September 2022
Impossible Things Before Breakfast
“‘There’s no use trying… One can’t believe impossible things.’
“I dare say you haven’t had much practice… When I was your age, I always did it for half an hour
Lewis Carrol, Through the Looking Glass
a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”
Fitting Remarks
Fitting remarks for what our collective consciousness has been through in the capital markets over the
last 18 months! Meme stocks, “surges/crashes” in cryptocurrencies from Bitcoin to Dogecoin, the rise
(and fall) of the SPAC craze, and daily interviews with Cathy Wood at Ark Invest (is she in the Witness
Protection Program now?). And closer to home, over $5 trillion in global M&A for 2021 – which was up
almost 50% over the trailing 5-year average!2
My, oh my, what a different world we live in in 2022. First, here are a handful of data points to
reference. We will tie it all together in the Conclusion and Summary below.
5-Year On-the-Run U.S. Treasury Rates
Then: 1.26% (Dec. 31, 2021) vs. Now: 3.43% (Sept. 9, 2022)
(We illustrate the 5-year Treasury yields as a general reference rate for business borrowing as it
pertains to long-term capital expenditure investing/M&A financing in the lower middle market.)
Global M&A Activity
- By # of deals through Q2 ‘22 vs. ‘21: DOWN 13%
- By transaction value through Q2 ‘22 vs. ‘21: DOWN 23% (in aggregate representing $475 billion less in transaction value through first half ‘22 vs ‘21)
Lower and Middle Market Summary
In the universe of lower and middle market companies, however, valuation multiples on M&A
transactions continue to cling to their 2021 elevated levels
Private Loans, Leveraged Loans, and Collateralized Loan Obligations (CLOs)
CLOs are aggregated data representing the institutional leveraged loan market. CLO
BBB-rated current yields at 7.6% (up 360 basis points since 12/31/2021) vs BBB-rated bonds at
4.7% (up 210 basis points since 12/31/2021) – creating a massive 300 basis point differential in
CLOs vs. Bonds!
Coincidentally, we are seeing pricing akin to the 4.7% rate for high-quality lower-middle
Market borrowers in the 5- to 10-year maturity range based on recent pricing in
competitively bid banking proposals.7
Summary and Conclusions:
Less Volatility and Pressure for Lower and Middle Markets
There is a lot of noise in the above data points, but we did our level best to provide the most salient data
points we used in order to flesh out our conclusions – that high-quality lower and middle market M&A
opportunities are facing less volatility and less pricing pressure than large global M&A opportunities.
This divergence is extraordinarily rare in my experience of over 20 years of practicing M&A!
YTD Volumes Are Down
Year-to-date M&A volumes, in both number of deals and transaction value, are decidedly down
from the record pace of 2021. This includes both global and large cap, as well as lower and
middle market segments.
Global M&A Strategic Transaction Valuation Multiples Are Off
However, things get much more interesting from a valuation standpoint. For all practical
purposes global M&A strategic transaction valuation multiples are off significantly more than
lower and middle market valuations – down 18% and down 1%, respectively.
Disparity Driven by Liquidity/Risk Re-pricing
We believe the valuation disparity is driven more by liquidity and risk re-pricing actions of
capital providers than it is by the significant moves in the overall level of interest rates. For a
better part of the last decade, private equity funds and global investors have had nearly
unconstrained access to cheap, flexible capital provided by the bond market and private loan
(e.g., leveraged loans, CLOs) market.
While the bond market’s cost of money has had a more muted interest rate move – similar to
the lower and middle market and almost directly corresponding to the Fed’s increases in rates –
the private loan market has been re-priced for risk on a spread basis of approximately 300 basis
points wider versus the bond market and lower and middle market direct bank loans.
The Crisis of Liquidity
This corresponds intuitively to the fact that the number of deals is down far less (-13%) than the
total transaction value of global M&A (-23%). The larger transactions, which have become
heavily dependent on the private loan market, are having a crisis of liquidity. Institutional buyers
of these private CLOs have significantly re-priced their risk appetite versus the bond and direct
bank loan market.
Bank Lending Market Is Fighting for Business
High-quality lower and middle market valuations are currently holding near record levels (mid 7s
in aggregate) because the bank lending market is fighting for their business and these
transactions are typically more conservatively leveraged (e.g., 3x to 4x debt to EBITDA vs. 6x+ in
CLO and private loan market).
NCP Samples Are Telling
From our own sample of completed and currently negotiated transactions in 2022, deal terms
not driven by valuation (e.g., indemnities, escrows, baskets, percentage of transaction value
received as cash at close, etc.) have definitely become more buyer friendly since early 2022.
However, which is the canary in the coal mine? Which metric will identify the sensitivity of the market?
That remains to be seen… Being that NCP focuses exclusively on lower and middle market clients in the
M&A space, we are counting our blessings for the time being.
Cheshire Cat
I am not crazy; my reality is just different than yours