Around this time of year, I am often asked about the mergers and acquisitions outlook for the childcare industry. Although I wish I had a crystal ball, I do not. However, I will share my thoughts about the childcare mergers and acquisition trends we will see in 2023.
To put things in perspective, we must first review mergers and acquisition trends seen in recent years.
The above graph from Pitchbook (as of Sept. 30, 2022) provides a good graphical recap of North America’s total M & A activities (across all industries) from 2017 through the third quarter of 2022. For the same period, childcare industry mergers and acquisitions showed a similar trend.
Mergers and acquisitions activity often increases during economic growth and decreases during slower or declining economic periods. As the US economy picked up in 2018 and 2019, so did mergers and acquisitions. With the sharp economic decline in early 2020 due to the COVID virus and lockdowns, mergers and acquisitions activity dropped substantially. With the lessening of lockdowns and the availability of COVID vaccines, mergers and acquisition activity increased in the second quarter and soared in the third and fourth quarters of 2021. Mergers and acquisition activity across all industries in 2021 for a recording-setting year – including mergers and acquisitions in the childcare industry.
What led to so much buying and selling of childcare businesses in 2021? The increase was tied to several things. First, due to the COVID pandemic and the inability to complete enough acquisitions in 2020, the national and regional childcare chains – privately owned and those backed by equity groups – had lots of cash (dry power) to spend on acquiring childcare businesses in 2021. And buy they did! Secondly, independent childcare business owners were ready to sell after weathering the storm and stress of operating a childcare business during the pandemic. Lack of staffing and the Biden administration’s proposed increases to the capital gains tax added to childcare owners’ motivation to sell.
In 2021 numerous multi-unit childcare operations and regional chains were sold across the country. Although still young and not contemplating an exit, many of the owners decided to capitalize on what they had built, not risk decreased profits from the low enrollments and revenues associated with the lack of staffing. And those with large real estate holdings (childcare building and land) cringed at paying substantially more capital gains taxes should the proposed capital gains tax changes pass. So they decided to exit earlier than they had planned.
Of course, the talk of Universal PreK and more government funding and involvement in childcare only added to the buying and selling frenzy. Independent childcare business owners opposed to increased government involvement in childcare knew it was time for them to get out. And we saw the large national childcare chain operators and franchise entities “pivot,” as they describe it, from focusing only on high-end demographic and high private pay tuition markets and seeking to acquire centers with a mix of private and public pay enrollment. The increased willingness of many of the larger childcare groups to purchase centers with public pay enrollment and to pay a good or more than good price resulted in the 2021 record year for childcare mergers and acquisitions activity and pricing.
In November 2021, the Build Back Better Bill failed to pass, the economy continued to slow, inflation had reached a level of “can no longer ignore,” and the decline of mergers and acquisitions in the US across all industries, including the childcare industry, began. Mergers and acquisitions activity declined in each quarter of 2022. Once all the numbers are in, overall mergers and acquisitions activity for 2022 will probably show a decline of 25%, if not far more.
Back to the original question, “What is the 2023 outlook for childcare industry mergers and acquisitions? To share my thoughts on what will impact mergers and acquisitions in the childcare industry in 2023.
After the plummet in activity in 2022, we will not see childcare mergers and acquisitions rebound substantially. Activity will likely continue to decline during the first half of 2023 due to ongoing concerns about the risk of a recession in the US and a global recession, high inflation rates, rising interest rates increasing the cost to borrow, industry labor shortages, and the financial instability the childcare industry will likely experience with the depletion of Stabilization grant funds will suppress childcare business acquisitions and values in 2023.
How much will childcare mergers and acquisitions decline in 2023? Answering that would require a “crystal ball.” But enough to suppress the large childcare chain operators’ growth by acquisition goals. Although their private equity backers are still flush with cash “dry powder.”, their required rate of returns will prove challenging to meet through owned center operations and most available acquisitions.
The ongoing labor shortage will continue to depress revenues and profits in 2023 for single-unit childcare, multi-unit operators, and large childcare chains. All operators, large and small, incurred substantial increases in labor costs – hourly wages and enhanced benefits required to keep existing employees and acquire new talent. By the middle of 2023, rising labor costs, all costs associated with high inflation, and lower revenues due to lower enrollments will no longer be offset by the receipt of Stabilization Grant funds. Should there not be another round of grant funds – “another pot of gold” the end of Stabilization Grant funding will lead to a far more financially unstable childcare industry than before the grant funds were initiated. As intended in its name, “Stabilization Grants,” the funds were intended to stabilize individual childcare businesses and the childcare industry financially. The Stabilization Grant funds will be both a blessing and an undoing. Yes, the grant funds allowed many childcare businesses to “keep the doors open,” increase employee wages and benefits and cover some ongoing operational costs. However, the requirement to “spend the money” has often resulted in unsustainable increases in labor costs and operational costs in childcare businesses where Stabilization Grant funds were not utilized strategically.
How will the end of Stabilization Grant funding impact childcare mergers and acquisitions in 2023? Large and small childcare operators will feel the impact of ending grant funding in 2023. To some extent, in 2022, some buyers focused on buying additional centers, particularly centers receiving large amounts of grant funds. And in some transactions, paying a higher purchase price based upon their receipt of grant funds for several months after acquisition. This type of buying will end. Unless there is another round of grant funding, expect childcare business offering prices and purchase prices to moderate and decline.
In addition to the loss of grant funds, other factors will impact childcare businesses’ value and offering prices in 2023. Just as an economic downturn decreases mergers and acquisition activity, business values also decline. I anticipate, at some point, an imbalance in the supply of childcare businesses for sale and buyer slowing demand. We may not see this imbalance in 2023 should the US not enter a recession and additional grant funding for the childcare industry be approved.
Much of this article has focused on merger and acquisition activity by large childcare operators. However, acquisitions by individual buyers are part of the total M & A activity. As interest rates increased in 2022, individual buyer activity declined due to the rising cost of debt. SBA-backed financing is the “go-to” funding source for individuals purchasing a childcare business. As 2022 comes to an end, SBA 7a loan interest rates are around 10.25%, increasing from around 5.25% since the spring of 2022. Increased cost to borrow (debt service) will make it difficult for individual buyers to obtain financing for marginally profitable and underperforming childcare businesses and lead to a slowing of individual buyer demand and childcare business values. Only childcare businesses that are appropriately priced with solid financial performances will be approved for financing. As I always say, “if you can get it financed, you can sell it; if you cannot get it financed, you cannot sell it.”
In one sentence, mergers and acquisitions in the childcare industry will continue to slow in 2023 based on the combination of the many factors listed. But some deals will continue to get done. If you are an owner looking to sell your childcare business in 2023, the determining factor will be how well you have prepared the business for sale. Financially profitable, well-prepared, and operated childcare businesses are always in demand – even in slow economic times.
If I may be of assistance, please call to discuss your childcare business and goals at 336-617-3181 confidentially.