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: Middle-market M&A players expect conditions to stabilize in 2023

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More than 80% of U.S. middle-market companies and private equity firms agree that company valuations will be stable or higher in 2023 after a year of big price adjustments, according to an annual survey by Citizens Financial Group Inc.

Most middle-market companies among the 400 respondents to the Citizens’ 2023 M&A Outlook expect better conditions in 2023 after macroeconomic uncertainty, inflation and steep losses in equities derailed deals in the past year.

Sixty-two percent cited growth as their motivation for M&A deals, up from 48% in 2022.

“When the macro conditions normalize, we see a pipeline of buyers and sellers eager to return to the market,” said Jason Wallace, head of M&A advisory at Citizens Financial Group
CFG,
+0.39%
,
in a prepared statement.

Some of that optimism is reflected in shares of bank stocks in 2023, which have started out in positive territory thus far.

The KBW Nasdaq Bank Index
BKX,
+0.56%

is up 4.5% so far this year as of Tuesday’s close, while the Financial Select Sector SPDR Fund
XLF,
+0.57%

has risen 3.7%. For its part, Citizens shares are ahead by 4.8% so far in 2023.

However, headwinds in the middle market remain with about 66% of respondents in the Citizens survey agreeing that inflation is making business more challenging. Nearly half said they’re challenged by rising interest rates. Other concerns include labor market challenges, geopolitical instability and loftier commodity prices.

On the plus side, 84% of respondents said they’ve been able to pass some or all cost increases onto their customers.

In another good sign for investment bankers, law firms, businesses, and private equity firms that focus on merger deals, management teams have said they’re increasingly turning to acquisitions as the primary growth driver for their companies, as organic growth stalls.

Respondents said they expect higher valuations across every sector but transportation and logistics, as well as aerospace/defense and business services drew the most bullish valuation views.

Healthcare valuations cooled from a year ago, with expectations for neutral valuations, compared to 2022 when it was the sector with the most bullish outlook.

The Citizens survey from a year ago showed that the quick drop in deal-making activity in the past 12 months took the middle market somewhat by surprise.

In January, 2022, 86% of the 400 respondents said they expected company valuations to either increase or remain stable, compared to 87% in January 2021. A year ago, 36% said they expect higher company valuations, down only slightly from 38% in 2021.

Macroeconomic uncertainty was a dominant theme of late 2022, but most middle-market companies and PE firms expect conditions to improve in 2023.

Companies do acknowledge the headwinds, however. Two-thirds of middle-market companies say inflation is making business operations more difficult, while nearly half cite the challenge of rising rates. Labor market challenges, geopolitical instability and commodity prices are also high on the list of concerns. Still, there’s evidence that companies have adapted well to the environment. Eighty-four percent say they have been able to pass some, or all, of their cost increases on to customers, a contributing factor for their confidence in the year to come.

M&A as a Growth Driver

Most middle-market companies said they expected slower economic growth in the year ahead — but they remain optimistic about their own performance. As economic challenges persist, management teams increasingly say they are looking to M&A as the primary growth driver for their companies, as opposed to organic growth.

Among middle-market company buyers, growth is by far the top reason for acquiring a company. Sixty-two percent of buyers named growth as their M&A motivation, compared with 48 percent the prior year. Sellers also point to growth as the main motivation, with 35 percent saying they seek a sale because of strategic growth opportunities, though it ticked down from 40 percent in last year’s survey. In 2023, the leading motivation bringing sellers to market is the lack of a succession plan and need for new leadership.

In terms of sector valuations, outlooks ranged considerably for 2023, though respondents said they anticipate higher valuations across every sector but transportation and logistics. Aerospace/defense and business services garnered the most bullish valuation forecasts. Healthcare was also close to neutral, a marked change from last year when it was the sector with the most bullish valuation outlook.

High-Performing Sellers in Driver’s Seat

Though valuations have retreated from 2021 peaks, middle-market companies and PE firms agree that the market environment still slightly favors sellers. With buyers on the lookout for growth, high-performing sellers could continue to have an advantage.

Need to Know: This has been a bad sign for stocks historically — when there’s a big gap between how companies and the government measure profits

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