The recent collision of rapidly rising interest rates causing the banking sector meltdown is creating a Perfect Storm for Middle Market owner/operators. Interestingly, the flipside of this Perfect Storm may also offer the last best hope to sell a quality middle market company at fair value for some time to come.
The Federal Reserve is charged with the dual mandate of stable prices (i.e., control inflation) and maximum employment. With recent inflation rising well above the Fed’s stated goal of 2%, starting in May 2022 they began rapidly raising interest rates. Although inflation is slowing, the action taken by the Fed had the adverse impact of creating a “run on the banks”. Silicon Valley Bank (SVB) may be the first bank to fail this time but we have not seen the end yet. The Fed, Treasury and FDIC quickly responded to the “systemic risk” posed by SVB but there remains uncertainly by depositors particularly with regards to local and regional banks. The net effect of the recent bank failures is putting enormous depository pressures on all local and regional institutions while they wait for new more rigorous regulation and capital requirements.
There is already a steady “run” on the deposits of these institutions that will continue unless (and until) the Federal Government takes the bold step of providing a full guaranty of all deposits, regardless of size. Given the requirement that such a step will need strong bipartisan support in Congress this is unlikely to happen anytime soon.
Taken together these factors do not bode well for middle market companies. A credit crunch and likely recession is looming. Any company that borrows money will see their operating profits squeezed as interest expense goes up. Middle Market companies, without access to the Commercial Paper market, rely heavily on local and regional banks for their working capital and other borrowing requirements. As these institutions respond to depository pressure, more stringent government regulation and higher capital requirements borrowers will face reduced credit availability, tighter borrowing restrictions, calls for greater capital contributions to their businesses and recessionary pressures.
These same market dynamics adversely impact Private Equity firms, forcing them to pull back on purchase price multiples being offered for deals.
Despite all these stress points the overall conditions suggest the current time may offer the best opportunity for middle market companies to move quickly towards a successful sales transaction. Interest rates are not likely to significantly fall in the near future. The shock to the banking system needs time to play out. In the interim middle market companies will be hard pressed to maintain operating profits without owners making significant capital contributions taking up the shortfall from the banks.
There is a truism in finance that “Time is the enemy of all IRRs”. A strong case can be made to middle market business owners and Private Equity firms that Now is the Time to consider a sale of their company.