Navigating Recession as a Business Buyer: Understanding Lower-Middle-Market M&A Dynamics
The ASE Fleet's Take Off 48
Hello Friends,
Recession 2024: What to Watch and How to Prepare
Heading into 2024, the U.S. economy, though stable, faces the risk of a recession due to lingering inflation and high-interest rates. Here's a summary of what investors and economists are watching and how they can prepare.
Economic Overview
Stable Economic Indicators: As of late 2023, the U.S. economy is relatively stable with cooling inflation, a steady labor market, and the Federal Reserve considering interest rate reductions in 2024.
Soft Landing Possibility: There's optimism for a 'soft landing' with slow GDP growth without a recession, contingent on the Federal Reserve’s policy decisions.
Inflation and Interest Rates: Inflation, after peaking in 2022, has decreased, but core personal consumption expenditures (PCE) are still above the Federal Reserve's target. The Federal Reserve has raised interest rates to combat inflation, with the possibility of cuts in the coming year.
Recession Risk Factors
Inflation: Although down from its 40-year high, inflation remains a primary risk. The latest trends indicate a decrease in inflation rates, but certain sectors like children's clothing, auto insurance, and medical products show 'sticky inflation,' resistant to policy changes.
Elevated Interest Rates: High interest rates, aimed at curbing inflation, increase borrowing costs, potentially slowing business investment and consumer spending.
Labor Market and Economic Growth
Strong Labor Market: Job growth remains solid, and unemployment rates are historically low, which is a positive sign for the economy.
GDP Growth Projections: The GDP grew significantly in 2023, but projections for 2024 indicate a slowdown to about 1.4%.
Indicators and Predictions
Yield Curve Inversion: The inversion of the 10-year and two-year Treasury yield curve since mid-2022 signals a strong recession possibility.
Rising Debt and Delinquencies: Record-high credit card debt and increasing delinquencies in mortgages, auto loans, and credit cards hint at weakening consumer strength.
Recession Probability: As per the New York Fed's model, there's a 51.8% chance of a U.S. recession in the next 12 months.
Market Sentiment and Responses
S&P 500 Rally: The market has responded positively to falling inflation rates and the prospect of rate cuts, signaling investor optimism.
Expert Opinions:
Bill Adams, Chief Economist at Comerica Bank, points to strong consumer spending, falling long-term interest rates, and declining fuel prices, suggesting lower recession risks.
Chris Zaccarelli, Chief Investment Officer at Independent Advisor Alliance, acknowledges the risks but notes that a resilient labor market and consumer spending were underappreciated factors in 2023.
Preparing for 2024
Investors need to stay vigilant about these indicators and adjust their portfolios accordingly. While being overly cautious might be a mistake, as seen in 2023, it's essential to balance optimism with a practical approach, considering the existing economic risks. Key to navigating 2024 will be monitoring inflation, interest rates, the labor market, and consumer spending trends.
It's crucial for business buyers, especially those eyeing the lower-middle market, to understand how a recession impacts mergers and acquisitions (M&A). As I draw from Ely Friedman's insights on the state of M&A in economic downturns.
The Impact of Recession on M&A
Recessions are unique events, and their impact on the M&A landscape can vary significantly. However, certain general trends and factors can guide business buyers in their decision-making process.
Lending Capacity and Appetite:
Unlike previous downturns, a potential slowdown now may not significantly hamper lending capacity.
Banks might adopt a conservative stance in underwriting, but the availability of capital for buyers may not dry up completely.
Reduced lending capacity can lower the amount buyers are willing to pay for businesses.
Cost of Capital:
The Federal Reserve's policies on interest rates are a key factor.
In economic downturns, rates are generally lowered or kept unchanged to stimulate economic activity.
Lower borrowing costs can increase a buyer's willingness to pay more, assuming consistent valuation levels and return expectations.
Access to Equity Capital/Cash:
In the initial phases of a slowdown, cash reserves of both strategic and financial buyers are likely to remain robust.
Government subsidies and private equity funds flush with capital can create a favorable environment for sellers.
Supply and Demand for Deals:
The seller-favorable period preceding a recession often leads to a surge in M&A activities.
Demographics, particularly aging business owners, continue to provide a steady supply of high-quality deals.
Despite uncertainties, demand from strategic buyers and private equity funds looking for growth and capital deployment remains strong.
Market Dynamics: A Closer Look
Understanding the dynamics of lower-middle-market M&A during a recession is key for business buyers:
Market Resilience: The lower-middle-market tends to be more resilient than the mega-deal sector. The discipline in lending and buying practices in this market segment helps stabilize it during economic downturns.
Valuation Fluctuations: While premiums paid in the M&A market may experience some contraction, it's not expected to be so pronounced as to significantly deter selling or buying activities.
Buyer-Seller Expectations: It's important for buyers to be aware that sellers might have adjusted expectations due to lower earnings and economic uncertainties.
Strategic Considerations for Business Buyers
Market Opportunities: Economic downturns can present unique opportunities for business buyers. Companies in distress or those needing to divest quickly may offer valuable deals.
Negotiation Leverage: Buyers might find themselves in a stronger negotiating position, especially if they have robust capital reserves.
Long-Term View: Look beyond the immediate impact of the recession. Consider the potential for growth and recovery post-downturn.
Risk Assessment: Carefully evaluate the risks involved in any M&A activity during a recession. Due diligence is key.
Diversification: Consider diversifying your investment portfolio to mitigate risks associated with any single market or sector.
Concluding Thoughts
As a business buyer in the lower-middle-market sector, it's essential to stay informed and adaptable. A recession brings challenges but also opens doors to potentially lucrative opportunities. Balancing risk with opportunity, maintaining a solid financial base, and staying attuned to market dynamics is crucial for navigating the M&A landscape during a recession. Remember, downturns are part of the economic cycle, and with the right approach, they can be navigated successfully.
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