The market for mergers and acquisitions continues to sizzle, with little foreseeable end in sight. This red-hot environment has benefited both buyers and sellers, spurring record deal activity across diverse industries. The conditions that led to this state of affairs could potentially endure well into 2022.

Rohit Subramaniam, a partner in the RSM transaction advisory services practice in Minneapolis, underscores three factors driving this bull market of deal-making. To start, the credit environment is very favorable with continued low rates. And there are many institutions that want to lend money, which continues to drive down rates. That’s good for both buyers and sellers because it attracts more buyers to the market who compete for sellers’ businesses.

A second factor propelling the frothy M&A market is that private equity firms and corporate buyers are rich with capital. It’s a holdover from the Great Recession when many companies were conservative with their cash. In addition, many institutional investors raised new funds coming out of the recession around 2012 to 2015, and they are eager to tap into the funds.

“They didn’t deploy those funds quickly because they believed valuations were too high,” Subramaniam says. “They were riding out the market to see if it would drop before they invested. That didn’t come to pass except for a brief two-month period during April and May 2020 when the sky was falling [at the onset of the Covid pandemic], and instead, valuations continue to rise.”

Finally, M&A activity is being fueled by the many promising prospective companies for buyers to consider, especially those that have thrived during the pandemic. That includes a variety of businesses that focus on consumer goods—especially for the home—and health care companies.

Soaring valuations
One issue for buyers, and a good thing for sellers, is that valuations have been trending high. That means it’s especially important for buyers to conduct thorough due diligence to make sure they are not overpaying for acquisitions, Subramaniam says. “It seems like a lot of B and even C assets are getting valuations on par with what A assets would normally get. There is a willingness by investors to invest equivalent dollars today into B and C assets that they would have reserved for A assets, and there are more A assets out there,” he adds.

When evaluating companies, it’s important for buyers to consider whether a business is performing well because of the pandemic and whether that success is sustainable into the future. Weigh whether the company has a demonstrated plan for topline growth, that the growth is sustainable beyond the Covid era, and that the company can manage its expenses, Subramaniam says.

Similarly, sellers shouldn’t rush into a sale because they are concerned about potential changes to the tax code related to capital gains and corporate tax rates. They should make sure that, in addition to a good valuation, they have favorable deal terms like the closing date. “You can get an amazing preliminary value offer, but if that buyer stalls or even kills the deal due to weak fundamentals and exposures only identified in their diligence, you are worse off,” Subramaniam says.

Tread carefully
In this hot M&A market, it’s smart to make contingency plans or alternative deal structures to reduce risk. For example, buyers can purchase the bulk of the seller’s equity but retain the former owner to help continue growing the company. Or, they can delay payment of some of the purchase price for a term until profitability milestones are hit. These moves hedge buyers’ bets, though it does diminish the buyer’s upside if the company performs well, Subramaniam says.

Due diligence and risk mitigation is vital because the market will cool at some point. The last thing buyers want to discover is that they overpaid for a company or that it’s not all it was cracked up to be.

Rohit Subramaniam is a partner in the RSM transaction advisory services practice in Minneapolis. A CPA and certified management accountant, Subramaniam provides due diligence services to private equity clients, private equity portfolio companies, strategic corporate buyers, family funds, and family-owned businesses. He primarily focuses on middle-market companies.