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Back to blog June 04, 2021 No Comments Author: Andy Jones

Seven Reasons for Record Deal Flow

Most middle market investment bankers I talk to are reporting record deal flow. Likewise, private equity firms, industry wide, are saying they are inundated with deal opportunities. In fact, May (2021) was likely a record month for most private equity firms, in terms of the number of inbound deal opportunities coming across their desks. Why is that?

Seven converging factors driving the abundance of M&A deals…

2020 Deal Overhang

Many deals were put on pause in 2020 due to the uncertainty of the overall economy at the time. Understandable. Some of these deals re-surfaced in Q4-2020, but many are just now becoming active again, 12 months later.

Excess Dry Powder

Financial buyers (private equity firms & family offices) had an abundance of capital ready to deploy in 2020. As the economy rebounds, the need to place this capital is now more pressing, having effectively lost a year from 2020 acquisition hesitancy.

Many corporates also have cash earmarked for growth through acquisitions.

Covid Benefactors Selling into Strength

The economic changes due to Covid created difficulties for many businesses, but it also created incredible opportunities for others.

Companies selling outdoor sporting goods, exercise equipment, home office supplies, face masks, home improvement products, etc. were all major benefactors of the economic shift due to Covid. Offsetting this were companies in retail, restaurants, hotels, hospitality, travel, conferences, clubs, concerts, sporting events – all industries that were significantly hurt.

Winners and losers.

Those companies that benefitted from the economic shift are trying to sell into strength… assuming they can convince buyers that the trailing twelve months is sustainable, and not an anomaly. Quality of earnings reports are more pertinent than ever on this point.

Potential Tax Changes

The change in political administrations in the U.S. has caused concern among business owners that the capital gains tax will increase substantially upon exit.

For business owners considering selling in the next few years, the thought is, “Why wait a few years to sell and net the same amount, even if the company grows?”

Fair point.

Low Interest Rates

Interest rates are extremely low. We likely won’t see rates this low again in our lifetimes.

Interest rates for debt are inversely related to purchase price.

Lower interest expense allows for higher borrowing capacity (while maintaining proper interest coverage ratios from cash flow from operations). Greater borrowing capacity allows for a higher purchase price.

In other words, the current low rates enable buyers to pay more and still manage cash flow.

Inflation

Inflation is the inevitable outcome of printing money, which the U.S. Federal Reserve has done to unprecedented levels, as have many other nations. (See my personal blog where I provide a 3-part series about the Federal Reserve… Part 1, Part 2, Part 3).

Inflation tends to squeeze margins in the near-term as companies fight to increase prices at a rate that outpaces increases in their cost basis for raw materials and labor.

Offsetting this margin squeeze, is that inflation also shrinks the value of the debt used to acquire a company, as the borrowed dollars used for the acquisition inflate away.

In other words, an acquirer repays debt with inflated dollars (future dollars of lessor value). Couple this with the historically low interest rates available now (discussed above) and you have an opportunity for interest rate arbitrage over time.

In effect, if interest rates are below the rate of true inflation, which I would argue they are, it’s free money, via leverage.

This is the If you can’t beat ‘em, join ‘em strategy, the game many private equity firms and other acquirers are playing right now. Accumulate appreciating assets with the longest possible fixed-rate loan (to capture and lock-in current low interest rates) and repay the debt with dollars of lesser value in the future.

Because inflation shrinks the effective value of debt, in a sense, this is a way to pseudo-print money… just like the Fed.

De-Risking

This last factor is somewhat anecdotal, but it is a motif I have heard consistently.

Owners spend considerable effort identifying, considering, evaluating, and mitigating business risks. We think about our products and services, the industry, competitors, employees and management team, suppliers, customer, operations, marketing, sales, etc. All these areas contain risks factors.

While owners are never completely comfortable with these risks (nor should they be because this discomfort is precisely the attribute of successful business leaders), they understand these risks come with the job. That is the nature of owning a company.

However, the global pandemic of 2020 underscored to many business owners that there exists some systemic risks for which they have no control. Even if their company managed to navigate the new covid economy, or even thrive in it, owners were forced to consider what other systemic factors might be lurking for which there is no immediate remedy.

I did not see any 5-year financial forecasts in 2019 that included the effects of a global pandemic in 2020, nor the implications of the Fed printing so much money thereafter.

In 2019, I outlined the following potential risk of significant inflation in my personal blog:

If China experiences an economic shock due to political changes, like tariffs, (or physical changes, like a significant natural disaster or viral outbreak), they may suddenly have a reduced interest in buying U.S. Treasuries. Or, China might simply shift its investment policy on how to repatriate the dollars, electing to purchase other U.S. asset classes instead of Treasuries.

Read my full analysis from 2019…

Even though I was looking for this risk on the horizon, and inflation as the natural consequence, I did not forecast these assumptions into my business model either. Nor did anyone else.

The point is, the pandemic caused many owners to reflect on the totality of risks they assume. It’s difficult to watch some businesses, some entire industries, get wiped out… to realize it could have been your business/industry just as easily.

The idea that there are risks out there beyond control became more difficult to ignore.

Most notably, cybersecurity. This is an example of an external factor for which few middle market businesses have prepared.

Sometimes, the answer to the question, “What other risks am I assuming?” is this, “Maybe it’s time to de-risk and take some chips off the table.”

And this is exactly what we are seeing. Thus, the record levels of deal flow.

Based on what you have seen, what would you add to this list (leave a comment below)?


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