The Markets are Turning: Tremendous Opportunities Return for Private Business Owners

Exclusive Interview with Capstone Founder & President John Ferrara

Capstone Partners’ Founder & President, John Ferrara, was recently interviewed by The Wall Street Journal, YahooFinance!, Schwab Network, and other media channels to discuss the state of the Mergers and Acquisitions (M&A) market and external factors impacting it. Capstone’s Market Intelligence Team took a moment to sit down with John and explore his more granular view on private business owner M&A opportunities, industry valuation trends, hot sectors, green shoots, and the three fundamental market demographics that will uncork the M&A market.

Sarah Doherty: John, welcome back and thank you for sharing your insights with us today. There has been a lot of buzz in the headlines. We have a lot to cover, but I’m going to stay focused on the Private Business market and the key trends you are seeing. Does that work for you?

John Ferrara: Yes, there has been a lot to digest recently. I believe we are seeing green shoots to a long-awaited recovery, but time will tell. I’m looking forward to speaking on how this is impacting private company M&A, so fire away.

Sarah Doherty: Great, thanks. I might circle back to get some predictions, but I want to start with some context. The economy—and certainly the Public market—has performed well. We have avoided a recession, but private business owners have had a different experience. What you have been seeing in that market?

John Ferrara: It’s been a painful run in the Private Business Owner M&A market, especially coming off the boom market in 2021. If you want to use the word “recession,” I think it can be applied to the Middle Market M&A environment since 2021. We are in the third year of an M&A downcycle for private businesses, which is abnormally long in our world. Market corrections generally last 12-18 months, maybe 24 months as an outlier. This market has been relentless for private business owners.

Consider first our starting point. During COVID, the markets were in disarray for six to nine months. Back then, we didn’t know when—or if—there was going to be a return to normalcy. I was surprised the year ended with a 12% decline in deal volume. What we learned was that appetite did not go away, it was just postponed. A good portion of those deals came back in 2021, which fueled a fierce +34% comeback in 2021. The M&A pace was hectic to say the least. We were spoiled by what I saw as a boomerang market.

This was the start of the slog. In 2022, we saw 15% decline followed by a more pronounced decline of more than 20% in 2023. I’m waiting to see where the M&A volumes sit for Q3 of 2024, but I do know that through the second quarter, volume was down again almost another -15%. Based on what I’m seeing in the market, there is not going to be enough activity towards the end of this year for 2024 to recover as a potential “breakout” year. Even if we go neutral for the last two quarters of the year, the middle market M&A world is down around 40% from its highs in 2021.

The reason this is all relevant is that time has run out of this down cycle, the markets are turning, and we are seeing tremendous opportunities return to private business owners. The wait will have been worth it.

Sarah Doherty: That’s a challenging market backdrop. I’m interested in learning more about the opportunities you mentioned. In this market, and in the immediate future, have you seen anything new—positive or negative—and how has it impacted either the market or private business owners?

John Ferrara: Every market cycle brings unique circumstances and lessons to be learned. In this market, there are three major themes that I would point to. First, and probably the most pronounced, is that “quality” rules the roost. Marginal deals are just not getting attention. In addition, due diligence is deeper, credit is tighter, and closing timelines are longer for most deals. There is a larger cohort of deals that are either getting put on hold or cancelled altogether. Specific to the private business owner, this means you have to have some “special sauce” that clearly differentiates your business.

The second trend is the shift in appetite. We are seeing this shift right now, but the private equity [PE] investor community changed the menu to some degree. What I mean by that is that they changed their gameplan during this time. Since PE plays a major role in the deal markets, this shift has had a significant impact. Beyond being less aggressive—PE deal volume was down about 35% since the 2021 peak—their focus has also been different. They generally went into hold-and-build mode, versus pursuing new platform acquisitions. From 2021 to 2023, there was a 50% decline in both platform investments and portfolio exits, together with a 20% increase in bolt-on acquisitions. This is off kilter from a normalized M&A market.

Sarah Doherty: Sounds like more challenges. So where are the bright spots in all of this?

John Ferrara: Well, with the PE community pursuing so many build strategies, private business owners must pay close attention to other private companies that are PE-backed. Companies that maybe were not likely acquirers in the past may very well be now. But that’s just putting some silver lining to my third and last point. The real opportunity for private business owners is that we are in a disconnected market. There is a valuation imbalance. With these dynamics, you might assume that valuations are suffering, when that has not been the case.

Think about this in simple supply-and-demand terms. On the demand side, strategic acquirers are starving for growth and PE acquirers have over a trillion of dry powder capital to deploy. We don’t have a demand problem. However, the private business owner that is not engaging in the M&A market takes normal supply out of the market…there are fewer deals available to pursue. Think about what this does to valuations: good companies with strong management teams are receiving valuations at or above the highs we saw in 2021. Valuation premiums exist in abundance for the right business.

What this means for private business owners is that they need to be smart about what’s happening in their own sector. The public headlines…the unrest in the Middle East, inflation, interest rates, recession threats, etc.…do not translate to the Private M&A markets. Across, many industry verticals, this supply and demand gap has created extraordinary opportunities.

Sarah Doherty: I would like to stick with the topic of valuations. It’s always a hot topic for business owners, especially in a higher interest rate environment. I would assume that higher cost of capital puts pressure on valuations. Can you speak to that and maybe drill down on what you are seeing in specific industry sectors?

John Ferrara: There’s a lot to peel back there on the industry sector topic, so let me address the interest rate environment question first. Higher interest rates are not the culprit—at least, not the only culprit—of the pull back. If you speak to leaders in the PE industry, the issue has been the lack of visibility on clear direction from the Federal Reserve over the past several years. So “no,” interest rates are not depressing valuations broadly, though certainly an issue in some instances. Good companies with attractive transactions do not seem to be affected by it.

Now, switching gears to what has been happening in specific sectors, I will give you some highlights from what we have been seeing in the middle market sectors that we cover. Maybe it would be best to put them in three different buckets: the “resilient” sectors, the “comebackers,” and the “about timers,”…which I will spend less time on, but they are worth noting.

The resilient sectors for us have been Aerospace & Defense [A&D], Consumer, and Energy. A&D has fared the best with median valuation multiples up more than 30% from 2021 to 2023, and still holding strong. Retail Consumer valuations suffered post-COVID, but Branded Consumer Goods’ valuations are up about 15% for the same period, though we are seeing some easing there. And the Energy sector, which has long been in a sideways cycle, found some traction with the “transition economy.” Valuations have consistently increased and now sit at 10% above the 2021 levels.

The ”comebackers” are an interesting group, and maybe a little surprising. The three sectors I would put in this category are Healthcare, Business and Professional Services, and Building Products. These sectors share a common pain—valuations were hit hard in the post-2021 era, but they have all recovered. So, they are the “comebackers.” Look at Healthcare first: multiples declined close to 30% from the 2021 levels but have roared back and are now higher than the multiples we were seeing in 2021. I think the median deal multiples in Healthcare is just over 11x EBITDA. With Professional Services, the sector suffered post-COVID, and valuations were off -25% at some point. In 2023 and YTD [year-to-date] 2024, multiples recovered close to +20% and we are seeing a run in niche areas like Accounting and Tax. The same dynamic occurred in Building Products. Valuations peaked post-COVID from the demand boom, then eased back about -10% by the end of 2023. That decline was made back, and then some, in 2024 with several hot subsectors like Roofing.

Before I forget, I just want to mention the sectors in the “about time” category. They were all hot sectors that saw valuation corrections, some more significant than others, but where we are starting to see green shoots. These are mostly technology-related: Software, FinTech, and Industrial Technology, but I would also throw Transportation & Logistics into this group too.

Sarah Doherty: Let’s go back to your comment on “visibility.” Where do we go from here?

John Ferrara: That’s something I spend a lot of time looking at and thinking about. As you know, it drives our posture here at Capstone. Right now, we are bullish, aggressively so. We are in investment mode, specifically building capabilities around the Private Equity markets in anticipation of a pronounced M&A market recovery in 2025. Forget the deal volume and valuation stats, forget inflation and interest rates…for that matter, put the geopolitical environment aside for now too. There are three fundamental market demographics that will uncork this market. It’s not a matter of “if,” it’s a matter of “when.”

I’ve already talked about the first one, it’s “history,” or the nature of market cycles. I think it was Twain that said, “History doesn’t repeat itself, but it does rhyme.” If you look back at all the M&A market downcycles—at least during my career—they all follow a consistent pattern: 12 to 24 months of decline, followed by a Bull market of three years, plus or minus. Market cycles also tend to compress as they become more efficient. We are now in our third down year—we are already beyond the normal correction period. This is the “when” part of the equation.

The other two fundamentals fall in the “why” part of the equation—they are “biology” and “capitalism.” They are both absolutes. At least to my knowledge, people don’t grow younger, and capital does not grow more patient. Over 80% of business owners are of prime harvest age…between 56 and 72. In the U.S., there are roughly four million M&A targets that could potentially transact. Waiting it out is becoming a less attractive option each year. The same is true of private equity, generally speaking. They earn returns on deployed capital. We are looking at $1 trillion of PE capital overhang—or funds that need to find a home. Assuming a 50-50% debt-to-equity mix, that is $2 trillion of purchasing power that is growing every year. Again, waiting it out is becoming a less attractive option.

Keep in mind that I am biased. I run an investment bank. If I were to grab a crystal ball, I think what we will see is the beginning of a very strong M&A market not later than Q3 of 2025. I would not be surprised if activity started to ramp after the elections.

Sarah Doherty: I hope you are right. There are a lot of people here at Capstone that would welcome that. This has been great. We appreciate your time. Thank you.

John Ferrara: Thanks, Sarah. I appreciate your time.

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