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The Cost of Money Impact on M&A feat. CJ Strehl

The Cost of Money Impact on M&A feat. CJ Strehl

Shoot The Moon
Shoot The Moon
The Cost of Money Impact on M&A feat. CJ Strehl
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Let’s dive in to how the rising costs of money are impacting M&A and the challenges it poses to things like valuation. Where does debt vs equity play a role and how will these macro changes impact the volume of deals and the structures? Revenue Rocket’s Director of Finance, CJ Strehl sits down with us to review the changes to the economy and the impacts of the rising costs of money. Learn how we are navigating these impacts in deals both domestic and foreign along with our thoughts on the continuing trend.

 

EPISODE TRANSCRIPT

Mike Harvath  00:05

Hello and welcome to this week Shoot the Moon podcast broadcasting live and direct from Revenue Rocket world headquarters in Bloomington Minnesota. Revenue Rocket is the world’s premier growth strategy and M&A advisor for IT services firms. And we are here today with my partners, Matt Lockhart and Ryan Barnett, as well as our special guests, CJ Strehl, who is the finance Lead here at Revenue Rocket. And we’re going to talk today about the cost of money and the increased cost of money and what impact that will have onM&A. Gentlemen, welcome. Thanks, Mike. It’s good to have CJ with us, I feel like our overall group IQ increased by more than a few percentage points. Now that we’ve got CJ with us.

CJ Strehl  00:57

Appreciate it, man. It’s been a while since I’ve been on a call. So it’s nice to be back. I’m excited to talk about how financing and how the macro environment and interest rates and all those types of things are going to impact M&A. There’s a lot of changes going on out there. And I’m sure a lot of people who are on our podcast today are hearing announcements and wondering how that’s going to impact their deals. So excited to be a part about things today.

Ryan Barnett  01:24

Yeah, we’re really excited to have you as well. CJ thanks for joining us. And just to kick this off and into level set, can you help us just explain what is the cost of money? Or what’s the cost of capital? And could they be different? And help this audience put some definitions when we talk about this topic in general?

CJ Strehl  01:47

Yeah, so I’m going to try to break this up into two pieces here, I think most of our conversation today is going to focus on you know, really, how’s the interest rate market changing and, and how that’s gonna be impacting deals. But to kind of start out with, you know, when you think about a deal, there’s kind of the cost of capital. And that’s really broken into two pieces. There’s a kind of a debt portion of that. And then there’s an equity portion. And when most of the time when you’re doing kind of a deal evaluation, you’ll be looking at, how will you balance those two things in order to come up with the kind of, you know, optimum structure, capital structure for a business? But for today’s discussion, I really want to have our focus beyond what’s going on in the macro environment, and how are those macro things impacting, you know, valuations? How does it impact how you think about deal structure? And how some of those things are going to kind of impact the overall marketplace in the next, you know, few months to maybe years?

Ryan Barnett  02:53

Let’s dig right in. So if we think about that, CJ, help us understand kind of what is the environment today? And we’re in July/August timeframe of 2022. So does that describe to our audience what’s happening on a macro sense and just start there?

CJ Strehl  03:13

Okay. So let me take a quick moment to kind of review with the listeners, how we think about valuations at Revenue Rocket. And then specifically, I’ll kind of pull out some of the key areas that the macro environments impacting and I’ll talk about the macro environment. So when we think about valuations at Revenue Rocket, really, we’re thinking about kind of four key areas. One is growth. One is profitability. One is industry. And the last is volatility. And the macro environment is really a huge driver of volatility, and then growth and profitability. Let me just cover growth and profitability real quickly. As the macro environment as we see a kind of a higher cost of interest rates, as we see a little bit slowing environment, obviously, that’s going to impact growth, the strengthening of the US dollar if a company has exposure to costs, or revenues and other markets, that strengthening and the dollar is going to impact those. And then finally, volatility is an area where interest rates really impact kind of our discount rates, and how we think about the value of $1 today, versus the value of $1 in the future. And that’s where interest rates are really going to be impacting kind of valuations. So, to kind of take a step back, what are what are we seeing in the macro environment right now? The first thing I think most people are aware of is that the Federal Reserve is embarking on a two pronged approach to try and bring inflation under control. The first piece that most people are aware of because they’ll see that on television is the interest in the increase interest rates. It’s, and we’ve seen now 75 basis point increases over the last two meetings. And the Federal Reserve has indicated that they’re going to continue to increase interest rates, really kind of through the end of the rest of the year. We’re currently around two and a half percent, a lot of folks see that going to about 4%, towards the end of this year. The second piece that a lot of people don’t realize is that the Federal Reserve is actually taking out a lot of liquidity from the market, in that pulling back of liquidity in the market, it actually increases volatility. Basically, it takes dollars that are floating around out there that could be used to do acquisitions or pay back debts to buy things. And the Federal Reserve is shrinking the number of dollars that are out there. When they do that, it just creates a marketplace, that becomes more volatile, and there’s less dollars chasing assets. And when less dollars are chasing assets, if you think about supply and demand, you’re typically going to see prices tend to move down a little bit. The other piece that a lot of people are seeing, especially if you decided to go on vacation this summer overseas is that the dollar has strengthened significantly over the last six months. And that’s that strengthen in the dollar is happening for a couple of reasons. One, you have higher interest rates in the US. And then second, you have the Federal Reserve, reducing a number of dollars, how that impacts our businesses that we’re seeing, if you’re a business, and you have a lot of overseas costs, right, your costs are going to be significantly less. So when you’re thinking about a transaction if you’re purchasing a business, and they have overseas operations in most of their costs, they’re seeing a nice pickup in their gross margin because those costs are going down. Conversely, if they have a lot of sales overseas, when you try to bring those dollars, not dollars, but those foreign currencies back into US dollars, those are translating back at a lower rate. So those revenues are declining. And it’s really important to understand that dynamic right now, because the US Dollar strengthened, against some currencies 20%. And that can be a big surprise, if you were to make a purchase right now, but business had a lot of cross overseas, and not recognize that there’s some artificial, or at least temporary benefits to those type of things. And so the interest rates in the US dollar, those type of things are kind of having an overall impact on liquidity on, you know, the dollars that are available to go out and do investments. And you’re beginning to see that impact in the public markets, you see that in the NASDAQ really declining as well as kind of the overall stock market? Will we have to wait and see, to determine whether the kind of policy of reducing the liquidity and increase in trades, if that’s going to have an impact on the overall economic cycle? And if we’re going to have kind of like a recession. But these are definitely factors that are impacting people’s decisions about making investments right now, right.

Ryan Barnett  08:10

That makes a lot of sense. When you start to consider this, what happens to buyers in this environment, is that do they become more turtle to nature to be more selective? In nature, it just can be for like CJ or Matt as well. But any indication of how buyers might treat this a little differently?

CJ Strehl  08:33

So we’ve had a large amount of liquidity in the marketplace for the last, say, five or six years that have you’ve seen an explosion of private equity. Because of that, because there’s all this money out there. And people are looking for ways to make those investments, and they’ve been turning to private equity vehicles. A lot of times those vehicles are based upon an initial investment and leverage, okay? In an environment like now moving forward, where you have higher interest rates, the cost of that leverage is going to cost more. And it’s going to increase kind of the risk that you’re taking in on your overall portfolio. And so it’s probably likely over the next year to two years, where we’re going to see, you know, the cost of that liquidity being more, because of that, you’re probably going to begin to see more strategic buyers in the marketplace looking for opportunities, and you’re probably going to see a little less activity from, you know, the private equity world. It wouldn’t surprise me if we do have a little bit of a bump here, kind of towards the end of the year. But the cost, you know, that cost of money, that cost of leverage and kind of the increased volatility and risk that comes with kind of the market cycle that we’re going to be in. That is going to have an impact probably on the number of buyers in the marketplace. I would first expect to shift more to strategic, and then based upon how the economy rolls, you know, a little bit of a pullback there.

Mike Harvath  08:41

Yeah, I don’t know if it’s going to have an impact on the overall amount of buyers, CJ. I mean, and that’s tough to you know, it’s tough to pinpoint exactly. You know, because the strategic imperatives, be it for financial buyers to private equity firms who have bought into the tech enabled services space, right, they’ve still got a lot of work to do, you know, to sort of complete their platform, which then, you know, gives them the greatest payoff to their investment, or certainly for strategic buyers, as you mentioned, the imperatives are there. I do agree, I think that if we looked back a year ago, we would say that the market was very frothy, there was just so much going on. And it drove people to deploy capital to try to be maybe a little less risk averse with regards to transactions. And I think that the you know, what’s going on in terms of the cost of capital and or the, you know, the liquidity, amount of liquidity may reduce that frothiness A bit people may be a little bit more conservative, a little bit more picky. But I don’t know if they’re going to exit the market altogether.

CJ Strehl  11:42

And I would agree with you, I definitely think there’s strategic, the strategic imperative. And the benefits for strategic buyers, in our industry sub sector is amazing, the returns on investment that you get when you make these deals, is still incredibly strong, given, you know, the increase that we’ve seen in the interest rate environment. So I agree with you there. I think that where deals are involving a lot more leverage, that’s probably where you’ll see a little bit of a decline.

Mike Harvath  12:17

I was just gonna say, Mike, you’ve you’ve been through previous cycles like this. So what do you think? Well, I, I think the you know, the tech industry is kind of insulated from the broader economy because of the domain. And, you know, the labor shortage scenarios around qualified tech labor. It’s certainly, you know, we saw major impacts in the major last two major financial crisis is, but they were just that, right. They were, you know, post y2k and 2008. I mean, those are very material times, there was impact and chilling of the market. I don’t know if in a moderate downturn or even, you know, we may argue that we don’t see a recessive period, certainly we see interest rate increase, coming to try to tamp down inflation. But I think this is going to be more, you know, if you want to use the term soft landing or whatever, in this current environment, I certainly don’t see any decrease at this time anyway, in demand. And certainly, we don’t see any impact on valuations, there’s always talk about, you know, we’ll, you know, higher interest rate environment impact multiples and valuation, I certainly would love to get your perspective on that, CJ, but, you know, in actual deals that are getting done, like, you know, now, we haven’t necessarily seen that as of yet, doesn’t mean that might not come. But I think based on a dynamic of, you know, the ever increasing percentage of the GDP that tech and tech services is, and the you know, supply demand curve imbalances that exist, not only for labor, but also for technical talent more broadly by consumers of that talent and companies that need that specialized skill, that we may not really see it impact any M&A volumes per se, or if so, it’d be very moderate and certainly not impact valuations. I know that buyers are hopeful that valuations will go down. We just haven’t seen that. And likewise, we haven’t seen the requisite demand decreases yet. So, you know, hard to predict the future. It’s part of what we’re trying to do here a little bit, but certainly, you know, time will tell.

CJ Strehl  15:06

I was gonna say that, to some extent, we have seen some impacts, Mike, in the public markets, right? The public markets and the private markets are very different. And they’re different for really important reasons. You know, we specialize here at Revenue Rocket, kind of a small and mid size. Most of our most of our clients have pretty strong cash flows. And that really matters right now. Because the more cash flows you have, the less impact kind of interest rates and kind of that decline in liquidity impacts things. So let me let me kind of explain that a little bit. So in the public markets, you probably hear a lot about the NASDAQ. And you might hear about some high flyers and stuff on the NASDAQ and those those some of those companies have corrected pretty significantly. And the reason, one of the main reasons they’ve been correcting has to do with this kind of higher discount rate, this higher rate of return, that’s expected, because of a couple of factors. So one of those factors is, you know, the volatility of the marketplace, one of those factors has to do with the increased cost of capital, the increased cost of money or the risk free rate. And, and that can be really significant because some of these companies, right, you have to go out 10 or 15 years sometimes to go out and find really good cash flows that support that value. And when you have to discount those cash flows all the way back today, at a much higher rate, you will see pretty significant kind of move down in valuation. And you’ve seen that, right? I mean, the NASDAQ as a whole is down 20%. But you have some high fliers in there that had very little cash flow, they were maybe losing money today, where in order to go and see when they’re gonna make money, you might have to go up 10 years. And so when you have to discount, positive cash flows back 10 years, in order to come with a valuation, you get a, you get a really kind of strong market response to that. However, in our world, most of the clients that we work with are having some pretty strong cash flows, and those cash flows are coming in every month, coming in every year. And so when you have that kind of stability, and when you have that kind of near term cashflow, the change in the discount rate, it doesn’t have as much of a factor because we’re not having to go out many, many years in the future, to justify that valuation. And so in our world, Mike, you’re absolutely right, we haven’t seen too much of an impact right now based upon the movements in both liquidity as well as interest rates on our businesses. But you know, every time those interest rates go up, that is having an impact on that discount rate. Obviously, it has more of an impact if you are a high growth company without cash flows than it does if you’re, you know, a mid kind of growth company with really strong cash flows.

Ryan Barnett  18:09

I’d like to take a little bit curiosity question on a macro view, the reason why the Fed is making these adjustments is based on the increased, you know, just the growth of the economy in general. Has that growth been passed on IT services firms? And is that kind of one of the reasons why we’re looking for buyers still so interested in this market?

CJ Strehl  18:38

Think that’s a great question for Matt.

Matt Lockhart  18:43

Yes. You know, when we think about it in a macro sense, there is such an imbalance. And we’ve talked about this a lot. A supply and demand imbalance. And what do we mean by that there’s, you know, Software is eating the world, and has been for 20 years. And really going back to the last financial crisis of 2007. Right, where large enterprise organizations had, you know, were forced to decrease their workforce because their workforce was, you know, just such a high percentage of their overall expense. Right. And so then they started to invest more and more in automation. Okay, well, that was sort of the start of it. Then all of a sudden, the money came back, and digital and transformation became the name of the game, how am I going to interact with the marketplace, you know, through my technology footprint, and lo and behold, that sort of combined with the push to more automation, only increased the the need for talent for services for people, then layer on top of that we’ve got the cybersecurity and up because of all of this automation and all of this new data and all of this new digital interaction, cybersecurity became that much more important, while that just put more pressure. And this imbalance of supply and demand. And we’re a long ways from fixing that. So, you know, that goes back to sort of what Mike was saying that this marketplace is more insulated, than just about any other marketplace. And sort of the overall impact of what’s going on in the market.

CJ Strehl  20:56

Hey, Ryan, I could probably add to that a little bit. I look at financial statements, you know, every day for the companies that are interacting with us. And sometimes, you know, I’m looking at four or five different companies each week. I think one of the things that’s happening and why the kind of Federal Reserve is doing what it’s doing is, when you look at the kind of the financials across the board, it looks like a lot of our clients are being able to take some price right now, they’re being able to push through price increases kind of across the board. And you’re seeing that pickup kind of in the revenues. And so can the IT space, because of what Matt just talked about that supply demand and imbalance? A lot of our company is able to take advantage of that. Unfortunately, the downside of that, right, is that on the cost side, a lot of our clients, a lot of the folks I’m looking at of the financial statements, you know, we’re seeing a pretty significant step up in both the cost of goods sold, especially for the people. And I’m sure that anyone listening to this is probably wondering, you know, how do I keep my employees? How do I prevent them from leaving, and I’m sure that, you know, salaries are being a big piece of that. What we had seen Ryan, over the course of the last two or three years, is that the opportunity for a lot of the financial stigma of a lot of our customers to pass on prices, pass on increases more than they’re actually seeing those kinds of increase in costs. I would say in the last kind of two quarters, kind of going back to maybe the end of 2021, we’ve really started to see that flip, where yes, our clients are able to take, you know, they’re able to take some price. But those cost increases that they’re seeing in their business are starting to really eat up or eat away completely. Those kind of revenue increases. And I think that’s kind of the whole definition of inflation, right. And I think that that is what the Fed is trying to get out in front of right now. And trying to bring down that inflation rate. And, you know, we’ll see if they’re able to be successful there.

Ryan Barnett  23:12

Really interesting. Can you explain, give us any prognostics on what a seller should do as far as timing? And is something where sellers should look at now and seize the day because there could be future rates and money could be tighter? Is it something where you should be concerned about valuation rates potentially decreasing? What What should a seller take out of this discussion?

CJ Strehl  23:44

Well, from my perspective, and obviously, I’m kind of the finance guy, I’ll give you my thoughts. And then, you know, I think it’s really important to get, you know, the perspective of Matt and Mike here. The first thing I would say is that a well run business with strong margins, producing great cash flows, is always in demand. Strong growth rates, excellent conversion of sales to net cash, people are always looking for those opportunities. And there will always be an opportunity out there for well run businesses with excellent cash flows to be sold at very good prices. But that being said, you know, when you’re going to sell your company, you have to be aware of kind of what the overall macro environment looks like. I think right now, there’s a couple of things that are really positive out there for sellers, you do have this environment where, you know, we have some revenue growth is coming from inflation that’s out there, that price taking that opportunity is there and those prices can potentially be sticky, right? Conversely, you know, on the cost side, a lot of our customers are dealing with really significant increase in costs and my expection would be that we probably will see a little bit of softening in both that kind of contractor market as well as employer market, as the Fed really tries to kind of deal with that imbalance in the marketplace. So the next couple months can be really exciting. From a standpoint of really well wrote really well run businesses been able to capture some of that revenue growth, but being able to really hold the line on, you know, costs, and be able to over the next say year, be able to really kind of accelerate cash flow generation. One thing I also think is going to be true over the next year or so is that over the last five years, companies that didn’t necessarily have a lot of net cash flow generation, because there was all this liquidity in the market, people were chasing those, and they were probably overpaying for those companies. And I think there’s a lot of focus on that both in the media, the stock market, all the excitement, because when money is really cheap, you can take big swings, you can go out there, and you can swing for the fences, and you have don’t have to worry as much about the return because interest rates are so low, and the payback on that, you know, is pretty minimal. But as you see those interest rates move up, there’s gonna be a lot more focus on companies that produce cash flow. And that’s kind of I think, one of our niches. And I think that a lot of the folks that are listening on this call are thinking, hey, my business produces cash flow. You know, I, I don’t understand how companies with no money making zero money, how they get these great valuations? Well, I think that pendulum is going to start to swing back. And I think there’ll be a lot more focus and a lot more opportunity. And probably, you know, a lot closer a fair valuation for companies that are producing, you know, great, great net cash flows to the bottom line. So that’s kind of my perspective, from a from a financial perspective. If I had a crystal ball and could tell you exactly what the economy is going to look like, over the next year, I probably already be retired. So I’m not that great at doing that. So I’m still working. But I think that we all have to be cognizant that increase interest rates, as well as the reduction of the number of dollars out there is going to pull back on liquidity. And as we see less dollars and less liquidity in the marketplace, that we’ll probably have a little bit of a softening of the overall market. And that would be kind of my prediction.

Matt Lockhart  27:32

You have too many young kids to retire CJ, and you have too much fun doing what you’re doing to retire anyways. So that’s not gonna happen. You know, I was gonna go exactly where you were, where you started there, CJ, which is good, well run businesses are always in demand, as we talked about, matching your capabilities to market needs is always smart. And regardless of whether or not you’re thinking about selling your business, but, you know, you brought up the context of volatility earlier, CJ, and I think that being able to demonstrate how your business and the results of your business over time, are predictable, is probably, you know, going to be something that’s really important when considering bringing your business to the market. And if that means that you know, there’s some things that need to be done in terms of longer term, M&A readiness, then that’s, that’s something to consider, because I agree with you that buyers are going to be looking for businesses that cash flow more than ever right now, given what’s going on.

Mike Harvath  29:10

Yeah, I guess I would add, we’ve said from the beginning, that it’s all about optimizing the business for profit and growth. And being able to do that and run a well run business serves you well today, as you know, business owners and leaders as well as at the time of a potential exit or, you know, as a target for an acquisition, right. Healthy companies are great companies to buy. And there will always be in demand. Just because they’re easier to integrate, they’re easier to map your return rate. They’re just in general, a better target overall versus trying to do a turnaround or trying to, you know, take more risks, I think to see this point, you know, buyers are gonna want to be taking less risk In certainly buying companies that have sub optimal profit visa vie their peers or, you know, their charts aren’t up into the right, as we like to say, as it relates to growth and profitability, is probably going to mean they’re less attractive. Certainly. I think also, I’ve just like to comment, we get a lot of questions about, you know, the impact and a tightening market and valuation. And, you know, I have a little bit of a historical perspective on that I want to share just so people understand that level set, the outline posts on that, from the worst period of financial crisis and market chill to the boom market for any given firm, from my personal experience has only been about a two times EBIT a multiple. So the bottom would have been about, you know, two times down from the top. You know, we don’t think that this market interest rate increase environment, or what she’ll maybe call it a market pause less than a market slowdown will have a material impact on valuations, that certainly will not have a 2x We know that it’ll be less than 1x. We just don’t know how much less if any impact. So I just wanted to add some historical context. So that as you guys think about that, we get a lot of questions right now, like, well, is this the right time to sell? Should we sell Should we wait, you know, I think when the time is right to sell, if you’re running a healthy company, it shouldn’t, you shouldn’t get overly consumed with market timing, right? It’s a sort of same advice, your financial advisor might give you about stock timing and stock picking, right? Pretty hard to predict the future and pick accordingly. I think from a M&A perspective, if you’re running a healthy company, and you have a competent advisor, which I’d put a plug in for that variability and the valuations and the pressure on the valuations will be not all that material, not as materials you might think. And as a result, you know, there’s much more of an opportunity to, if you run your business well, you know, at a top quartile profitability, to get a fair deal done at anytime. And to Matt’s point about, you know, great companies will always be in high demand, I think that’s absolutely true.

Ryan Barnett  32:21

Great points for everyone. Thank you, CJ, for being a guest here today. Any parting thoughts?

CJ Strehl  32:29

I would probably just add that, you know, we have some buyers in the call, they’re also listening. And there’s, there are some things that are happening that are going to kind of make, you need to dig in a little bit more into the financials, when you get ready to do an acquisition. And that’s the type of stuff that, you know, my team does. You know, I mentioned earlier about how FX is impacted, and how that can impact some of the operations and stuff. And so, I know a lot of the focus on this call has been on our on our sell side. But I think that there’s a lot of things out there that as the macro environment changes, that’s really, really relevant for the buy side. You know, for overall sales side, I think the main message is, you know, cash is still king. And if anything, it’s probably become more king. And so, you know, when you think about how you structure deals, you’re going to be thinking about cash. When you think about how valuations are going to come up, it’s going to be about really, how much cash are you generating, the more cash you generate in the short term, the less this entire discussion is going to have an impact. The more your growth, the more the cash flows are in the future. You know, the more that we’re dependent upon forecast, that’s where valuations are more impacted. So for anybody who’s out there listening, if you’ve got a business and you’re running it well, you’ve got, you know, great margins, it’s dropping cash to the to the bottom line, this marketplace is actually probably firming up for you. Because I think that recurring dependable cash flows are going to be really highly in demand over the next probably six months to 18 months. And if that’s the type of environment you’re in, I think that you know, the M&A world can be could be the right place for you.

Ryan Barnett  34:19

Great, thank you so much, Matt or Mike. If there’s nothing else I’ll turn it over to Mike.

 

Mike Harvath  34:26

Now it’s great to have you on CJ. We need to do it more often.

 

CJ Strehl  34:32

Thanks everyone. I appreciate the time.

Mike Harvath  34:34

You bet. Thanks CJ and the team for your insights today. With that, we’ll tie a ribbon on it for this week’s podcast. Thanks and make it a great week.