On this episode of Deal-by-Deal, host Greg Hawver is joined by investment banker Derek Zacarias from DAK. Together, they explore what the next 12 months may hold for M&A relating to founder-owned businesses, private equity-backed transactions and the broader middle market. This engaging discussion explores the macroeconomic trends as well as more intricate strategies and emerging themes anticipated to play a pivotal role in the coming year.

Greg and Derek also reflect on 2023, a year that saw relatively subdued M&A activity in the middle market. Finally, Derek offers valuable insights on approaches that can lead independent sponsors and other private equity professionals to success in navigating auctions and seizing M&A opportunities throughout 2024.

You are listening to Deal-by-Deal, a McGuireWoods independent sponsor podcast. Deal-by-Deal invites you to conversations with experienced independent sponsors and other private equity professionals. Join McGuireWoods partners Greg Hawver and Jeff Brooker as they explore middle market private equity M&A to provide you with timely insights and relevant takeaways.

Hello, and welcome to Deal-by-Deal, a podcast for independent sponsors and other private equity professionals investing in the middle market. My name's Greg Hawver. I'm an attorney at McGuireWoods, I'm based in our Chicago office. And I'm excited this episode to be joined by Derek Zacarias of DAK, an investment banker. And what we're going to be talking about today is an outlook for 2024 M&A in the middle market to lower middle market. We're going to do a little bit of a look back on 2023, but as we sit here at the start of the year, I thought it'd be interesting to focus on what the upcoming 12 months has in store.

And a focus here that I was excited about was if you look at the literature online, much of it is focused on global M&A trends, mega cap deals, Wall Street Journal top-of-the-fold-transactions. What I wanted to dive into here is really founder-owned businesses transacting for the first time, which is what many of our listeners do on a daily basis, and that's definitely what Derek does on a daily basis.

So excited you could join us, Derek. Do you want to tell us a little bit about yourself and about DAK?

Of course, Greg. Glad to be here, thanks for having me. DAK is a middle market investment bank based out on the East Coast. We're based in New Jersey, beautiful New Jersey, the Garden State. I'm actually here in Chicago with Greg, and we have folks across the country. So we have people in New York, New Jersey, Philadelphia, Chicago, LA, Southern Florida, so a bit of a national presence. And our focus tends to be around founder or family-owned businesses, working with a lot of entrepreneurs, and people that have built a business over one, two or three generations and are now looking for an exit opportunity.

Most of the deals that we do tend to be sell-side M&A. We do a little bit of buy-side for some of our better corporate clients, but primarily sell-side, and a little bit of work with the private equity firms. That said, 55 or so percent of our deals go to strategics. So at the end of the day, the private equity community, it makes up a meaningful amount of our people who buy our businesses. So that's DAK.

Personally, I'm from the Midwest, a Midwestern guy, born and raised in Indiana. Been in Chicago now for about five or six years, practicing M&A, and before that I spent about a decade in New York City.

Great, great. Yeah, we are in the time of year in Chicago where it really tests your metal. If you hear some scratching outside, it's the snowplows running through the streets.

Yeah, definitely glad to have you, Derek. And so before we look forward to 2024, why don't we just spend a little bit of time on 2023 now that we're closing the books on that year. Obviously M&A was down by historical numbers, what some might call the golden era of 2021 and some of the years leading up to it, are no longer here. You want to give your observations on 2023 and maybe what were some of the drivers of the muted activity?

Yeah. Not to bury the lead, as you said, Greg, 2023 was one of the worst years we've had in a decade from an M&A deal-making perspective, and I think that that's largely true whether you look at it from a global M&A context or if you look at it more at the middle market here in North America.

Globally M&A volumes were down 20%. And M&A, if you look at it from a market perspective, so the way I would define that as anything under $500 million of total value, deal volumes were down almost 30% versus 2022. Which in itself was down about 30% from 2021, which is a little bit of an unfair comparison. 2021, as we all remember, was a gangbuster year. It was a level of M&A activity that I think most advisors would tell you was unsustainable, so we all expected a moderation to come out from 2021. But that decline in deal activity continued into 2023, which led to what most people are saying is a pretty bad year.

Where I look at it though, and I say going into 2023, what was my guess? My guess was that corporates were going to play a bigger role in M&A activity, just given the rate environment and the lack of liquidity, and we kind of saw that in the numbers. If you look at percentage of deal volume that corporates were doing versus private equity, it kept inching up as a percentage. We saw 2021 was a low point for corporate deal making, and then 2022 it inched up, and then it inched up again to about 62% of total deal volume was from corporates. And I think a lot of that is because you had a lot of these large entities that had cash on the balance sheet, and so for them it was cheap capital to deploy.

And do you see that dynamic changing at all in 2024?

When you look at going into 2024, I think at least in the first half I would expect to see a lot of the same from what we saw in 2023. I think that as rates stabilize, hopefully that gives a lot more visibility to buyers in the marketplace, and so a lot more of the buyers will hopefully come off the sidelines.

I think we continue to see an issue where buyers and sellers have a disconnect in valuation expectations. Some of that's been moderating and we've seen deals starting to close. Speaking for ourselves, we've seen a decent amount of close activity actually in the last 30 to 60 days and we expect to see more coming up, but I think the deal dynamics that a lot of people have been witnessing over the last 12 to 18 months is really that processes are elongating. It's taking longer to close deals. The diligence process is becoming a lot tougher. The focus on data and being able to back up results, not just, "Hey, what's the Q of E say," but what's really driving those results is becoming a bigger factor for buyers.

And it just means that we need to be better prepared as we bring businesses to market, and make sure that we're crossing our t's and dotting all of our i's before we go into the marketplace, which hopefully will lead to more closes down the road.

Right, that's great analysis. I think there are a couple really important concepts that you raised, and maybe we just pivot now to 2024. And again, I think there's a lot of drivers that are going to impact M&A. Interest rates, we should unpack that a little bit and what are the expectations over the next 12 months and how does that impact timing of deals.

But you mentioned this disconnect in price between what sellers are asking and what buyers want to pay, and you're in an interesting spot as an intermediary. What are those conversations like? What are the dynamics from a seller's perspective when they're thinking about what their ask is compared to the market?

If you look at what sellers are looking at right now, it's not that long ago that we were in the peak days, the heady days of 2021, when valuations were at historic highs. So when they're at their country club and they're talking to their buddies and see that they got 10x, they want to see 10x as well. When the bids come in at six to seven times, that's a bit of a gut punch.

What we do is we spend a lot of time with our clients trying to make sure that we're aligning expectations, and understanding that at the end of the day we're all capitalists and we need to understand that the market will speak when it comes to deals and what the valuation of a company is. If you get five qualified bids or 10 qualified bids or whatever the number is in an auction, and the range is pretty tight, I think that you can go saying that you understand that that's where the market's at today. And if our clients are not in a position mentally or financially to accept those types of offers, then I think we need to, as advisors, spend a lot of time making sure that we're not wasting our time and we're not wasting the buyers' times with businesses that won't transact for that reason.

Logically, it all makes sense. If you see all that your business was worth a lot of money two years ago and it's not worth that today and you're happy to manage the business going forward, then you shouldn't sell. You should wait. But not all sellers are in that position. There's a lot who are at a point in their life, from a health perspective or otherwise, where they want to get a deal done and they understand that. We've had a number of people who say that, "Give us the best deal you can and we will live with that."

Yeah, that's super important, I think. Let's unpack those timing drivers for these processes. And just touching upon interest rates, I mean, my own sense of it is that rates are much higher than they used to be. There's a general sense that they are going to come down a bit and then stabilize. And so I would think a general concept would be if you're a buyer, why not wait for those rates to come down a bit? And there's also, the other driver there is that we are in the midst of a soft landing that we think is going to occur with respect to recession versus not recession, but maybe why not wait a bit and see, and so you're not buying into a recession.

I think there's some drivers there that would cause buyers to wait several months. Maybe it's the back half of this year, maybe it's later. I mean, that's what I'm hearing. And let me know if you're getting a different sense, but so maybe put those concepts next to what drives a founder-owned business, what drives their timing from an age, health perspective, and how do you strategize around that over the next 12 months?

Yeah. I'll start with the seller's perspective first, I guess. A lot of our founders and folks who are looking to sell their businesses, if you look at the average age of business owners, the people are starting businesses younger and they're also looking to sell businesses younger. We're not in that age where you found a business and you plan to pass it on to your son or daughter to continue to run the family business for the next three generations. Most people who are building value through business creation understand that it's to really achieve a value there, there needs to be a liquidity event. Whether that's an IPO, whether that's a sale to a private equity firm or what have you, that there needs to be that kind of an event to really see the value and pass that on to your family.

So we're seeing people form corporations, liquidate those corporations through a sale or an IPO earlier. And then people who maybe had the idea that, "We'll pass this on to the next generation," are seeing that they went through something in 2020 and 2021 that challenged their view of the world. We like to think that that's a once-in-a-lifetime event, that it's a black swan, it's never going to happen again. But a lot of people are saying, "If this happens again, I quit." That's kind of the mentality. And so they want to get out now, get some value, get credit for what they built, and go to market.

When you look at it from the buyer's perspective, I think that there are a lot of people who are doing exactly what you said, they're sitting on the sidelines. The problem with that is that there's an amount of capital right now on balance sheets and in funds that is unprecedented. If you look and you say, where is dry powder today in the United States, I think PitchBook has it at just about a trillion dollars of dry powder in private equity funds to deploy. And at a certain point, you have to deploy that capital. You need to return capital shareholders and you need to put capital to work.

And so we're seeing more equity going into transactions to get deals done. We're seeing sponsors who are willing to put 100% equity checks into deals, with the idea that their ability to get capital a year or two from now is going to be sufficient enough to recapitalize their investment and take cash out. We're seeing people who have real conviction behind their thesis make those types of plays. Not everybody's willing to do that, I think that's why you're seeing volumes drop the way they are. But people who have a real A class asset, they're more likely to get an over-equitized deal from these buyers.

When I think about though, why go now, why not wait, I think it's because there are deals to be had. I think that if you can go and develop a relationship with a business that maybe is sitting on the sidelines to start a process, maybe they're saying, "We'll launch at the end of Q4," or going into the second half of this year, and you can develop that relationship, build that rapport, and disintermediate basically a transaction auction, an auction process, you can actually do very well right now.

And I know a lot of people who follow this podcast are in the independent sponsor community. One thing I would say is that to the extent that you're able to go out and find those proprietary transactions, now is a great time to step up to the plate, pay a multiple that's going to clear a transaction hurdle, and get deals done before a process gets run. Pay a little bit more than maybe you're comfortable with, but if you can do that, you can get assets for a deal compared to what they'll go for in a true auction process.

That's a great point. I know that independent sponsors can play in wide auction processes, but that's not the sweet spot. And so in a way, the first half of this year or whatever you want to forecast, it is going to be a space where independent sponsors can play, work those relationships. And that's a great point.

Getting a bit more granular, you mentioned over-equitized deals. I've been seeing more typically control, private equity funds and investors either over-equitizing a transaction or coming in for a significant minority stake. And I think that one of the big advantages of that is, hey, if you can come in and give meaningful chips off the table to a founder and also keep their credit agreement in place and leverage existing financing without recapping the whole thing, that could be powerful. As you mentioned, you're acting on your thesis that you're confident in and you're moving forward. Have you been seeing either that strategy or other unique strategies in this time?

Yeah, Greg, I think that if you look at deal structures, deals are tending to get a little bit more structure around them. And that's typically as a way to de-risk a transaction from a buyer's perspective. That's typically how we think about things. And so what we're seeing is significantly more equity rollover, whether that's to minority transaction or they're only buying 60% of the equity, as opposed to maybe we would've seen it closer to 80-plus percent or a complete control, 100% transaction in the past. We're seeing a lot more of that.

And I think part of what's driving that is fixed-charge coverage ratios is a major hurdle right now for especially private equity. If people are getting 1.1 to 1.2 times coverage ratios, that's really going to limit the amount of debt they can put on these deals. And so if they're having to put in 40, 50, 60% equity, that changes their valuation hurdles, that changes their returns analysis, and kind of impacts what they can do.

Which is why I'm saying flexibility here is key. If you can find flexible structures, if you can get comfortable with the idea of refinancing down the road, that's going to really change the way that you view the marketplace and your ability to get a deal done here and be proactive, rather than reactive, in the marketplace.

Right, I totally hear you. I'm seeing a lot of creativity. I mean, just to stick on a specific point, when you're talking about the equity invested, by the new money equity invested, I'm seeing more of a trend to that being a preferred equity structure vis-a-vis the rollover. Maybe historically rollover sellers would be pari passu with the invested capital, and there's a lot of good reasons that that result makes sense, that they would be pari passu, which is on common footing. I hate to bring out Latin phrases as a lawyer.

But I'm seeing more of a trend of, okay, instead of giving a hit to the purchase price for a seller, whereas like, okay, there's a little uncertainty here, but seller really wants this higher purchase price. What can we do to give that seller a higher purchase price? One of the things, in addition to earnouts and things like that, is the new money comes in with a 1 x liquidation preference, so they're the first money out in a downside scenario. And there's all sorts of variations on that.

And so I guess, are you seeing that specific trend more? Are you having that fight when you're representing sellers, and what are some other tools you're seeing? Tools that people can utilize until the ship turns and we get back into a bull market here?

Yeah. We're certainly seeing that, especially on some of the larger transactions in the middle market, where that kind of structure makes sense or could make sense. We don't like seeing things that have preference personally for our clients. We prefer the paper to be pari passu with the new equity coming into a transaction.

And the thing that I would say to buyers who are looking to use that as part of their toolkit to get a deal done, is really make sure that you're focusing on the downside risk as opposed to trying to build in mechanisms that might give you additional upside in the backend. I think that that goes over much better with sellers, as opposed to it has a 1.15 liquidation preference. Suddenly you're building in a 15% return hurdle before their equity is getting any sort of payback. But if you really look at it as, "We're just limiting our downside," I think that that goes over much easier with a seller, especially if there's a significant equity role.

I totally agree with you. I couldn't agree more with that positioning of it, and many sellers have the confidence in their business that that won't come into play. It's funny, I don't want to get too granular here, I have not yet had my podcast used against me in a negotiation, but you never know. I guess that's when I'll know that the podcast is really blown up in popularity, but haven't had it yet.

Exactly. Just to, I guess, give myself a little bit of coverage, it doesn't make sense in every transaction. At the end of the day, you need to look at every deal is different. We talk about this all the time. Every process is bespoke, every deal has different dynamics running into it.

And we understand, as advisors, and I think sellers tend to understand this as well, that at the end of the day, buyers want to figure out how can they minimize their risk of doing a transaction. They're putting sometimes hundreds of millions of dollars of their investors' money at work here. How do they make sure that they don't end up with egg on their face down the road? And I think that if everybody can get aligned with that idea, I think there's a route to get more deals done and more deals closed.

Right. What are some other trends or themes that you're thinking about in 2024, whether it's specific industries that may be strong, whether it's private credit funds, for example, continue to be big in the market, but maybe give me some themes to watch for.

Yeah. I think that one thing that you just touched on that we haven't really talked about too much is just that from an M&A perspective, private credit is becoming a much larger piece of the pie in terms of getting deals financed. A lot of the more traditional lenders have pulled back on what they're willing to do. They're giving much less leverage. They're having much more restrictive covenants in place when they do transactions. Where they're more likely to play today is through add-on or corporate transactions where there's already an underlying business that supports the debt. But for new platform investments in private equity, it's either coming from the fund itself or it's coming from maybe a unitranche offering from one of these private credit guys.

That's something that I think you're going to continue to see until rates drop more. When I'm out at events and talking to mezz lenders, they love today, because mezz lending has actually not gone up that much. Maybe it's a few points here or there, but it's stayed relatively flat compared to the rest of the lending community. And so they have their pick of transactions compared to what they're used to, because at the end of the day they're looking more and more affordable.

But at the same time, it's that old saying, "pigs get fed, hogs get slaughtered," it's making sure that you're being reasonable in terms. Having a pick, toggle kind of instrument out there that's going to kill the equity if you can't refinance it in a year, things like that are hard to get done and hard for private equity to live with at the end of the day.

Other things, from an industry perspective, I think that you're going to see a lot of businesses transact that have maybe a less cyclical story behind them from an end market perspective. I think you'll continue to see some weakness in the building product segment. Things that are new house construction type of end market exposure, I think is going to be a little bit different. Which is interesting, given that if we look at housing shortages, they need to build more houses, but with interest rates where they are, I think that's going to be tough. I think once you see those interest rates come down, that'll be a great time for that segment because there's just so much demand out there that needs to be built for.

AI, I guess we could talk about AI. I don't know. Do you want to be an AI podcast, Greg?

I would quickly be out of my depth on the AI, but no, it's a theme. It's certainly a theme.

It is, it is. And I mean, you look at things like the JP Morgan Healthcare Conference that they just had, and one of the big trends out there was AI, and driving diagnoses and ease of explaining diagnoses to patients and things like that. I think that as you see that continue to be a bit of a trend and a tailwind to businesses that can find ways to put it to use, I think that's going to be good.

I'm always a little bit skeptical about big trends. I covered automotive for a long time, and we talked about for a long time CASE, connected, autonomous, shared and electric, and all these things that were driving the automotive industry. Tesla remains the most valuable automaker in the world. But at the end of the day, is the uptake really hitting what was expected three, four, or five years ago? We always talked about range anxiety with electric vehicles. Well, a lot of that's been fixed, but they're still not getting the uptake that we thought. So it's kind of recalibrating expectations around those technologies.

In our lane, in the lower middle market, I think being mindful of how do these businesses really make money and trying to peel back from some of the hype is going to be important, so that we don't have a similar issue that we had with a lot of the SPACs that came out in 2020, 2021. What we found out was that the fundamentals underlying the companies weren't really there.

Yeah, I hear you. I mean, yes, some trends tend to come and go. I look, and this is not my day job of being an economist, but being in the middle market to lower middle market, the overall trend of founder-owned businesses are attractive acquisition targets for financial sponsors who can go in and make improvements, and there is a backlog of founders looking to exit. And then from a generational perspective, it's also trending in that direction as well. That's a longer term trend, but I think one that benefits I would think the listeners of this podcast and people in this space generally. So no, definitely insightful there.

Maybe we, as we wrap this up, take out the crystal ball a little bit. I won't hold you to this, but what are you seeing as far as when is the ship going to turn do you think on M&A activity? And then is it going to be a deluge of deals and craziness, or will it be ... What level do you see it ramping up to? We can delete this part of the podcast.

Yeah, exactly. Exactly. Well, maybe we can talk a year from now and figure out how close I am, but consensus seems to be the second half of '24 is going to be significantly better than it is today. I think that the longer that rates stay steady or start to decline, it's going to open up a lot more activity. I think that you're going to see a lot of, just from a private equity perspective, you're going to see a lot of funds have building pressure to deploy capital. Maybe you could sit on the sidelines for a little bit, but at the end of the day, if you're not deploying, you're not making money. So you're going to see that affecting transactions.

And we at DAK, we're seeing significant appetite from sellers to get into the marketplace. So what we keep telling people is that you should always operate your business like you're going to own it forever, but be prepared to sell it tomorrow, because the last thing that you want is to see the window open and then be on the back foot. And be unable to actually get into market quick enough to take advantage of that capital being deployed.

So now's a great time for businesses to hire an advisor, get prepared for a sale, make sure that you're doing all of your upfront diligence so you can maximize value on the backend. Get a sell-side Q of E. Know your numbers, be able to track data. That's one of the trends that we've certainly seen over the last 12 to 18 months, is a focus on data. Which is a silly thing to say in one hand. Of course data is important, but it's not just having a quality of earnings, it's also what are your operating KPIs? How do you track operations to financial outcomes? What's your unit level economic analysis for your business? Have you grown 20% year-over-year because of price increases or is it volume-based? Are you actually selling more products to more people?

And all those things are things that we're seeing a lot more scrutiny on in the deal process than we did two years ago. So as we continue to move forward, I think now is a great time to be prepared for a sale. And I do think that we're going to see a lot more businesses, quality businesses, come in for sale in the back half of this year, hopefully sooner.

That's great. I think that's great advice for people thinking about selling a business. For sure, use this time to get ready to go to market. And I loved your advice earlier for independent sponsors and others trying to find unique opportunities, now is the time to build those relationships before those companies are fully baked and ready to go to a broad auction. Work those relationships now.

Well, great. Derek, I really appreciate you joining us. This has been super interesting as we look ahead to 2024. Thanks for your time.

No, I appreciate it. It's always fun to talk.

Great. Thank you.

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