suggesting the next peak in transaction activity is not far out. Since 2006, the U.S. private equity market has experienced three downturns in transaction activity lasting at least two consecutive quarters: the Great Recession of 2008-2009 (six quarters), 2012 (two quarters) and the Covid-19 pandemic of 2020 (three quarters). In the 2012 and pandemic downturns, transaction activity rebounded to new all-time high levels within two quarters of the trough. Following the transaction downturn associated with the Great Recession, which experienced the deepest downturn, transaction activity rebounded to a new record within 12 quarters.3
The volume of private equity uninvested capital commitments, or “dry powder,” available for transaction activity hovers near record levels, at nearly $800 billion for U.S.-based PE firms alone, according to PitchBook. Most funds have a finite period to invest the capital commitment, so a temporary downturn in M&A typically leads to an accelerated level of transaction activity as funds seek to invest available capital before commitments expire.
Moreover, a recovery in private equity M&A activity will be bolstered by a year’s worth of PE portfolio company “inventory” ready to be sold, suggesting a rapid recovery in activity and valuations once macroeconomic factors improve.
Is now a good time to be an aggressive acquirer? In the near term, competition from private equity firms for acquisition targets likely will be reduced, and at lower valuation multiple levels relative to 2021 and early 2022. However, despite recent trends, the long-term fundamentals for M&A activity remain solid, and competition from private equity firms is expected to rebound. Corporate acquirers currently have an attractive window of opportunity to execute acquisitions at reduced valuation multiples with less competition from private equity firms.
