Crazy Rates and Valuations
Curbing inflation has been the name of the game in the last year or two and so interest rates have continually crept higher and higher. And while people are certainly concerned about the price of groceries, gas, and other staples, the big question we are hearing from clients about M&A is “how are these crazy interest rates impacting HVAC deal valuations?”
Recent Market Experience
It’s a fair question as buyers typically take on a significant amount of debt to fund transactions. That could lead one to believe that the current high interest rate environment negatively impacts valuations. Interestingly, that has not been IEI’s experience. For our four closed commercial HVAC and mechanical transactions in the last 10 months, our clients have all received as good or better offers than they might have in the very active M&A deal environments of 2021 and 2022. Per the graph below, rates were much lower then.
While the causes of these strong valuations in the current economy are difficult to pinpoint, we suspect a main driver is the number of commercial HVAC consolidation platforms. We’ve written about consolidation previously and also recently updated our consolidation tracker graph below. We’ve watched the consolidation trend closely over the past five years and new buyers have continuously entered the market. With each new buyer comes a mandate to make acquisitions which simply fuels the already frenzied pace of acquisitions. Buyers know that to hit their growth goals in this competitive environment, their valuations of acquisition targets must remain strong to secure deals.
Broad Market Analysis
In addition to our own advisory experience, we also reviewed the available data on the broader market. GF Data is an aggregator of anonymized information on private equity sponsored transactions. GF Data member private equity firms share key deal benchmark terms from closed transactions in exchange for GF Data's analysis of the market.
GF Data is widely considered the go to source for M&A data in the lower middle market (often defined as transactions less than $250m in value). This is a sector of the market where most companies engaged in M&A aren’t public. GF Data’s approach fills the need for lower middle market deal data whereas public company filings provide data on larger transactions.
IEI Advisors is a subscriber to GF Data which releases data on the “business services” market segment which is typically the broad segment within which HVAC sits. For the latest GF Data business services valuation data, see Chart 2 below. First, three definitions are important to note in interpreting Chart 2.
“TEV”: Total Enterprise Value is the size of the transaction in millions of dollars.
“TEV/EBITDA” Multiple: The numbers in the chart represent Total Enterprise Value (TEV) divided by Earnings Before Interest Taxes Depreciation and Amortization (EBITDA – a common measure of profitability) which is often also referred to more commonly as the transaction multiple.
“N”: Number of transactions analyzed in each year column or TEV row. The YTD data for 2023 is through June 2023 which is the most recent period available from GF Data.
The Chart 2 multiple data does confirm IEI Advisors’ experience with strong valuations. In fact, GF Data shows that business services valuations were up slightly through the first half of 2023 versus 2021 and 2022. Only valuations for the lowest TEV category (10-25) dipped in the first half of 2023 but those are still above the historical average.
While the cause of these higher valuations may be more difficult to pinpoint, one contributing factor could certainly be the growth of “dry powder” (uninvested funds) committed to private equity firms.
This dry powder is primarily looking for acquisition opportunities. Knowing private equity’s fondness for fragmented industries, all this pent-up capital is likely targeting HVAC deals and fueling the ongoing investment in consolidation.
For someone outside of the M&A industry, the conclusions from this blog may seem hard to believe. It certainly seems like high interest rates impact every aspect of our economy and particularly anything involving financing. While that perspective certainly makes sense, M&A professionals have often observed that the lower middle market M&A is less impacted by economic swings versus larger transactions which typically do follow economic cycles.
Our conclusion after reflecting on our own experience and examining the market data available through June 2023 is that inflation hasn’t impacted HVAC M&A deal valuations yet. Is it possible that there is a lagging impact on valuations as high interest rates persist? It’s hard to say but that is certainly on our minds and a possibility that we will continue to monitor.
(1) Chart 2 is from GF Data’s Business Services Drilldown dated September 2023 and is included within this blog with permission from GF Data.