Capstone Partners released its Q1 2023 Capital Market Update, reporting that total middle market merger and acquisition (M&A) volume declined 14.3% year-over-year (YOY) in Q1 2023 as macroeconomic headwinds caused a slowdown in dealmaking. However, middle market deal volume continued to outperform the broader M&A market, as total M&A volume declined 25.2% YOY in Q1. While buyers have demonstrated increased selectivity, quality companies with strong margin profiles have continued to command M&A interest at premium valuations. The Federal Reserve's ability to navigate a soft landing will likely prove consequential for middle market M&A throughout 2023.

Uncertainty is seldom received favorably by capital markets and the lack of economic visibility has caused angst among many market participants. The Federal Reserve has yet to settle on a terminal interest rate, with the continued strength of the labor market complicating the task of whether to hike or pause. Recent turmoil among regional banks has contributed to the tightening of the U.S. economy—an element that may be difficult to quantify in basis points. As the U.S. navigates a higher-for-longer rate environment to quell stubborn inflationary headwinds, confidence in a smooth recovery has often fluctuated with equity market swings, leaving many to wonder when the U.S. will enter a recession, or if the economy is already in the midst of one. As the economy eyes an emergence from monetary tightening, there is hope that the M&A market may have reached a modest trough—presenting a strong backdrop for a recovery in middle market dealmaking.

Inflation and elevated interest rates have continued to pressure M&A valuations in the middle market. However, there has been evidence of some upward pricing momentum in early 2023. The average EBITDA multiple amounted to 9.1x in Q1, following a drastic decline to 7.2x in Q4 2022. Interestingly, it is the large-scale transactions that have seen the most significant pullback in pricing. The core middle market ($100-$250 in enterprise value) has continued to be the bellwether of middle market pricing. Valuations at this range have held steady at 10.9x EV/EBITDA, nearly mirroring the prior year's average of 11.1x EV/EBITDA.

Business owners, dealmakers, and lenders will be closely monitoring the monetary policy environment and its reverberations on the broader economy. If the U.S. has reached, or is approaching, its trough in the M&A market, there is a precedent for what is to come. Sellers can expect an exuberant interest from buyers looking to reengage in inorganic growth upon a market recovery. Timing and asset position will be key as a substantial level of pent-up demand can be expected to create healthy levels of competition in the middle market.

"As has traditionally been the case, M&A market valuations and activity levels are driven more by credit trends than by equity market levels. Tightened credit conditions have decreased the amount of debt available for transactions as well as increasing the cost of that debt. With higher required equity contributions and more expensive debt, valuations have adjusted downward to maintain returns. Further, the natural flight to quality in times of uncertainty has further reduced supply in the short term. We look forward to the inevitable rebound in activity as conditions stabilize," said Phil Seefried, Executive Advisor at Capstone Partners.

Also included in this report:

• Key considerations for middle market business owners regarding dry powder levels, buyer appetite, lending conditions, and M&A pricing trends.
• Commentary on the primary drivers of transaction volume and valuations through Q1 2023.
• A breakdown of private equity dealmaking activity and data on dry powder reserves.
• How to create an evidence-based post-acquisition strategy, featuring Capstone's Financial Advisory Services group.

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