Dealmakers Remain Positive While Uncertainty and Risk Loom Over Middle-Market M&A in 2022

Business-level M&A trends remain positive but they’re contingent on a macroeconomic environment that's tied to the uncertainty of the pandemic and inflation.

The unpredictability of new COVID-19 variants, prolonged inflation, and the compound effects of rising interest rates loom as some of the largest threats to the economy and M&A in 2022.

As they did in 2021, waves of new infections will continue to shape business confidence and their economic outlook.

While most dealmaker and executive surveys show lower amounts of concern over interest rates in 2022, when paired with higher rates of inflation, tighter capital markets could have a negative trickle-down effect on M&A by dampening the economy.

While some large and multinational companies could see higher taxes in 2022, middle-market deal makers are beginning to look past the threat of higher corporate and capital gains taxes.

While some of the key macroeconomic trends that supported last year’s M&A boom, like a steady recovery from the pandemic, the risk of rising taxes, and manageable inflation rates aren’t guaranteed to last, most dealmakers expect volumes and valuations to remain high in 2022.

The Bull Case

As long as the pandemic remains under control and The Federal Reserve can manage inflation without a negative reaction from markets to rising interest rates, we will likely see middle-market deal volumes and valuations get close to their 2021 levels as many dealmakers expect. However, a sustained return to the same levels carrying into 2023 is less likely.

The Bear Case

New and potentially stronger COVID-19 variants could dampen economic growth and executive confidence while disrupting business strategy and putting some M&A plans on hold.

Similarly, an overreaction by the economy or The Fed on interest rates during a period of longer-than-expected inflation or new variant infections could do the same.

In an environment of greater risk and uncertainty amidst the rising costs of the pandemic’s disruptions, inflation, or both, M&A volumes and valuations would come down in 2022, as executives lose confidence in their ability to predict and prepare for the future.

Even with a less dangerous variant, prolonging the pandemic’s state of uncertainty and risk for businesses and consumers alike would still have a measurable effect on economic growth.

With inflation between 4 percent and 5 percent alongside rising interest rates and the resurgence of one or two moderately disruptive new variants, a middle-ground scenario in the economic outlook would still see lower volumes and valuations for middle-market M&A in 2022.

After beginning the year with strong, carried-over deal flows from 2021, this scenario could see activity levels return to those of a relatively normal but calmer year for dealmakers.

In both cases, two macro trends that seemed transitory at their outset could prove to be more endemic than expected.

In any case, the frenzied drive to complete middle-market deals before tax hikes will subside, as Democrats have been unable to unify around a broad-based corporate and capital gains tax and many predict they will lose control of Congress in November’s midterm elections.

Still, some large and multinational companies could see higher taxes this year. While most of the president’s ambitious original tax plan will remain unpassed, Democrats will more than likely remain united on a corporate minimum tax of 15 percent for companies with over $1 billion in profits and a roughly 15 percent global minimum tax on overseas profits of US-based companies.

While 2022 could bring higher taxes on the highest income earners, which could affect some sellers’ margins, the Democrat’s intra-party challenge of organizing enough votes amidst the

narrowest possible party majority will continue throughout 2022, making any tax changes beyond the two minimum taxes exceedingly unlikely.

M&A activity levels from 2021 will likely carry into the beginning of 2022

Looking back at 2021, middle-market buyouts between January and November 2021 reached $714.8 billion, compared to 2020’s year-end total of $613 billion and $699 billion in 2019, according to data from Pitchbook.

That amounts to nearly 25 percent of the US’ total M&A transaction volume of $2.9 trillion for 2021, compared to the middle-market’s total-year share of nearly 33 percent in 2020 when the value of all announced deals fell by nearly 18 percent.

After strong levels of activity in the first half of the year, the amount of new deals for many middle-market M&A professionals peaked at the end of the summer.

With large amounts of private equity dry powder, high demands for business transformation through M&A, and strong deal flows all carrying into the new year, business-level M&A trends suggest the volumes and valuations from 2021 will carry into part of 2022.

Larger companies are more optimistic about M&A in 2022 than the middle-market

Tracking business and dealmaker opinions about the future during such a tumultuous period of time is difficult. Compounding the problem, many year-end dealmaker surveys often include responses that were collected throughout the course of a few months or more, during which conditions and opinions can change.

Still, by looking at how outlooks and sentiment have changed over time, we can begin to put together a clearer picture of what 2022 could look like for M&A.

Analyzing survey data from multiple mid-market and global research firms on predictions for 2022 from M&A professionals, larger firms buoyed by soaring public equity markets are more optimistic about M&A activity than their mid-market counterparts, but both remain very optimistic.

Published in November, data from a Grant Thornton survey, an audit, tax, and advisory firm with many middle-market clients, found 68 percent of surveyed dealmakers expected volumes to increase “over the next six months” and 53 percent expected valuations to rise during the same period.

Talking to middle-market Dealmaker at the end of 2021, which predicts a “slightly cooler” market for M&A in 2022, Art Penn, founder of direct lending firm PennantPark said, “I’m positive on dealmaking, but I don’t think it’ll be gangbusters like it was in 2021.”

Looking towards larger firms, in a November through December KPMG global survey, from which almost three-quarters of M&A respondents came from public companies, more than 80 percent of executives said they expected valuations to rise in 2022 and a third expected them to climb by at least 10 percent. Nearly all of them expected M&A volumes to increase.

“Sheerly from a valuation perspective, the amount of capital or capacity of buyers is growing faster than the creation of new companies, so almost by definition, the law of supply and demand would say there’s no reason to think valuations won’t go up,” Phil Colaco, Deloitte Corporate Finance CEO told the publican Mergers and Acquisitions in January 2022.

COVID-19 and inflation are weighing down business and economic outlooks for 2022

After peaking in the summer at roughly 80 percent before the US’ September surge in the COVID-19 Delta variant, a McKinsey executive survey recorded a steady year-end decline of 20 percent in the number of respondents who expected macroeconomic conditions to improve in 2022.

Taken before the US’ surge of the Omicron variant in December 2021, positive executive outlook on the economy at the beginning of that month had already dropped to its levels from January 2021.

In that same December survey, a majority of respondents cited the pandemic as the biggest risk to domestic growth and for the first time in several years, inflation was a top concern, coming in just after the pandemic. The pandemic’s supply chain disruptions and labor shortages came in third and fourth place.

Similarly, after dropping 17 percent between Q3 and Q4, CFOs in Deloitte’s Signals Survey were less optimistic about their own company’s growth outlook, with 59 percent in Q4 expecting inflation to be significantly higher in 2022.

“Businesses are notably dour on their assessment of present business conditions with only about one-third of respondents saying that conditions are improving. A higher percentage say they are weakening,” said Mark Zandi, Chief Economist at Moody’s Analytics on January 18th. “Surging Omicron COVID-19 infections continue to weigh on global business sentiment.”

Lower levels of confidence in the economy could lead to lower levels of M&A in 2022

Ultimately, the drop in new middle-market deal activity at the end of the summer, the drop in business sentiment around the September surge of the Delta variant, and sentiment’s continued decline alongside the resurgence of new variants and inflation suggests M&A will remain vulnerable in 2022.

Compared to larger public companies, SMEs often have less pricing power, supply chain leverage, and resources, which could make disruptions from the pandemic and inflation all the more consequential. While it’s difficult to generalize across firms, middle-market M&A in 2022 could be more sensitive to changes in a business’s economic outlook.

Looking ahead, the central question is whether the long-term business strategy of middle-market firms and their plans for M&A will be able to weather the myriad of disruptions that could unforeseeably lie ahead.

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In 2021, increasing levels of immunity, new treatments and vaccines, and business’ improved adaptability to the pandemic’s disruptions helped unlock 2020’s pent-up demand for M&A.

Even as each of those variables continues to move in a positive direction and a majority of dealmakers expect volumes and valuations to remain steady with their levels from 2021, the disruptive potential for new COVID-19 variants is by definition unpredictable.

The drops in middle-market deal activity at the end of the summer and business and executive sentiment during the September surge of the Delta variant, in addition to sentiment’s continued decline alongside the occurrence of new variants, all suggest middle-market M&A won’t be immune to the pandemic in 2022.

Bull Case

After widespread infections from the relatively transmissible Omicron variant in January, we could see a high level of durable herd immunity develop in the US that softens the health and economic impacts of new variants, including some of the virus’ effect on cost-push inflation.

While the pandemic continues to linger, executive confidence is strengthened as the economy picks up in Q2 after a small, Omicron-induced slow-down in Q1. In this case, M&A volumes and valuations remain close to or steady with their levels in 2021.

“Each successive wave of COVID has less and less economic impact on the markets and has had less and less real economic impact frankly on the economy because of the adaptations that have taken place,” said David Bailin, CIO and Global Head of Investments at Citi Global Wealth in December.

Bear Case

After a larger than expected hit to economic growth during Q1 from Omicron amidst rising inflation, some executives could take a wait-and-see approach to business strategy, as the pandemic’s labor, supply chain, and price disruptions place growing pressure on margins while driving inflation higher.

In the case of a new variant as transmissible as Omicron and as dangerous as Delta, the number of businesses putting their plans on hold would grow as executives become more uncertain about the future. In this case, M&A volumes and valuations would come down as rising costs and negative outlooks push weary buyers to the sidelines.

In any case, so long as the virus continues to spread around the world in populations where antibodies remain below herd immunity levels, the course of the pandemic and its impact on business will remain uncertain.

“Forecasting during the pandemic has been akin to standing in quicksand,” Diane Swonk, chief economist at Grant Thornton wrote at the beginning of January. “Every time it seems we have a tether to pull us out, the ground beneath us shifts again in response to a new wave of infections.”

So far, forecasters surveyed by The Wall Street Journal in the first half of January cut their Q1 growth projections from 4.2 percent in October to 3 percent in January due to the Omicron variant and rising inflation.

The pandemic had a measurable effect on executive confidence in 2021 that could carry into 2022

After peaking in the summer at roughly 80 percent before the US’ September surge in the Delta variant, a McKinsey executive survey recorded a steady year-end decline of 20 percent in the number of respondents who expected economic conditions to improve in 2022.

Even before the US’ surge of the Omicron variant in December, positive executive outlook on the economy at the beginning of December 2021 had already dropped back down to its levels from January 2021.

With less pricing power, supply chain leverage, and smaller market shares, conventional wisdom suggests middle-market firms will be more vulnerable to pandemic-induced disruptions and their inflationary pressures.

This may be part of the reason larger firms are more optimistic about 2022 than their middle-market counterparts, which rebounded slower than larger companies in 2021 and saw a peak in new M&A deal activity just before the September surge of the Delta variant.

Regardless of whether it’s in the foreground or background of boardroom meetings, the pandemic will continue to linger throughout business strategy and M&A for much of 2022.

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In 2021, a relatively strong and stable economic recovery bolstered by historically low interest rates drove up business valuations and M&A activity levels.

In 2022, that same recovery risks overheating as it faces record levels of inflation, which could drive down M&A activity by shrinking business margins and dampening executive confidence in the future.

Bull Case

If inflation remains transitory, supply chains self correct, and the economy shrugs off a series of relatively low and gradual interest rate hikes, deal volumes and valuations could remain steady with their 2021 levels.

After markets raised nearly $1.3 trillion in private capital in 2021 after $880 billion in 2020, the momentum from last year continues and companies go long with debt to invest aggressively in M&A.

Even if inflation settles a little higher, between 3 percent and 4 percent, businesses could adjust and adapt to limit their moderate inflation exposure as the outlook would remain relatively steady, albeit slightly more restrictive.

LBO activity would decrease amidst slightly higher interest rates that still remain historically low.

Without the resurgence of a new COVID-19 variant adding cost-push inflationary pressures on the economy, M&A volumes and valuations remain close to their levels in 2021.

Bear Case

If inflation ticks higher and longer than many economists at The Fed expect, the economy will have a harder time adjusting to higher interest rates. In the case of a fourth, quarter-percentage interest rate hike to try and tame rising prices, markets would begin to wonder if more are on the way, while businesses and consumers anticipate a future with less spending power.

In a higher-than-expected inflation scenario, business margins would shrink amidst the rising costs of everything and for many SMEs, rising input costs could hit their bottom lines harder. Valuations would decrease as buyers discount future cash flows, narrow in on the fundamentals, and contend with their own rising costs.

Ticking higher, supported by the inflationary pressures of a new COVID-19 variant, in a scenario of 8 percent to 9 percent inflation, sharp interest rate hikes could cause a recession and put a pause on many businesses' buy-side ambitions.

In this scenario, we would see a shift in M&A towards more divestitures, cost-reduction and inflation mitigation strategies, and low valuation exits from weary entrepreneurs who are uncertain about the future.

Inflation is having an impact on executive's outlook for their business's future

"U.S. inflation pressures show no sign of easing,” James Knightley, chief international economist at ING told the Associated Press after the December CPI increased by 7 percent for the first time in almost 40 years. "We could be close to the peak, but the risk is that inflation stays higher for longer."

Beginning to weigh on executive sentiment, a December survey by McKinsey found a majority of respondents citing inflation as a top concern for the first time in several years, coming in second after the pandemic.

Similarly, after a 17 percent drop between Q3 and Q4 in the number of CFOs with a positive growth outlook for their business, Deloitte's Signals Survey found 59 percent of respondents expected inflationary pressures to be significantly higher in 2022.

Rising interest rates alone aren't enough to slow M&As momentum from 2021

Supported by steady deal flows and high business demand carrying over from 2021, rising interest rates will take time to impact M&A, with many expecting the effects to settle in during the second half of 2022, assuming higher than expected inflation rates don't force The Fed's hand to move sooner.

Looking at the most recent historical data from a KPMG analysis, when interest rates rose between 2016 and 2019, both US deal volumes and valuations rose.

While most dealmaker and executive surveys show lower amounts of concern over interest rates in 2022, if they're paired with a prolonged, high-inflationary environment, the resurgence of a stronger COVID-19 variant, or both, tighter capital markets would have a negative trickle-down effect on M&A by dampening the economy.

Meanwhile, we could see more activity in LBOs during Q1 as buyers move to take advantage of a more favorable lending environment.

Businesses will adapt to changing conditions until they can’t

For well-positioned businesses in industries on the right side of inflation, profits can rise during inflationary periods. Still, many businesses have been struggling to raise prices fast enough to keep up with their rising input costs.

Though SMEs can adapt more quickly to changing economic conditions, conventional wisdom suggests they’ll be more vulnerable to inflationary pressures, with less pricing power, supply chain leverage, and smaller market shares than larger, public companies. This may be part of the reason larger firms are more optimistic about 2022 than their middle-market counterparts, which rebounded slower than larger companies in 2021.

While rising interest rates create less volatility for SME company valuations, in contrast to public companies, they’ll be relatively vulnerable to the economic shock aggressive rate hikes could produce.

In either scenario, despite the bullish sentiment amongst dealmakers stemming largely from last year’s M&A trends, the interplay between interest rates, inflation, and the pandemic will create a cloud of uncertainty and risk for businesses in 2022 that will take some time to clear.

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In 2021, the threat of higher corporate and capital gains taxes helped fuel an M&A boom. In 2022, while there could be higher corporate taxes for large and multinational businesses, SMEs will more than likely avoid them and the frenzied M&A deal activity they fueled will subside.

The Bull Case

With a razor-thin voting majority in the Senate and dissenting opinions from moderate voices in the party, Democrats may be unable to pass any type of corporate and capital gains taxes in 2022.

Regardless, if Republicans take control of both chambers of Congress, any changes made by Democrats to this portion of the tax code will likely be reversed.

Right now, most analysts predict Democrats will lose control of the House while the Senate, split 50-50, remains a toss-up.

Though Democrats have a good chance at passing an increase in corporate taxes for large and multinational companies, their time is running out. With every month that passes in the run-up to an election, passing legislation grows more difficult.

The Bear Case

If Democrats lose the House but keep the Senate, they'll have the power to stop Republicans' efforts to reverse whatever legislation Democrats can pass before they lose their majorities in 2023.

While most of the president's ambitious tax plan will remain unpassed, Democrats will more than likely remain united on a corporate minimum tax of 15 percent for companies with over $1 billion in profits and a roughly 15 percent global minimum tax on overseas profits of US-based companies.

Though Democrats were unable to pass their marquee economic agenda in 2021, the $1.75 trillion Build Back Better spending bill, which contained both of these taxes, many predict the party will be able to include them in a series of smaller spending bills this year.

Regardless, the Democrat's intra-party challenge of organizing enough votes amidst the narrowest possible party majorities in the Senate will continue throughout 2022, making any tax changes beyond the two minimum taxes exceedingly unlikely.

Democratic Senators Sinema and Manchin will continue having have an outsized voice on the economy in 2022

After starting with a proposal to nearly double the capital gains tax to 39.6 percent for incomes over $1 million and raising the corporate tax from 21 percent to 28 percent, President Biden’s tax plan was whittled down by his party in Congress.

In the fall of 2021, Democratic party leaders proposed a capital gains tax for individual incomes above $400,000 of 25 percent, up from 20 percent, and a corporate tax rate of 26.5 percent.

Both increases were opposed by some moderates in the party, namely Senator Kyrsten Sinema from Arizona who has remained generally opposed to any increases in both types of taxes, except for the two corporate minimum taxes.

With the smallest majority in the Senate created by Vice President Harris’ tie-breaking vote, moderate and dissenting Democratic voices like Senator Sinema’s and Joe Manchin’s from West Virginia have had an outsized voice in the legislative process, helping keep taxes lower than many analysts predicted.

In December, the last remnants of the party’s original tax proposals, written into the Build Back Better social safety and climate change spending bill were put on hold after Senator Manchin pulled his support over concerns with the bill’s costs.

While both Senator Sinema and Manchin are, compared to their party colleagues, fiscally conservative Democrats, Manchin is more conservative on spending, whereas Sinema is more conservative on taxes.

In 2021, their dissenting opinions played a critical role in shaping economic policy and in 2022, they’ll continue to be two of the most closely watched legislators on Capitol Hill.

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