No Time to Panic: Why this recession is still a good time for small business M&A

With the Federal Reserve raising interest rates, a bear market on Wall Street, and the media proclaiming doom and gloom, you may be asking yourself questions like, “What happens to the M&A market during a recession or market downturn?” Or “Should I hold off selling my business until things get better?” Or “Should I hold off buying a business until the economy improves?”  While those are all valid concerns, in our opinion, this is no time to panic.  In this article, we’ll examine the four key variables that impact M&A activity as the economy changes and why, in this particular situation, we still view disciplined buying or selling as a sound option, especially in the lower middle market.

As the economy changes, whether in a positive or negative direction, there are four key variables that are impacted and, in turn, affect the market for buying or selling businesses: access to debt financing, cost of capital, access to investor capital, and supply and demand of businesses on the market.  We’ll explore each in some detail.

Access to Debt Financing

Commercial lending is one of the best bellwethers to determine the health of the economy for businesses.  A bank’s job is to make money on the assets under their management by, first, not losing money, and second, by earning interest.  As the wider economy enters a recession, banks have to respond by being more disciplined with their investments (i.e. not losing money on bad loans), but they also still have to make money by earning interest – the only way to do that is by making loans.  So, generally, a decline in banks’ appetite for commercial loans is due to either a specific driver of a downturn, such as the subprime mortgage crisis in 2008, or due to a more conservative view of underwriting (i.e. a more disciplined approach).  As we’ll see, the drivers of this downturn shouldn’t have a direct effect on access to debt financing, so we see any impacts as driven by more discipline in underwriting.  This conservatism will likely be driven by the uncertainty of the broader market recovery and presumed softness in potential earnings.  The bottom line: debt financing should still be available for good deals, but marginal deals will be more difficult to fund.

Cost of Capital

As the Federal Reserve, and other central banks around the globe, raise interest rates to combat inflation, the cost of borrowing will continue to rise.  As of September 2022, the prime rate in the United States is 6.25%, higher than it’s been since January 2008.  However, it’s important to put this rate into historical context.  A prime rate of 6.25% is still lower than throughout most of the last seventy years.  So, while it feels like rates are impossibly high, the cost of borrowing is still lower than most of the timeframe since World War II.  This higher cost of borrowing will likely affect M&A activity in the near-term by reducing buyer’s appetite for debt and increasing the impact debt financing will have on post-acquisition earnings.  As a result, buyers will likely get pickier as they analyze businesses and may seek alternate sources of funding.

Access to Investor Capital

The most common measurement of an economic downturn is the state of the stock market, as evidenced by the level of the S&P500 or Dow Jones Industrial Average.  As we currently sit in October 2022, both measurements sit squarely in bear market territory, more than 20% lower than their recent highs and down 20%-25% year-to-date.  Facing this reality, investors that are holding cash reserves are looking for more attractive investments, outside of publicly traded companies.  With any investment decision, the calculation centers around expected return, perceived risk, and liquidity.  Depending on how an investor views the downturn, the calculation between liquidity, risk and return changes, with some investors willing to sacrifice liquidity to maintain a high return on their capital.  This behavior favors investing in small business, as a successful small business can deliver strong returns and risk can be mitigated by having a higher degree of control of the operation of the business than you can typically exert on a public company.

Supply and Demand

While the supply and demand for M&A activity is certainly affected by an economic downturn, the underlying causes are important to understand.  Demand is typically driven by access to capital, whether debt or equity, and attractive places to invest.  We’ve discussed the access to capital in the previous three items.  Investors in the middle market and below are savvy investors who generally play for the long-term (even the three-to-five-year hold periods of Private Equity firms are “long-term” compared to the stock market).  So, while they may get more disciplined in what they consider attractive, the demand for good deals will remain strong. 

On the supply side, again, it’s important to examine the underlying factors driving a decision to sell.  For founder-led (or family-led) companies, the decision to retire or exit the business is largely driven by factors other than getting the best return (retirement, health, family, etc.).  With a large amount of business owners facing retirement age, a market downturn isn’t going to affect their decision much.  The biggest impact is likely due to a perceived lower valuation that can only be resolved by testing the market.  While some larger closely held firms may hold out for a more stable market to ensure a high enough return for their investors, we don’t expect the supply of available companies in the rest of the market to be significantly affected.

The Current Situation

This market downturn is an interesting one historically.  Looking back to the two most recent big corrections, they were both initiated by massive external forces (the dot-com bubble burst in 2000 and the sub-prime mortgage crisis in 2008).  Those were both single-cause events that shook a significant portion of the market and investors took some time to process the implications, understand the effects on the global economy, and get comfortable moving back into the market. 

This situation is different.  On the surface, this recession is driven by central banks dramatically raising interest rates to cool off an economy that was too hot, as indicated by inflation.  Most important in that equation is the drivers of that high inflation: unprecedented central government stimulus during COVID; historically low rates of unemployment; significant increases to minimum wage rates; supply chain disruptions causing companies to take extreme steps to produce, ship, and stock goods in short supply, driving up costs and prices (not always in sync with each other); a war in continental Europe, further disrupting the supply chain for all goods going in or out of Russia (not to ignore the massive humanitarian cost); and, through it all, consistently strong corporate earnings. 

In fact, most of the “bear market” is driven by fear that the central banks will go too far in correcting inflation, causing the economy to crash.  But all indications are that people are out there, spending money, and continuing to drive the economy.  Corporate earnings, as reported by public companies, continue to be solid and exceed expectations.  All told, except for the impact of higher interest rates, it seems that the underlying indicators of the health of the economy should continue to support investing in small business.

The Bottom Line

To summarize, while there is certainly a reason to be cautious and maintain good discipline in evaluating M&A opportunities, neither buyers or sellers should be scared away by the prospects of a recession, at least at this point. 

For prospective sellers, it’s a time to extract the value of the business you’ve built and give yourself a large cash reserve to deploy as the market comes back.  While the average stock market return over the long-term in 8%-10%, outsize returns can be made by riding a recovering market.  Perhaps now is a good time to turn the value of your business into deployable cash. 

On the other hand, for potential buyers, this is a great time to pivot and invest your money into an asset where you can directly affect the outcome and eventual return.  Acquiring a business puts that control in your hands.

While we don’t expect the next 12-18 months to have record-breaking M&A activity like 2021, we do expect to continue to see robust activity in this space and good returns for both sellers and buyers.