Phil Neuffer,
Managing Editor,
Monitor

Last year was not a particularly active one for merger and acquisition activity in the equipment finance and leasing industry. Despite headline-grabbing deals between Eastern Funding and Macrolease, Wingspire Capital and the former Liberty Commercial Finance and Peoples Bank and Vantage Financial, transaction activity more or less slowed to a trickle in 2022, especially compared with 2021, when buyers and sellers were eager to put pen to paper.

The trickle of 2022 has become even more faint in 2023, with very little activity to be found across the first couple months of the year. As Brent Ferrin, a managing director in Houlihan Lokey’s Financial Services Group, summarizes: “It’s been pretty quiet so far,” with multiples still a couple turns below where they were at the peak of 2021.

Slow Motion

The slowdown in M&A activity is largely a symptom of a less than deal-friendly economic environment. In the last year and a half, the U.S. economy (and global economy overall,

for that matter) has endured severe headwinds, including rising inflation, higher interest rates, supply chain disruption, the war in Ukraine and more. While supply chains are stabilizing and inflation is trending down, more substantial progress will need to be seen before buyers and sellers reenter the market with gusto.

Of the myriad economic headwinds dragging M&A activity down, rising interest rates have been particularly damaging. In 2022, the Federal Reserve raised interest rates seven times, and it did so yet again in early February, boosting the target range to between 4.5% and 4.75%. In announcing its rate hike in February, the Fed did say “inflation has eased somewhat,” but it also noted that it “anticipates that ongoing increases in the target range will be appropriate.” During a livestream presentation for Monitor in early March, Elliot Eisenberg, PhD, an economist and public speaker, said he expects there to be at least three rate increases before the end of June.

“The overall interest rate environment has been starting to squeeze some people’s profitability and cash flow,” Ferrin says. “So, they’re paying higher interest expense, which for these businesses, is a cost of goods sold.”

Although higher interest rates affect every type of company, recent rate hikes have been more of an issue for businesses with higher credit quality and lower yield, as they have less top-line yield cushion, according to Ferrin.

Regardless of a company’s credit and yield status, Ferrin says there are simply fewer buyers in the market right now across all segments, including private equity firms and banks. On the private equity side, such buyers need higher yields for “the math to work” given their higher returns, while banks often look for companies with solid management teams, institutionalized platforms, a low loss history, strong vendor and OEM relationships and niche asset classes within their lease portfolios. Ferrin says “there always will be” bank buyers for companies that have those attributes, but that doesn’t mean banks will be shelling out as much cash to close deals in the current environment.

Planning Ahead

For companies looking to buy or sell, patience will be the key. Fortunately, many businesses are already taking such an approach, which could lead to higher yields and improved performance in the long haul, even if it may be dampening M&A activity in early 2023. To that end, Ferrin says while actual deals aren’t closing right now, many companies are actively planning for 12 to 18 months down the line, examining what their alternatives will be at that point, whether that means pursuing a merger, acquisition or even a capital raise. Ferrin says some companies are even taking a dual track to pursue a capital raise and M&A deal simultaneously.

“This is a trend that we’ve seen across not just equipment leasing, but with potential sellers or issuers of equity or debt planning a little further ahead,” Ferrin says. “Companies are being a bit more forward-thinking as opposed to just waiting and rushing at a deal like folks were doing back in 2021 in a really hot market.”

Ferrin is particularly bullish on the current capital raising market. As he explains, if companies want to continue to grow in the face of higher interest expenses, they may need to raise additional junior capital through equity, mezzanine debt or some other form of sub-debt.

Alternatively, Ferrin says companies could move away from putting their production on their balance sheets and sell off some leases to other lessors, credit funds or flow buyers. Some of these alternative avenues could include or lead to a preferred equity or minority investments that will serve as a bridge to a sale.

“For the right acquisition targets, some of these financial sponsors can see the opportunity to use their flexible capital to come in and take a minority piece or a preferred equity position to not necessarily bridge to profitability but bridge to the exit profitability,” Ferrin says.

For private equity firms, seeking these types of alternative investments may mean turning away from buyout deals in favor of setting up separate funds with a more flexible mandate within their primary funds to seek out minority investment and/or preferred equity transactions.

“There are going to be some unique opportunities there. And I think in 2023 there’s going to be more actionability as buyers, investors and sellers come a little bit closer with the gaps from last year,” Ferrin says.

Closing the Gap

It’s still very early in 2023, so there is plenty of time for activity to pick back up. Ferrin believes at least a few deals will get done this year, although he predicts many will be the culmination of negotiations that started in 2022 but failed to reach the finish line before the calendar flipped.

“I think most of the deals that close this year will more than likely be some of the deals that had stalled or were put on hold last year,” Ferrin says.

Ferrin’s optimism, albeit guarded, is also buoyed by a belief that some of the looming uncertainty brought about by high inflation and a pending recession will dissipate over the next year.

“We’re in sort of this warm spot in the market now where people are getting a little bit optimistic about the overall rate environment,” Ferrin says. “I think folks are relatively in alignment that a recession is probably going to happen — or we’re already in one — but it’s going to be relatively mild.”

With a “catastrophic” recession seeming less and less likely, the gap will close between companies that couldn’t find a compromise for a sale last year, while newer buyers and sellers will better understand where their losses will be through the recessionary cycle, giving them more confidence when going to market.

“I don’t think it’s going to be a gangbusters year, but I do think a few deals will get done in the middle to back half of the year,” Ferrin says. “I think there’s a bit more optimism today than there was a couple months ago.”

ABOUT THE AUTHOR: Phil Neuffer is senior editor of Monitor.