Closing a Deal in Today’s Environment [Axial Roundtable]

In a recent roundtable discussion, four Axial members joined Axial CEO, Peter Lehrman to discuss opportunities and challenges in the current lower middle market M&A environment. From the cost and availability of today’s debt, to the importance of spending the time to build a rockstar transaction team, this group of deal professionals – all of whom have closed a deal in recent months – covers a myriad of pain points, learnings, and opportunities that they have uncovered in today’s landscape.

A big thank you to the Axial members who participated in the discussion:

• Tanner Borger, Senior Director of Corporate Development, Cardone Equity Group

• Ethan Brown, Managing Partner, Red Oak Ventures & Acquisitions

• Al Cameron, Managing Partner, Rox Capital

• Paul Evans, Partner, CRI Capital Advisors

Introductions: 00:00-2:14

Extensions, extensions, extensions: from capacity constraints to debt holdups: 2:15

• Peter Lehrman, Axial – We have not seen a single deal on Axial close within the original exclusivity period; without exception, all deals have gone through extensions
• There are plenty of normal factors that can cause this, but it seems like something else is weighing in on the slowdown this year
• Paul Evans, CRI Capital Advisors – Deals are almost always hard, but we are coming off of a pretty big backlog after a very busy close last year, and this is causing hold ups
• There are a lot of capacity issues with Q-of-E 
• It is taking groups longer to bring debt into deals
• A recent $19M deal that CRI represented – the business was being acquired by a strategic – had $14M in debt, and the debt took two months to secure
• It was standard bank debt; the buyer had secured a lower rate and they were then having to get a lot more people involved in order to keep that original rate as time progressed
• This strategic buyer had completed two other acquisitions earlier in the year and had put in a lot of cash, so they wanted to load this company with debt because that particular business was structured well to easily make the payments
• CRI has another deal right now that is being slowed down by debt, and it’s because the sellers were not willing to budget on their price, and the buyers are trying to really think through whether not they want to pay the extra percentage points on $5M of debt
• There is a mixture of fixed price debt and floating debt
• Ethan Brown, Red Oak Ventures – As we got towards the end of COVID, everything began getting pushed because no one was sure of the next 12-24 months
• Figuring out how to measure financials has been tough
• There is also generally just a lack of certainty from sellers around what they can expect
• If a business owner has owned a business for two decades and is exiting with a seller’s note, they want to be very, very sure of who they’re selling to
• The external factors around the economy – recession, inflation, etc. – on top of everything we just faced from COVID are causing a lot of pause for business owners
• Red Oak recently acquired a business through Axial – a TX-based nurse staffing company – and the firm really had to build a lot of trust
• There were a lot of moving parts – equity, a seller’s note, and an SBA loan – so getting to the finish line was tough
• The deal went past the exclusivity period by six months
• Red Oak has also seen brokers pushing exclusivity periods that aren’t realistic to begin with just so they can get an LOI signed
• Peter Lehrman – were there any issues going past the exclusivity period? 
• Ethan Brown – 90% of the time they were in good lockstep because there was a lot of communication going on
• The only time things got somewhat contentious was when Red Oak did not do a good enough job communicating their intents, and it could make the seller feel cornered
• The better both sides got at building rapport and trust, the easier it became as time went on
• This deal closed in Q3, but they started working with the SBA before rates started going up, so they saw the impact of the floating rates very quickly and then had to adjust expectations
• The underwriting process is very onerous and the seller needs to be willing to stomach a lot of work, and the buyer has to be willing to hold their hand through that to make that happen

The importance of building a “rockstar” team – 12:15

• Al Cameron, Rox Capital – Rox Capital closed on a fiberglass manufacturing business in FL a few months back, and they were in the midst of the deal as the economy started changing
• Peeling back the layers of the onion and understanding how all of the recent external factors – COVID, backlogs, material cost increases, backlogs – are affecting a business is really important: “meeting of the minds”
• Alignment is extremely important, because some businesses had an artificial COVID bump, others suffered, and others proved themselves as steadfast and recession-proof
• The value of putting together an all-star team has become very important; Rox has found a legal team that they work very well with, an accounting team that has done multiple Q-of-Es for them and understands their workstyle
• At the five yard line of the deal, there was a sticking point that Rox couldn’t get past/compromise on, so they had to get on a call with both legal teams; after the call, the seller called Rox back and complimented them on their legal team and how the lawyers approached the situation and represented Rox well
• Went to conventional financing through a bank for this specific deal, which was different than their past few deals which used SBA financing
• Banks are also considering a lot of turbulence, so they’re looking at different parts of their portfolio and seeing how they can diversify
• The bank that provided financing for this deal has not historically done a lot of lower middle market work, but they wanted to increase that exposure
• Rox worked pretty closely with the bank explaining their thesis and getting their full buy-in so that they were very aligned 
• Within the Rox team, they divide and conquer on deals: Al worked very closely on a lot of the debt and equity sourcing, and his partner Mark worked on a lot of the other deal aspects

Identifying the right source of debt – 18:10

• Peter Lehrman – It’s quite common for banks to change their appetite as they weigh their exposure in different markets
• It’s not uncommon to have worked with the same bank for multiple deals over many years, and then call them up and have them tell you that they’re looking to cut down on their lower middle market “x industry” exposure 
• Al Cameron – Rox has definitely had bank relationships ebb and flow as appetites change
• They spent a lot of time with the bank and built out several models with the bank and built their own spread, even though they knew the bank would have their own spread

Adapting to unique circumstances – 20:10

• Tanner Borger, Cardone Equity Group – Cardone invests out of $100M fund as well as making acquisitions corporately
• In the home services space, there are a lot of sub-$10M businesses with lower multiples
• In a lot of the tertiary markets, you’re working with owners who have not gone through a transaction before, so their legal team may not be familiar with the M&A process
• Cardone recently worked on a deal with a seller whose legal representation for the transaction was a litigator who was actually in a trial as they were trying to close the transaction, which drew out the transaction much longer than they anticipated
• A week out from closing, the sellers got cold feet and they had to sit them back down and walk them through everything again to get them completely comfortable in order to close
• In that particular deal, Cardone sourced the deal via Axial and the deal moved very quickly on the front end; from being shipped on Axial to being under LOI was only 10 days
• Tanner believes that had they not had such a long delay on the back end of the transaction, it’s likely that the sellers wouldn’t have had so much time to rethink things, and the reset wouldn’t have been necessary at the one-yard line

Rethinking the exit – 25:25

• Paul Evans – One of the things CRI started doing early in the transaction process is warning the business owners how emotionally taxing the transaction process is 
• They tell them it’s going to take more time than you think, it’s going to be more difficult than you think, you’ll wake up in the middle of the night crying and not wanting to sell your business
• They don’t care if it’s not a terrible decision, but they need the confidence that it’s going to be the right decision

The evolution of pricing – 27:10

• Al Cameron – Debt pricing was established on the Rox deal prior to there being a lot of economic turbulence; they had a time-bound term sheet and they went quite a bit over the timing of the term sheet, but because they had focused so closely on building confidence with the bank, they honored the original pricing
• On the equity side of things, the businesses that Rox looks at are recession resistant, so they aren’t typically concerned about major shifts in overall pricing due to major shifts in demand or anything like that; however, a lot of smaller businesses don’t have in-depth cost analysis or the tools to help them forecast, so they see changes in their margins in the rearview mirror versus predicting it in advance
• Because of that Rox anticipated that in this deal and helped the business adjust prices and get new contracts in place to mitigate any challenges with rising costs
• Because of these adjustments, they did not end up re-pricing the deal once from start to finish (and this is something that they really try to consistently hold fast to)

Valuation versus valuation expectations – 33:40

• Paul Evans – The spread is widening
• Sellers are taking their valuation more seriously than ever before because they’re nervous about the taxes that are going to be taken, their own personal interest rates – without considering the investment interest rates – their personal portfolio
• Instead of the seller thinking “this is what my company is worth”, they’re thinking “this is what I have to have”. And what they have to have today is more than it was a couple of years ago
• Sellers always ask what their company is worth, and CRI tells them that their company is worth what people are going to pay for it. And after doing a fair market assessment, they show the seller the bucket where 80% of the offers are going to come in, and that’s almost always lower than the seller wants.
• Al Cameron – There are a lot of really good businesses coming to market after COVID, so Rox is looking to pay market rate for businesses, but is looking for those really strong companies that may not have otherwise been on the market
• Paul Evans – On the flip side, there are some business owners who weather COVID well and they’re feeling really confident after having four strong years, so they’re thinking they can continue on indefinitely; it’s Paul’s job to remind them once they have any sort of downturn, they’re going to be in a rebuilding phase, so it’s actually better to consider selling now than waiting to weather another storm
• Even if it’s not peak season for sellers, it’s still really good
• There are also a lot of really strong buyers out there right now, which means that sellers get to be a little more choosy and they can take the time to find a partner versus a purchaser
• Ethan Brown – If you had asked six months ago if Red Oak was interested in exploring M&A, Ethan was still in the “learn and listen” phase and would have said no, but based on the market today, he is more open to it
• While M&A isn’t currently a core part of the business he acquired, Ethan is open to considering it, because there are a lot of potential opportunities that may come from business owners who weathered a recession in 2008 and don’t want to have to go through that again
• Tanner Borger – Cardone has been actively looking at deals and submitting LOIs in the HVAC space; they see consolidation opportunities in other home services areas as well, but are focusing right now on HVAC

Expectations for the year ahead – 45:50

• Al Cameron – Optimism; turbulence can be good if you navigate it well
• There are a lot of reasonable sellers, and interesting businesses right now
• COVID is in the rearview mirror almost two years, and we’ve now gone through inflation and a number of other economic shifts and headwinds 
• Because of these things we’ve seen businesses through a really interesting business cycle, and if a business has navigated through all of those things successfully, that makes it a really interesting business
• If your investment thesis is materially at risk due to a couple of percentage points, you should probably sit on the sidelines 
• Tanner Borger – because Cardone is investing out of a fund, they’re considerate of sitting on a lot of dry powder 
• Looking to potentially see some discounting on pricing as we head into 2023
• Paul Evans – there is still so much money available, so CRI feels like it’s a great time to sell as long as the business is strong 
• It’s not worth saying people are going to be stingy, because you only need one buyer who is willing to meet you where you want to be 
• Every single economy has an advantage if you’re willing to see it