Global problems don’t necessarily mean universal impacts. How are different geographical regions and economies responding to disruption in the lower middle-market? We hear from five local experts in North America, Latin America, Asia, Europe and Africa.
Managing Director and Head of Consumer Investment Banking, Capstone Partners – IMAP USA
Inverlink – IMAP Colombia
Pinnacle Inc. – IMAP Japan
CEO, Equity Factory Italy
Chief Executive: Corporate & Advisory, Deal Leaders International South Africa
On a global scale we’re hearing about disruption from factors like inflation, supply chain issues, Covid-recovery, and the war in Ukraine. Are you seeing disruption from any of these/other factors?
Kenneth Wasik, USA: Absolutely. It is an unusual market. Coming out of Covid, with high savings and a feeling of finally being unchained, the US consumer is spending strong. This is resulting in property values skyrocketing, flights being overbooked and excess demand for consumer goods, which stands in contrast to supply chain shortages, staffing shortages and inflation. So, unusually high consumer demand is being countered by high prices, shortages of goods, and a lack of workers.
Mauricio Saldarriaga, Colombia: Absolutely. The level of uncertainty and lack of visibility we are currently experiencing is unprecedented. On a macro level, we continue to see significant disruptive factors affecting many of our clients’ businesses. Supply chain issues, FX volatility, higher interest rates and high inflation, are among the major factors impacting the performance and profitability of many companies. At the same time, however, this situation also presents new opportunities for the region and LATAM companies, as a result of trends such as nearshoring towards the US market and high commodity prices, among others.
Regarding prices of most goods and services, despite the fact that economic rebound is still strong, inflation is a major concern that is likely to impact demand, especially in developing countries where purchasing power is much more limited for most people.
Jeffrey Smith, Japan: While Japan’s globally operating manufacturers are certainly dealing with supply chain disruptions, inflation and other disruptions have not been as extreme domestically, compared to other developed economies. While the increasing rate of inflation is starting to worry Japanese companies, there had been a desire for wage-driven inflation and a moderate level of inflation could be positive for Japan.
Stefano Marsilii, Italy: Yes, the disruption carried by these factors is clearly visible to anyone. Until a few months ago, the impact was mainly confined to consumer markets’ current trading, or to certain B2B businesses (mainly due to the long wave of disruptions that occurred in the supply chain, generated by Covid). More recently though, these factors are also impacting other industries that had appeared resilient. For example, in the luxury market the protracted lockdowns in China and the sanctions against Russia caused a global demand reduction.
In a nutshell, although EU subsidies are supporting corporate investments, the current global events are undermining consumers’ confidence and are leading to reductions and delays in spending.
Andrew Bahlmann, South Africa: We are definitely seeing a material impact on supply chains and pricing inflation. Companies that import goods are facing delays in supply, pricing increases and uncertainty in the markets. The knock-on effect of pricing increases, along with currency fluctuations, have had a massive impact on the SA market. Oil prices have had a direct impact on inflation across the board. That being said, these challenges are creating investment opportunities in South Africa/Africa in the form of manufacturing and business process outsourcing. The delays out of the far east, increases in costs and limited freight/logistics, are enabling us to become more attractive for Europe and the US.
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How are people navigating and responding to the challenges in the middle-market? How is it impacting M&A?
Kenneth Wasik, USA: There is the beginning of a “flight to quality.” Buyers are starting to question how a target will do in an uncertain economy. Higher gross margin businesses are attracting more attention, as are staples like food.
Mauricio Saldarriaga, Colombia: Companies are being forced to look for substitutes of certain raw materials and optimize their supply chain as they try to adapt to the current market conditions. 2021 was a strong year for the M&A market. 2022 is likely to present a more challenging environment, but for now it continues to have good traction.
Jeffrey Smith, Japan: A lot of IMAP Japan’s business is working for large corporates in Japan to support their acquisition of middle-market companies domestically and abroad. These large corporates are still very active in seeking acquisitions, and we don’t see those companies putting on the brakes due to challenges like inflation, supply chain and war in Ukraine. However, Covid recovery in some industries, like hospitality and retail, is still just beginning, so in those industries corporates are still hesitant to make acquisitions before seeing at least one or more solid quarters of financial performance.
Stefano Marsilii, Italy: The response of investors to the challenges depends on their perspective: the more far-sighted are not particularly influenced by short-term fluctuations, but those lacking a strategic view are. In this sense, M&A has always been oriented to the medium/long term, so it has not been particularly affected in the first half of 2022. However, the composition of the M&A activity may change as the buy-out model is threatened by the rising interest rates, while add-ons, VC deals, buy-and-build transactions and strategic investments are not materially affected by the current challenges.
Andrew Bahlmann, South Africa: The larger companies that entered the Covid period with strong, debt free balance sheets, have definitely been able to weather the impact far more effectively. With the requisite cash flows, inventory levels could be increased to levels that would enable them to manage the uncertainty. Ironically, the Ukraine crisis seems to have resulted in a mining boom for SA, along with an increased interest in M&A in this part of the world. I am assuming that this is due to the risk of eastern Europe as an investment destination.
There’s been anticipation of increased private equity activity in the middle-market as a response to the current conditions. Is this something you’re seeing play out?
Kenneth Wasik, USA: To the extent that PE firms who thought valuations were too high last year and are back now, then yes. But the majority of PE firms are starting to get more selective. Several filled up on acquisitions in the consumer space over the last two years and are now searching for add-on acquisitions for those portfolio companies.
Mauricio Saldarriaga, Colombia: In the case of Colombia and Latin America (excluding Brazil), the region has been experiencing significant political changes that are impacting foreign direct investment. Investor confidence in countries like Chile, Peru and Mexico has been negatively impacted by the recent presidential elections and the changing rules and conditions proposed by these new governments.
Jeffrey Smith, Japan: The private equity market in Japan has been very strong for at least the past five years. There is a good volume of new acquisitions, and exits are getting done in a timely way and at good returns to investors. Many divestitures of large corporations and known deals in the market are now dominated by private equity players.
Stefano Marsilii, Italy: Even if private equity in the middle-market is still active and stable due to the significant dry powder at its disposal, I don’t see an increase of this activity. Harder negotiations about price adjustments and changes in earn-out mechanisms have occurred since the beginning of 2022 and delayed many processes.
Rising interest rates present a threat to the buyout model, where deals are primarily funded via floating-rate financing. This is true, especially for the largest, high-valued targets. These companies do not form the core of Italian industrial arenas though, and moreover, Italian average multiples are lower compared to the US and even to Central Europe: a southward shift of PE interest is a possibility in the next few years.
In general, PE’s dry powder remains impressive: for the longer term, I anticipate that value investment strategies will recover market share vis-à-vis leveraged buyouts.
Andrew Bahlmann, South Africa: We have seen private equity dominate the middle-market for the last two to three years. We anticipate that this trend will continue for the foreseeable future. Larger corporates and listed ‘trade’ players seem to have felt the brunt of the negative economic impact and have held on to their cash reserve to trade out of the deflated conditions, versus using them to grow through acquisition. This has left an opportunity for PE investors to target quality businesses with high growth potential.
One possible response has been an uptick in buyer interest in Higher Gross Margins businesses. Are you seeing this?
Kenneth Wasik, USA: Absolutely. The thinking is that higher gross margin businesses are better equipped to face uncertain economic conditions. Examples include food, personal care, and certain direct-to-consumer businesses.
Mauricio Saldarriaga, Colombia: We are seeing some companies focusing more on added-value products and services and less on commoditized products, where there is less room for transferring price increments on supplies into end-product prices.
Jeffrey Smith, Japan: Buyers in Japan are more generally focused on strategic objectives, and current profitability levels are less important than the potential synergies.
Stefano Marsilii, Italy: I see no changes: higher gross margins businesses have always been the main target for Italian private equity houses.
Andrew Bahlmann, South Africa: Yes, PE investors are definitely looking closely at the higher margin and high growth opportunities. With the ‘trade investors’ being a lot less buoyant in the market, PE has a much greater choice of investments. I believe that the developments over the last two years have made business owners review their risk profile and consider selling a portion of their business to a big brother/sister to either weather the storm, or to capitalize on higher growth opportunities.
There’s the perception that sectors like IT/Software, Healthcare, and Consumer Goods remain largely unaffected by geopolitical disruption. Do you agree or see evidence to the contrary?
Kenneth Wasik, USA: On the consumer sector, I disagree. Demand remains high for most consumer sectors, however, the M&A market is changing slowly. We are doing a lot more upfront work on a deal to ensure that buyers are well-equipped and motivated to make a run at our companies.
Mauricio Saldarriaga, Colombia: In our market, we are seeing how capital is chasing opportunities in more “defensive” sectors, such as Healthcare, Education, Energy, Financial Services and Infrastructure. We are also starting to see shifts arising from changes in the behavior of end consumers, such as a reduction in home-improvement spending and an increase towards sectors such as Travel and Leisure. Certainly, the significant slowdown we are seeing in the US economy will likely mark the change of a cycle, and could benefit certain emerging markets such as Colombia.
Jeffrey Smith, Japan: In Japan, IT/Software and Consumer Goods companies continue their search for outbound M&A. Healthcare companies are more focused on domestic M&A.
Stefano Marsilii, Italy: In the IT/Software space, for instance, you have cybersecurity players whose business is strongly expanding, whereas sales from certain system integrators whose strong share of revenue is made up of hardware, are heavily impacted by the disruptions in the relevant supply chain.
In general, it appears that the demand for non-essential consumer goods is slowing down, while holidays and leisure spending is recovering after the pandemic.
The healthcare sector is in a positive trend because of the increased attention to diseases and public health, as well as to the restarting of a preventive-medicine approach.
Andrew Bahlmann, South Africa: I don’t think that any industry has been unaffected by the pandemic. We have seen that larger businesses with healthy balance sheets have weathered the storm well, and have been able to outlast smaller, less competitive companies, but they are still experiencing pressure due to their customers being exposed to the various market challenges. Decision-making from customers is also taking a lot longer, so project-based businesses are feeling pressure. IT/software companies that are focussing on SaaS appear to be doing very well, but again the competitive landscape has also grown exponentially in this space.
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When responding to disruption, there’s an important distinction to be made between short-term adaptations and long-term fundamental changes. What are some of the long-term changes you anticipate will emerge from the current disruption?
Kenneth Wasik, USA: The e-commerce landscape will become more competitive. Large firms with an ability to ensure the steady supply of raw inputs, will gain a greater advantage. Consolidation will increase.
Mauricio Saldarriaga, Colombia: I believe some of the most relevant long-term and fundamental changes will be those related to the labor market and education (higher levels in particular). Certainly, technology will continue to play a key role in the changing habits of consumers, which will have a significant impact on sectors such as Financial Services, Healthcare and Mobility, among others.
Jeffrey Smith, Japan: The supply chain disruptions and security concerns are causing Japanese companies to further diversify away from China. Of course, many Japanese companies have spent decades building their infrastructure in China, so diversifying away from suppliers, manufacturing and customers in China requires many tough decisions. It’s an ongoing and time-consuming process.
Stefano Marsilii, Italy: I don’t see specific long-term fundamental changes arising from the current situation, but mostly short-term adaptations that will be particularly perceptible in 2022 Q3-Q4 and 2023 Q1. However, ESG criteria (including the selection of investments to avoid companies related to rogue states) are becoming the main drivers for private equity and strategic M&A.
In the longer term, the cyclical nature of the economy might bring a less favorable scenario for “standard” M&A, with a parallel increase of distressed deals. However, I do not foresee a clear macro-trend leading the future: even if inflation will raise interest rates, investors (also including mass affluents) are now used to asset diversification to keep a balanced portfolio and to include a material share of private equity and private debt asset-classes.
Andrew Bahlmann, South Africa: I believe that there will be fundamental shifts in ‘normalized’ working capital structures due to logistical/supply chain issues that are here for the medium-term. The developing economies will become more attractive to international buyers due to continued global instability. The risk premium has to be re-looked, as there are very few ‘safe’ investments in my view. The higher returns warrant a riskier investment outlook in South and southern Africa. This, coupled with a growing middle class in Africa, will ensure that the international M&A lenses remain fixed on our shores for investment.
Illustration by Christy Lundy