According to Capstone Partners’ recently released Q1/23 Capital Market Update, total middle-market merger and acquisition volume declined 14.3% year over year in Q1/23 as macroeconomic headwinds caused a slowdown in dealmaking. However, middle-market deal volume continued to outperform the broader M&A market, as total M&A volume declined 25.2% year over year in Q1/23. While buyers have demonstrated increased selectivity, quality companies with strong margin profiles have continued to command M&A interest at premium valuations, according to Capstone Partners, with added that the Federal Reserve’s ability to navigate a soft landing will likely prove consequential for middle-market M&A throughout 2023.

Uncertainty is seldom received favorably by capital markets and the current lack of economic visibility has caused angst among many market participants. The Fed has yet to settle on a terminal interest rate, with the continued strength of the labor market complicating the task of whether to hike or pause. Recent turmoil among regional banks has contributed to the tightening of the U.S. economy, an element that may be difficult to quantify in basis points. As the United States navigates a higher-for-longer rate environment to quell stubborn inflationary headwinds, confidence in a smooth recovery has often fluctuated with equity market swings, leaving many to wonder when the United States will enter a recession, or if the economy is already in one. As the economy eyes an emergence from monetary tightening, there is hope that the M&A market may have reached a modest trough, presenting a strong backdrop for a recovery in middle-market dealmaking.

Inflation and elevated interest rates have continued to pressure M&A valuations in the middle market. However, there has been evidence of some upward pricing momentum in early 2023. The average EBITDA multiple amounted to 9.1x in Q1/23, following a drastic decline to 7.2x in Q4/22. Interestingly, large-scale transactions have experienced the most significant pullback in pricing. The core middle market ($100 million to $250 million in enterprise value) has continued to be the bellwether of middle-market pricing. Valuations at this range have held steady at 10.9x EV/EBITDA, nearly mirroring last year’s average of 11.1x EV/EBITDA.

Business owners, dealmakers and lenders will be closely monitoring the monetary policy environment and its reverberations on the broader economy. If the United States has reached, or is approaching, its trough in the M&A market, there is a precedent for what is to come. Sellers can expect exuberant interest from buyers looking to re-engage in inorganic growth upon a market recovery. Timing and asset position will be key, as a substantial level of pent-up demand can be expected to create healthy levels of competition in the middle market.

“As has traditionally been the case, M&A market valuations and activity levels are driven more by credit trends than by equity market levels,” Phil Seefried, executive advisor at Capstone Partners, said. “Tightened credit conditions have decreased the amount of debt available for transactions as well as increasing the cost of that debt. With higher required equity contributions and more expensive debt, valuations have adjusted downward to maintain returns. Further, the natural flight to quality in times of uncertainty has further reduced supply in the short term. We look forward to the inevitable rebound in activity as conditions stabilize.”