Record-Breaking Year for M&A? Not So Fast

After a hot start to the year, merger and acquisition activity in the commercial finance space has stalled during the back half of 2021. Tim Stute and Chris Hemler of the Hovde Group explain the economic, monetary and political factors behind the trend.

BY TIM STUTE AND CHRIS HEMLER, HOVDE GROUP

Mergers and acquisitions have been a hot topic in recent months. The rapid recovery in the number of deals in the first half of 2021 got a lot of people’s attention, and it’s easy to see why the volume of transactions has been so high. Buyers are flush with cash and eager to grow, which sellers expect will translate into attractive valuations, and that’s without mentioning business owners’ uneasiness about the timing and magnitude of capital gains and estate tax increases. Across the commercial finance industry, 21 transactions were announced between January and June 2021, which was not bad for the amount of uncertainty still permeating the market in the early part of the year.

But since June, this pace has significantly slowed. Only five transactions have been announced in the last three and half months at the time of this writing. This contradicts the trend established over the last 15 years, where the second half of the calendar year was nearly as active as the first half (17 deals on average between January and June and 16 deals on average from July to December).

So, what’s driving the increased interest in M&A from potential buyers? Why has activity recently slowed? And what can we expect for the rest of 2021 and beyond?  

Annual Commercial Finance M&A Transactions

Multiple dynamics are leading the buyer universe for factoring businesses — which is mainly made up of banks, business development companies and credit funds — to look at acquisitions in the current market. Banks are flush with cash, as the average personal savings rate was nearly double the 50-year average during 2020 (17% vs. 9%) and loans-to-deposits were at an all-time low of 60%, down from 77% as recently as Q1/19. Acquisitions of high-yielding factoring businesses are a great way for banks to deploy this excess capital at attractive net interest margins without meaningfully altering their loan portfolio composition. BDCs and credit funds are likewise struggling to deploy their record-breaking capital raises. Insurance companies, pension funds and other investors have been increasing allocations to private debt, as they are attracted by the yield and illiquidity premium compared with public debt and the relative stability compared with equities and other alternative strategies. These factors have led to significant competition in commercial lending, leading these buyers to look for acquisitions.

Private Funds Have Grown Significantly in 2021

The high level of buyer interest drove the quick rebound in transactions in the first half of 2021, especially during the spring, when commercial finance industry confidence was at an all-time high. This confidence was buoyed by government stimulus programs in support of small businesses that had averted wide-scale defaults and bankruptcies as well as vaccines against COVID-19 rolling out, schools reopening and the economy preparing to get back to business. Several companies that were interested in selling prior to the pandemic and in well-performing industries (e.g. transportation) took advantage of their good fortunes and quickly sold, often to buyers with which they had previous relationships, allowing for the relatively speedy processes.

However, the rapid pace of transactions quickly slowed over the summer. A primary reason for this was likely the timing of when the next wave of sellers decided to enter the market. Many business owners who preferred to wait and see if the economic recovery was sustainable or for stimulus funds to fully flow through their industries saw how quickly the M&A market rebounded and decided to begin a sale process during the summer with the goal of closing before the end of the year.  

Given this trend, you would expect to have seen a wave of announcements over the next few months as sellers tried to cash out prior to what many expect to be the final effective date of any capital gains tax legislation. However, despite the significant number of businesses currently on the market and the high level of buyer interest, the number of deals getting done has been somewhat underwhelming recently. This is likely because several current sellers are in no rush to transact, preferring to test the market in the hope that they receive an offer they couldn’t refuse. However, while record-breaking deals are more likely today than in the recent past, not all of these companies deserve such lofty valuations at their current stages. Many may decide they’d rather continue building their businesses, expecting a multiple on growth between today and a future sale date a few years down the road.

The most recent Democratic tax proposal has also reduced some of the urgency to sell. In September, the U.S. House Ways and Means Committee proposed increasing the top federal capital gains rate from 20% to 25%, far below the 39.6% top rate for taxpayers with income of more than $1 million sought by the Biden administration. Now, more recently, Democratic leadership has signaled that they may only be able to raise capital gains taxes on billionaires.  Additionally, continued supply chain disruptions, the rise of the delta variant and increasing inflationary concerns have infused more uncertainty into the market. These issues led the OECD’s Consumer Confidence Index to drop below its long-term average in July. Interestingly, the Business Confidence Index has remained in positive territory since January, although it has leveled off in recent months.

While there’s still time for 2021 to be the record-breaking year many thought it would be six months ago, economic, monetary and political factors may limit its potential to reach a respectable, above-average year for acquisitions. Expect similar dynamics and trends to persist into 2022, depending on whether consumer anxiety or business optimism wins the day.

Tim Stute is the managing director and head of specialty finance at Hovde Group. Stute can be reached at tstute@hovdegroup.com.

Chris Hemler is senior vice president at Hovde Group. Hemler can be reached at chemler@hovdegroup.com.