In the dizzying world we work in currently, we often don’t stop and look back at history to learn lessons. The team at Watermark has been researching prior recessions and how they influence M&A transaction outcomes.
This current economic downturn is driven by (1) a massive, unprecedented injection of M1 and M2 money supply after COVID struck combined with (2) over $5Tn in stimulus injected into the economy.
Stunning Increases in M1 and M2 Supply Since 2020
This has led to a rapid spike in inflation, now at 8.6%. If we calculated inflation in the same way economists did in the seventies and eighties, it would be in the high teens. Historically speaking, 2Q’22 inflation would be higher than what the country experienced in the seventies or eighties.
We studied both the seventies recession (1973-1975) and the Great Recession (2008-2009) to gain insight on what we might be facing in the M&A markets. We see that the current conditions more closely resemble the seventies. In 1973, the country was burdened by deficit spending driven by the Vietnam War combined with 1973’s oil embargo crisis and the collapse of managed currency rates. The total duration of this recession was 16 months (while the Great Recession lasted 19 months). However, the seventies continued to be plagued by stagflation (slow economic growth combined with high inflation) even after the recession ended. This is worrisome as the Fed districts are currently forecasting low growth ahead; all the while, we are dealing with record high inflation.
An important takeaway is that even though monetary and fiscal policy may lift the country out of a recession within months, the impacts of that recession can linger, like inflation. Looking at the chart below, you can see that inflation remained high throughout the period from 1973-1982. Further, this chart shows that when inflation is high, M&A volume declines and vice versa.
A period of stagflation exacerbates the problem. M&A volume peaked in 1969, at 6,100 closed transactions, and we didn’t see those levels again until 1989, when M&A volume reached 6,900 closed transactions. The takeaway? M&A volume declines in recessions, and there is a lag effect of recovery back to a peak by several years. Furthermore, M&A multiples paid overall retract due to higher costs of capital combined with lower future cash flows.
As a business colleague shared, “History does repeat itself, just on different stairsteps.” What is similar is that we have an energy crisis (high gasoline prices bring down consumer confidence, high diesel prices affect the health of the nation’s distribution systems, and high natural gas prices affect manufacturing since most manufacturers run on natural gas).
If it takes a long time to correct, the longer stagflation, or a recession, may last. However, what is different now versus the seventies is that the M&A market has somewhat decoupled from the economy. Why? The private equity industry has matured past its nascent stages in the seventies, and there are now huge levels of corporate cash. As a result, we don’t anticipate M&A deal volume to crash but instead reduce by some fraction.
Considering takeaways for sellers, we believe the season that we have been in for many years now of a sellers’ market is coming to an end, likely in the next 6-9 months. After that, M&A multiples will retreat to some degree for all but “elite companies.” Expect trough-to-peak multiples to take several years to return to 2021 levels. Add on top of that the fact that inflation will eat away at purchase price considerations. Selling for $10MM cash in December 2022 will be a higher cash payout than selling for $10MM in 2026 due to heightened inflationary pressures. A business owner motivated to sell but unsure on timing should consider making the move now before the shift to a buyers’ market.
For acquirers, especially those that are healthy and have stored up a nice war chest of cash, the market is going to move in your favor soon. Studies have shown that companies that make acquisitions in down cycles outperform those that only acquire in growing economies. We will share more details and research in the final Wire of this series. You should expect less competition soon and M&A multiples that retreat. Therefore, the odds of capturing significant ROI above your hurdle rate will increase from the 20%-30% overall odds. Carpe diem.