Winds of Change: 2021 in review, 2022 in forecast

FOMO (abbreviation): Fear of Missing Out; fear of not being included in something interesting or enjoyable that others are experiencing.

As we embark on a new year, I suspect some business owners are feeling FOMO. 2021 set records with $80-120 billion(1) of wealth creation for small business owners selling their companies. The private markets overlooked the pandemic and aggressively deployed dry powder (investment capital) into these highly attractive mom-and-pop companies through buy-and-build acquisition strategies.

At Imperial Capital we acquired pest control companies, vet hospitals, car washes, food testing labs, optical clinics, and more. Collectively, Imperial completed 197 transactions worth $1.3 billion: more than 1% of the SMB market(2).

It was a seller’s market. Kudos to the owners who sold and are living their retirement dreams. For some it was earlier than expected, so I applaud your timing and vision:

1. Sky High Valuations: Purchase multiples (price divided by profit) reached an all-time peak in 2021. The Federal Reserve has suggested higher interest rates in 2022, which may cause valuations to decrease. Why? Investors have a higher cost of capital and need to pay less to achieve target returns.

2. Rising Inflation: Input cost increases squeezed business profit margins thanks to the Great Resignation and the Supply Chain Crisis. In 2022 businesses will be impacted by labor shortages, expensive raw materials, and the unpleasant reality of explaining pricing increases to customers. The operational and financial challenges may increase the supply of businesses for sale.

3. Capital Gains Tax: 2021 saw a frantic rush to sign and close transactions ahead of proposed capital gains tax rate increases. The impact is equivalent to a purchase price reduction of 15%+. Although the legislation is not final, business owners continue to fear that private capital is not going to bridge the valuation gap.

Although I cannot pinpoint when the transition from a seller’s market to buyer’s market will occur – a watchful eye might agree that the winds of change are already blowing. For investors: 2022 is going to be marred with uncertainty, and with uncertainty comes caution and risk adjustments. For business owners: we are hearing anecdotally that they “have found the past year to be very stressful, and are simply ready to sell and move on."

My prediction: SMB transaction volume will continue to reach record highs (due to excess investment capital), while valuations will begin to normalize and private capital buyers will become more aggressive with structures such as holdbacks, reps and warranties, and earnouts tied to employee/customer retention.

This note serves as observations from the field by Ryan Aimers and should not be taken as investment advice to capital holders or business owners.

All figures in US dollars (1) FactSet, Statista & Pitchbook data based upon the United States market (2) Small and medium-sized businesses defined as transaction size below US$100.0M