Pent-up demand for deals likely to lead to increase in M&A

 

Analysis: The time for dealmaking may be coming soon

 

For the back half of 2023 and the first several months of 2024, the consensus was that the Federal Reserve was going to soon lower interest rates, which would lead to a jump start in M&A activity.

 

However, recent inflation data and Fed comments have thrown a wet blanket on this notion. Most signs now point to 2025 as the year when interest rates will decline. While there is a strong correlation between lower interest rates and an increase in M&A volume, as evidenced in a historical analysis dating back to 2015 performed by Grant Thornton professionals, there is reason to believe M&A volume will ramp up moderately for the remainder of the year, even if rates don’t decrease in 2024.

 

“And then, like a locomotive picking up steam, look out for increasing deal volume in 2025,” said Grant Thornton CFO Advisory Principal Todd Patrick.

Todd Patrick

“Like a locomotive picking up steam, look out for increasing deal volume in 2025.”

Todd Patrick

Grant Thornton CFO Advisory Principal

 

The thesis for a moderate increase in M&A activity in 2024 in the face of historically high interest rates is that there is a significant amount of money on the sidelines and pent-up demand for deals. Many companies looking to make strategic acquisitions to improve their businesses simply cannot wait any longer.

 

Then, when interest rates do begin to decline, they are likely to sustain that increased activity — or even accelerate it.

 

“If we’re looking at historical trends and extrapolating upon that to forecast what M&A will look like, a lot of private equity firms and other buyers will be very interested in jumping on opportunities, preparing for opportunities, or engaging in conversations about deals once they believe that we’ve really hit a top in the risk-free effective funds rate,” said Grant Thornton CFO Advisory Senior Associate Louie Baker.

 

 

 

Coming off the sidelines?

 

For most of 2023, many potential buyers and sellers sat on the sidelines with concerns about whether they could get maximum value out of a transaction. Deal volume in North America plunged from 20,413 in 2021 to an estimated 16,391 last year, according to PitchBook statistics, and the value of the average deal plummeted as many leaders in the M&A space pursued add-ons and other smaller deals.

 

That plunge corresponded with an increase in EFFR over that period. The EFFR rose from below 0.25% in March 2022 to 5.33% in August 2023, where the rate remained constant through October of that year. Previously, between April 2020 and February 2022, the EFFR remained consistently below 1%. This correlated with an unprecedented transaction surge, as deal volume rose to a record high of 20,413 deals in North America in 2021.

 
 

 

Although it may be decades before rates decrease back to the below-1% level that PE professionals called the “free money” period in 2020 and 2021, Baker said that based on historical trends, the expected reduction in rates in 2025 should lead to increased deal volume.

 

“Rate cuts will be very helpful,” Baker said. “The cost of borrowing is going to make it a lot easier to finance deals.”

 

This prediction mirrors the outlook emerging from Grant Thornton’s recent M&A pulse survey, in which 81% of M&A professionals said they expect deal volume to increase or significantly increase in the next six months. Although expectations of an interest rate decrease were one factor in those predictions, other factors such as improving financial markets, AI-related digital transformation, and ESG-related innovation were also cited by survey respondents as fuel for greater M&A activity.

 

 

 

 

Get ready to go to market

 

Assuming that the forecast of a deal resurgence is correct, sellers might want to prepare now to enter the market.

 

If that’s the case, one of the first tasks for a seller could be to undertake a quality-of-earnings analysis. This can give the seller a better idea of the true value of the business, and it can uncover red flags that should be addressed before putting a company on the market.

 

"If you're contemplating taking your business to market, you'll want to understand and analyze the quality of your earnings and working capital well ahead of when you begin speaking to buyers,” said Grant Thornton Transaction Advisory Manager Charles Mullens. “By performing your due diligence proactively, you'll become an active player during buyer diligence procedures and purchase price negotiations.

Charles Mullens

“If you’re contemplating taking your business to market, you’ll want to understand and analyze the quality of your earnings and working capital well ahead of when you begin speaking to buyers.”

Charles Mullens

Grant Thornton Manager, Transaction Advisory

 

“What you don't want to do is delay the process and find yourself scrambling to land on adjusted EBITDA or working capital figures around the same time as your potential buyers — that's when you become a reactive player, struggling to put your best foot forward and potentially losing out on additional enterprise value or landing on an unfavorable working capital peg."

 

Sellers won’t want to be surprised during the transaction process, so they should keep in mind that a buyer will investigate the quality of earnings during the due diligence phase.

 

“If you are looking at a company whose financial statement is showing revenue growth of 30% year over year, the buyer can probe deeper into that in a quality-of-earnings analysis,” said Grant Thornton Transaction Advisory Manager Lawrence Watkins. “Is that just the current management team being extremely aggressive and hiking up pricing? Or is that sustainable pricing that was implemented two years ago and is well-established?”

Lawrence Watkins

“The improved, data-driven insights drive more strategic decision-making and accelerate value realization.”

Lawrence Watkins

Grant Thornton Manager, Transaction Advisory

 

Sellers should also remember that the bar for due diligence has been raised in recent years. In the past, a buyer’s scrutiny might have been limited to a thorough examination of the purchase target’s financials. Now buyers are digging deeply into other areas that have a profound effect on performance, such as human capital, IT capabilities and the supply chain.

 

“Data analytics empowers buyers and sellers to significantly lean on their professional service providers by enhancing the depth and breadth of insights into the company’s performance,” Watkins said. “The improved, data-driven insights drive more strategic decision-making and accelerate value realization,” Watkins said.”

 

If the EFFR decreases and historical trends hold true, more buyers will soon be taking these deeper looks at acquisition target operations.

 
 

Contacts:

 
Todd Patrick

Todd Patrick is the National Managing Principal of the Valuation & Modeling practice of Grant Thornton LLP. He is based in Dallas, Texas.

Dallas, Texas

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