Business Owners Eye Inflation, Supply Chain Disruption, Labor Shortages, Interest Rates and Evolving Financial Services as the Core Themes Impacting Lower Middle Market M&A, Capital Raising and Growth Strategy in 2022

2021 is in the rearview mirror. As we travel down Route 2022, lower middle market business may come across winding roads with a mix of opportunities and challenges for decision makers.

Having supported a range of clients across various industries with engagements that include strategic advisory and growth consulting, fairness opinions, capital raising, and buy/sell-side transactions, Auctus Capital Partners is familiar with the many issues facing corporate America.

While navigating 2022 will not likely playout the same way for any single company, the following trends are expected to impact business, drive deals, and shape the landscape:

Liquidity, debt availability, and economic sentiment will drive continued dealmaking activity.

While we may see a slower start to 2022 compared to what shaped up as a banner year for deals — including US PE dealmaking that not only rebounded from the shock of COVID-19 but set a historically blistering pace and $1.2 trillion annual record for value — the deal climate will remain activate.

Exit activity was proportionally more robust last year as sponsors tapped red-hot public markets through IPOs and reverse mergers with SPACs, and the flood is expected to endure into 2022.

As pandemic-related economic uncertainty continues to cool, both public and private markets will remain comfortable particularly with buy-and-build strategies, as well as add-ons to deploy capital with diminished risk. Across the lower middle market, companies that will take advantage of deal opportunities must turn to investment banks to mitigate new layers of complexity inherent in today’s highly competitive landscape.

The ongoing global supply chain crisis has been a contributing factor to inflationary pressures, which can weigh heavier on smaller and mid-sized companies. While larger market players maintain pricing power and more leverage with global suppliers, the lower middle market will continue to face higher commodity prices, energy and shipping costs that are difficult to pass on.

While debate continues around how the inflationary environment will affect dealmaking, investors and lenders will be forced to be more disciplined in valuing targets. At the same time, both buyers and sellers face new layers of complexity in agreeing on pro forma EBITDA adjustments as the Fed begins to increase interest rates. Both factors are especially true for companies that tend to be valued on earnings many years out, such as technology and early-stage healthcare.

Businesses must adapt quickly and become more agile to protect not only their bottom line, but against factors that can have a significant impact on valuation. In many cases, owners that haven’t previously considered M&A are exploring deals related to an exit, motivated by wealth maximization, as well as others looking to acquire business to gain access to resources that ensure supply chain resiliency, such as equipment, intellectual property and advanced production processes.

Labor shortages are expressively increasing operational expense with challenge tied to both hiring and retaining talent. The labor market has tightened to 4.2% unemployment — and with ongoing COVID-19 risks, unemployment benefits, job skills mismatches, the number of employed workers is around 5 million below pre-pandemic levels. While the ongoing trouble filling positions and necessary increase to wages is becoming the new normal, the shift in expectations from existing employees wasn’t immediately obvious. Employers are not only increasing compensation levels across the board, but also having to get creative to incentivize a mor democratized workforce with non-monetary benefits. As a result, rising operational costs have pushed more lower middle market companies to restructure (including changes to working capital, reorganization, cost reduction, and legal entity restructuring) since the labor crisis has shown its true colors. Businesses with strong employee retention track records or those that have increased productivity with technology are commanding a change.

Rates, regulation, and reform always stir late-year deal making and point to an uptick in M&A for the year ahead as entrepreneurs and business owners look at divesting interests for lower tax bills. Sellers with closings that were not feasible in 2021 are considering structuring transactions as installment sales in order to spread the gain across two or more years in order avoid a surcharge tax. At the same time, motivation is greater on the buy-side. Rising interest rates drive the cost of capital for dealmakers who are now racing to beat imminent hikes and more obstacles stemming from a tightening regulatory environment. Indications of this activity is shown across PE deal volume, value, and debt and EBITDA ratios that broke records in 2021. Unlike the wave of distressed-induced amended deals seen in 2020, dealmaking shifted to future growth planning, providing liquidity to LPs, and securing favorable terms before the tides change.

While the potential impact of increased leverage from PE deals adds pressure on the businesses to perform for the long term, the impact of the pandemic and lingering economic recovery remain an uphill battle more immediately. Companies across all sectors should adjust their long-term risk appetite and focus on after-tax cash proceeds and strengthening their balance sheets in the New Year.

PE dry powder and private debt is going to work. Despite the trends mentioned above, the broader private capital landscape is generally more resilient to economic threats than public markets and undeployed capital is abundant. On the buy side, more than US $1 trillion of PE dry powder and $250 billion of private debt will fuel investment as the pool of desirable sellers grows, including more aging entrepreneurs who are weary of ongoing COVID challenges and supply-related or economic uncertainty.

The lower middle market will also access financing through leveraged credit loans — such as mezzanine or unitranche financing — which are already driving deals. Growth equity will remain an effective tool for owners that want to remain investors but also realize a portion of their investment. In addition, it can be an effective vehicle for providing liquidity to certain shareholders, while allowing other equity owners to remain invested in the company.

The lower middle market demands greater attention and support from investment banks. Companies seeking corporate financial advisory will only turn to firms that can provide added value when facilitating mergers and acquisitions, raising capital needed for growth, or other services that go far beyond the offerings of commercial and retail banks.

We are in the midst of a revolution; moving towards true value-added financial advisory that can serve not just the c-suite, but support everyone directly working within the organization, and advising on what to do to transform business — not just the transaction.

While 2022 will certainly bring about change, and a fundamental rethinking of the client engagement model is needed: a pivot from capabilities or service orientation to a client-centric, bespoke delivery of support with innovative and customized solutions that address the increasingly complex needs of lower middle market businesses.

As investment bankers, strategic advisors, and business counselors, we understand that our role has never been more important. Auctus Capital Partners exists to help businesses identify opportunities and navigate their way through complex business transactions, maximize value and achieve favorable outcomes.