A Lower-Middle Market M&A Update

As an organization committed to Environmental, Social, and Governance (ESG) principles, we extend our gratitude to both our continuing client relationships and our new clients. Your dedication to conducting business with a conscience is the cornerstone of our mutual success. We remain dedicated to supporting responsible businesses - helping them create enterprise value while protecting their purpose, mission, and core values – through capital raising, ownership transition, and strategic acquisitions (buy-side). Those who share our vision of responsible and conscious business and those who are interested in doing the right things for all stakeholders continue to inspire us and the work we do.   

Since March of 2022 the Federal Reserve has increased interest rates eleven times in an effort to curb inflation and avoid recession. Lower middle market deal multiples have expanded while deal volume has increased. While there is a mixed outlook for deal activity through the remainder of 2024, M&A activity will bounce back, even if the timing for that is unclear. This is in large part because there is a need to do deals. Pent-up demand (and supply) of deals has resulted from funds from private equity firms continuing to grow combined with lower M&A activity over the past two years. There is mounting pressure on sponsors to deploy their dry powder. In addition, companies interested in growing their businesses in a low-growth economy also create M&A opportunities.

Corporate and private equity investors have a growing appreciation for the way environmental, social, and governance (ESG) factors can drive value.  With the availability of increased data and the assistance of more precise, consistent measurement tools, M&A principals are better positioned to understand the impact of ESG on valuations, targeting, and portfolio management. Overall, incorporating ESG factors into the M&A process continues to grow from the occasional area of focus to a more consistent and influential consideration. Europe and Asia remain committed to implementing ESG in their due diligence and investment evaluation processes with unified frameworks moving closer to full legal implementation. In the United States, ESG has remained a valuable tool while the term itself and its visibility has shifted due to the continued pressure from its detractors.

The Global Alliance of Impact Lawyers (GAIL) hosted a panel discussion on “Values-Driven Governance Models: Perspectives from Practitioners & Business Leaders Relating to Governance Models of Mission-Driven Companies” which included one of our co-founders, Lynn Carpenter. The panel shared their knowledge, experience, and insights on governance models for mission-driven companies and navigating legal considerations and practical aspects of forming and maintaining values-driven organizations.

Market Analysis

 Indexes, Multiples, and Deal Flow

Market Index Performance

The above index comparison includes the following indices:

(1) JUST 100 – Just Capital’s evaluation of the Russell 1000 companies across 20 core issues, 236 underlying data points, and five stakeholders: workers, communities, shareholders & governance, customers, and the environment,

(2)  Fortune Change the World - companies selected by its reporters and editors that embrace corporate purpose and recognize how it can add value to business and society and turn a profit,  

(3) Firms of Endearment – companies highlighted in Raj Sisodia’s book of the same name who seek to maximize their value to society as a whole, all their stakeholders and create emotional, experiential, social and financial value; and

(4) S&P 500

Since June of 2023, our tracked indexes performed similarly up until January 2024 when the Firms of Endearment (FoE) started to outperform each of the other three indexes. The FoE ended five points higher than the S&P 500 on June 30, 2024.

The Fortune Change the World and JUST 100 Indexes tracked the S&P closely up until March of 2024 where they started lagging. As of June 30, 2024, the Fortune Change the World and JUST 100 Indexes were 17 and 11 points lower respectively than the S&P 500. A third of the S&P 500’s growth was on the back of a handful of technology- and AI-driven stocks (NVIDIA, Alphabet, Apple, Meta, Microsoft, and Tesla). The large tech companies have invested in developing AI as a product which has driven their value higher and faster than those that have not. To us, this means some of our tracked indexes have lagged the S&P not because doing business with people, planet, and profit in mind has seen diminishing value but, as a short-term driver of value, find it difficult to compete with the current sentiment surrounding AI’s potential. People remain the core of operations and systems execution, and we believe that doing well by doing good will remain vital for the long-term success of businesses. Arguably, with AI becoming more widely proliferated, using it ethically and transparently will become ever more important for businesses and could present real risk. Companies that adopt AI as a core part of their operations may find the ethics and transparency of its use become part of “doing good” as they strive to do well.

Deal Volume Improved in Lower Middle Market

Deal volume grew 3% from Q1 2024 to Q2 2024 and 7% from Q2 2023 to Q2 2024. Overall, deal volume has continued to grow in the North American lower middle market each quarter from Q3 2023 onward, with deal flow for <$100M in value being most consistent.

Deal Value Increases

Valuation multiples (enterprise values/EBITDA) in the North American lower middle market have varied by transaction size but overall have increased since Q2 2023. Valuation multiples for deals <$100M have increased 1.8x from Q2 2023 to Q2 2024 while multiples for deals between $100M-$250M and $250M-$500M have declined 2.4x and 1.9x respectively.

Pitchbook’s cross-sector momentum scores provide insight into how changes in M&A deal activity and median valuations compare across sectors. In determining valuation momentum, Pitchbook uses the TTM change for EV/EBITDA and EV/Revenue metrics. For North America and Europe, Pitchbook reports that the Energy sector has the most positive momentum in valuations followed by B2C and IT. Industries experiencing negative momentum include materials & resources, B2B, and financial services while healthcare is neutral.

What We Found Interesting

News and Analysis

Morgan Stanley reports sustainable funds outperformed traditional funds,  with returns of 12.6% and 8.6%, respectively . For 2023 they report “by asset class, sustainable equity funds performed best, with median returns of 16.7%.” Despite the outperformance, U.S. sustainable (includes closed-end funds, exchange-traded funds and open-end funds; excludes feeder funds, funds of funds and money market funds) experienced $4.7B in investment outflows in Q2 2024 (Pitchbook). High interest rates have made alternative investment options more appealing and reduced sustainable fund allure. Continued concerns about greenwashing contributed to outflows along with the increasing politicization and regulatory scrutiny ESG investing has come under.

Regardless of the controversy surrounding ESG, as a framework, it remains important in the public markets and in M&A. Investors continue to want the material ESG aspects of an investment to be evaluated. An Axios article provided different perspectives as to why ESG isn’t going anywhere. Some interviewees say that ESG (or what some call “responsible investment”) serves as a guide to future-proof companies, enabling them to address future issues like climate and energy efficiency. Others point to the enduring and evolving regulatory requirements in Europe that will force global companies and investors to evaluate investments from an ESG perspective. Additionally, KPMG reported that “four in five dealmakers say ESG is now firmly on the M&A agenda with more than half of dealmakers expecting to perform ESG due diligence in most transactions over the next two years. Despite rising importance, budget constraints for robust implementation remain.” A Wall Street Journal article finds that even though companies mention ESG and DEI in their earnings calls less frequently, their financial reports are maintaining a focus on ESG and sustainability. Companies are shifting their language to describing ESG and DEI efforts as “sustainability” or more explicitly “clean air, clean water, and economic opportunity.”

Blue Earth, an impact investment firm in Switzerland with $1.2 B assets under management, released its inaugural Impact 360 Survey this summer. Their survey included 130 impact market participants across the globe. 63% of respondents are in Europe, 18% in North America, with the remainder in Latin America, Africa, Asia, and Australasia. The report finds that 26% choose investments geographically close to them. Based on the survey, investors have found that 83% of their investments have met their financial return expectations and 96% have delivered the impact they expected. Additionally, private equity and venture capital are the top asset classes for investing in the impact space. Based on this survey, impact investing is delivering both financial value and social value. Additionally, those seeking funding for their impact-focused enterprise might look to PE or VC firms in their region for the best chance of success.