Third Quarter Update 2023
Market Conditions: The third quarter of 2023 saw declining deal flow, purchase multiples, and lower returns in the public equity markets. A mild recession is still possible, and some argue that we are either in a recession or soon will be. With that said, we expect that 2024 will be a better year for markets and that strong corporate balance sheets will drive increased deal flow. At EPOCH, we believe companies seeking to create stakeholder value are more resilient and therefore fare better than those focused solely on shareholder value.
Increased interest rates have put pressure on Private Equity fund's returns. With little multiple expansion over the last year, value creation at the portfolio level increasingly has to be driven by gains in market share, improved operational efficiency, and acquisition. This was reinforced by Kevin Cooper from Cooley LLP, (Axios M&A Forecast event, October 4th, 2023). His analysis shows that corporate buyers have increased activity (17% increase v. Q3 2022) and will create value by incorporating automation, gaining supply chain security and redundancy, building organic growth strategically, and simply beating the competition. These sentiments have been voiced before by Bain Capital. As rates are forecasted to remain close to their current levels, downward pressure on valuations will continue. This may prove to be a long-term benefit to disciplined acquisitive companies with strong balance sheets and PE funds with dry powder.
Risk Mitigation: Buyers need to understand a target business’ risks, and a well-executed due diligence process includes a growing list of ESG items. These ESG items are impacting deal closings and price. In July, KPMG released its ESG Due Diligence Survey which includes global responses from over 200 corporate and financial investors, along with M&A debt providers. 41% of respondents believe that ESG engagement is driving major financial value today in M&A efficacy. The same percentage of respondents also believe that ESG will provide financial value in the next 2-5 years in terms of tax benefits and mitigated risk. Tellingly, 53% of corporate investors canceled a deal due to material ESG findings during due diligence. And 42% reported that material ESG due diligence findings reduced purchase prices. For those exploring a sale or acquisition, ESG considerations are becoming a larger part of risk mitigation strategies. We believe incorporating material ESG factors, tailored to the deal context, into the offering materials and due diligence process increases the likelihood of a successful transaction in the long term.
Index Comparison
Conscious Business Market Performance: Our index comparison includes the JUST 100, Change the World, and Firms of Endearment indices. These indices are rooted in the belief that when companies align their operations with stakeholder needs, they can create both social and financial value without a tradeoff. As an investment bank committed to maximizing value while maintaining our client’s mission, we believe highlighting the benefits of a conscious approach to business is important. The JUST 100 Index led the compared indexes with a 15.02% return over the prior year, Change the World Index following at 12.19%, the S&P 500 came in at 11.22%, and Firms of Endearment at a 9.65% return. Firms of Endearment returns lagged as 8 of the 21 firms in the index saw their stock go down in the prior year. The gains of other companies in the index, including Adobe and FedEx, were not enough to offset those losses. The lowest performers in the Firms of Endearment were The Container Store, 3M, and Disney. The JUST 100 is part of the Russell 1000 index and is more diverse in terms of industry representation.
Private Equity quarterly deal count by size ($M)
Middle Market Outlook: Middle Market deal volume continued declining in Q3, down 24% from Q2 and 70% from Q3 2022 with the largest change in volume in those deals under $25 million in enterprise value.
Enterprise Value/EBITDA multiples
The threat of a government shutdown and prospects for additional rate hikes drove middle market deal multiples down from Q2 to the levels they were in Q1. Larger deals still occurred as buyers with cash were willing to pay a premium to acquire strategic growth opportunities. The outlook for global M&A activity in the last quarter of 2023 is expected to remain relatively sluggish, with the possibility of further interest rates hikes and the prospect of mild recessions across several key markets. However, the M&A market is likely to rebound in 2024 as acquisitions remain a key element of corporate growth strategy and corporations are sitting on some $4.1 trillion in cash, according to PitchBook.
The way companies choose to invest in their people can create value. The JUST 100 Q3 report shows that of the Russel 1000, the companies in the top decile of worker care outperformed those at the bottom decile by 7.24%. Caring for workers was measured by paying living wages, having strong health and safety policies, encouraging work-life balance, and creating a culture of inclusion.