By: Nathan Kelly
As the year is coming to a close, there are multiple areas worth evaluating when considering raising growth or exit capital in 2023. In the midst of much economic turbulence, we will be sharing our thoughts on how business owners can be thinking about outside investors in the coming year. We’ll look at five key factors to consider:
- Interest Rates
- Recessionary Pressures
- Private Equity Dry Powder
- Tax Increases
- Personal Timing
Consideration #1: Interest Rates
The Federal Reserve appears to be positioning for continued rate hikes throughout 2023. In September 2022, the Fed released the following statement, “Recent indicators point to modest growth in spending and production. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation… [and] Russia’s war against Ukraine…are creating additional upward pressure on inflation and are weighing on global economic activity. The Committee is highly attentive to inflation risks.” Based on this statement and others, we should expect rate hikes to continue for a while. Because most private equity buyers use meaningful leverage to invest in private businesses, the increasing cost of debt will place ever-stronger downward pressure on valuations as 2023 progresses. In addition, private equity buyers may not be able to fund their acquisitions with as much debt, which may also put pressure on deal pricing. Strategic buyers and family offices generally use less leverage than private equity groups, and their valuations may be less affected by interest rate changes. In most cases, buyers should be able to source cheaper debt earlier in the year. Therefore, if business owners are considering selling, we recommend they target closing earlier in the year (meaning get started now) versus waiting for interest rates to rise further.
Consideration #2: Recessionary Pressures
A number of indicators are pointing to an economic recession in the United States. The Wall Street Journal reported on October 26th that, “the Bond Market’s Most Powerful Recession Indicator Is (Finally) Flashing Red,” in a commentary on the recent bond yield curve inversion. Historically, the yield curve inversion indicates a recession is coming in the next 9-15 months. Separately, public stocks have fallen throughout 2022 after skyrocketing immediately post-pandemic. The stock market is another commonly trusted leading indicator for a recession. However, some experts see it differently, including one Forbes writer, who stated “fortunately, the U.S. labor market remains strong, and experts are divided on whether or not a recession is inevitable in this unique economic environment. This is why Fed Chair Jerome Powell said this summer that he didn’t believe the U.S. was in a recession.” Another positive indicator is that GDP in the third quarter grew at 2.6% annual rate. In any case, recessions do not tend to change Americans’ lives significantly, and actually, can be a great investing opportunity. We expect M&A buyers to remain bullish on acquisitions by and large, but with a tendency to shy away from highly cyclical industries such as construction or luxury brands.
Consideration #3: Private Equity Dry Powder
The explosion in popularity of private equity funds over the last several years has led to record-setting levels of dry powder, which is private equity’s cash available for immediate investment. Many estimates place dry powder with US private equity firms above $3 trillion. Typically, private equity firms raise capital from individual investors with a commitment to deploy the cash within 3-5 years, or else face returning the unused cash to their investors, so these buyers are highly motivated to make acquisitions continuously. In fact, some professionals point to the glut of investor cash available for investing in private businesses as the key to the US economy’s soft landing. Most frequently, the funds and the businesses they own are actively managed, with equity firm bonuses attached to company performance. The strong availability of equity capital should support valuations and competition for quality business throughout 2023, which bodes well for business owners looking at growth or exit capital.
Consideration #4: Tax Increases
The Biden administration’s Fiscal 2023 tax proposal leaves out the whopping 20% increase in federal capital gains taxes it floated in 2021. However, it’s unclear how well the current tax plan will be received. Political analysts say increasing capital gains taxes could still be a realistic strategy for the Biden administration in 2023. The party may look to garner popular votes by increasing taxes on business sales, while at the same time claiming to use increased tax rates as a way to pay for its recent student loan forgiveness program. From a tax perspective, business sales look much safer than they did earlier this year, when capital gains increases were a popular discussion topic in Washington. How long that safety continues remains uncertain.
Consideration #5: Personal Timing
While external factors are important, oftentimes, personal timing for the business owner can be the most influential factor when considering a business exit or business capital raise. The average economic cycle lasts 6-7 years, according to the Congressional Research Service. That means business owners might be waiting until around 2028 before seeing valuations as strong as they have recently been. Any business owner within a few years of retirement should consider whether or not they are willing to wait for the next economic growth cycle to attempt a liquidity event. In order to maximize valuations, business owners who are considering selling should look at a couple of options. The first option would be to evaluate the market in early 2023 for a potential sale. Interest rates are expected to continue rising and a recession could be on the horizon. Selling now might be ideal for an owner looking to take chips off the table before a potential longer-term slow down. The second option would be to wait out this economic slowdown for 5-10 years, when the market picks up again.
In summary, tailwinds have been stronger than headwinds for private business valuations for several years, and that trend appears to be slowing down. As the economy tightens, sellers may have fewer options. In any case, business owners considering an exit or capital raise in the coming months should start planning earlier rather than later to maximize the value of their businesses.
If you or someone you know has questions about any of the above as it relates to exiting their business, please feel free to reach out to Nathan Kelly.