Enough to make your hair turn gray
Search entrepreneurs who ride the silver tsunami will have to beware of riptides.
Ethan Wu at the FT’s Unhedged newsletter had an excellent piece last week on the demographic undercurrents pulling us towards a possible “forever labour shortage.”1
Over in the WSJ’s Heard on the Street Column, Justin Lahart took up the same theme and warned that blaming Covid for the worker shortage overlooks the more fundamental issue: people are aging out of the workforce in greater numbers than ever before.
Aging is not only a personal hobby of mine - I do it every day - but also a topic that informs my investing activities and entrepreneurial goals.
Today I’ll briefly look at how the wave of expected retirement among small business owners has propelled the growth in search investing / ETA, before speculating about how and when the tide might begin to recede. I’ll also consider how the same demographic cycle that’s resulted in more owner-operated businesses coming to market could also make it more difficult for new owners to operate those businesses down the line.
Generational handovers as an investment thesis
That Baby Boomers are retiring in droves won’t come as a shock to anyone who’s so much as heard the term “search fund.” A central part of the investment thesis is that a generation of small business owners are reaching an age where they would like to step away. Some will pass ownership to family members, but many others will look to sell.
If you take an initial pool of 15+ million-ish Boomer owned small businesses, put aside the ones that will get passed down within the family, then toss out the vast majority of the remaining ones because they lack compelling economics, you’ll still be left with a huge opportunity set of high quality companies. Even for someone who doesn't live in Japan, where the melons aren’t cheap but the businesses are given away for free, it wouldn’t be so crazy for an ambitious young Millennial to convince himself that it’s possible to acquire a good business at a fair price.2
Could this wave be losing momentum? Someone born in 1957, the year with the highest number of births in US history, will be 66 in 2023 - one year away from reaching the full Social Security eligibility age of 67. There’s some evidence that the typical business owners are ready to retire younger:3 the latest Stanford Search Fund Study puts the median seller age at 55, suggesting a majority of the Baby Boom generation might have already passed the peak years for business owners to transact in this manner.
There might also be some hidden reflexivity speeding up the transition: the coming of the “silver tsunami” brought more attention and capital to the SMB acquisition thesis, attention and capital allowed owners to transact when they might otherwise not have, transactions validated the thesis and accelerated the next cycle. In this model, the change in generational ownership that was projected to take place over several decades instead wraps up ahead of schedule. More capital chases fewer opportunities, acquisition multiples ratchet up in a self-reinforcing process, and armchair experts like me start dropping links to the Wikipedia page for Minsky Moments.
This is not to argue that the supply of compelling deals is about to run dry. The “retiring owner looking to sell'' scenario is familiar, but it’s never been exclusive. Nor is it even guaranteed to become less common in the future simply because there were fewer babies being born in 1965 than in 1955.
Anecdotally, the post-2020 macro situation would seem to have provided many older business owners with an additional inducement to move forward with a sale. Operational disruptions, worker shortages, and a volatile economic outlook made retirement look more appealing, while rock bottom interest rates (for 2020-2021 at least) and surprisingly resilient earnings meant owners could achieve a higher valuation than they previously imagined.
Perhaps that moment is already over. In an environment characterized by sustained higher interest rates and lingering recessionary fears, owners might choose to delay their retirement while waiting for more favorable conditions. Though that would depress the number of transactions seen in the short term, it would preserve the pool of potential transactions that are left for the medium to long term, extending the viability of the generational handover thesis.
There are simply too many secular and cyclical factors influencing SMB M&A activity for us to confidently say what impact we’ll see as the Baby Boom generation moves further beyond their prime working years. But the picture looks a little clearer when we look at the impact on labor force participation.
We’re not getting any younger
A pandemic generates no small number of pet theories to explain a labor shortage. People are staying at home because of stimulus checks. Or because they’re scared of getting sick. It’s the Great Resignation. No one can get into the country. Everyone retired early - maybe because their houses rose in value.
Allocating the precise amount of credit or blame among these theories looks increasingly academic: clearly something’s up. In November, the seasonally adjusted ratio of unfilled jobs to unemployed persons was 1.7. The aforementioned WSJ piece points out that “the highest that ratio got in the 20 years of available data before the pandemic was 1.2.”
In fact, that pre-pandemic high of 1.2 was where the ratio stood in February of 2020, only a blink of an eye before Tom Hanks got sick and we all started hoarding toilet paper. Even before Covid, we were in the midst of a decade-plus trend that could crudely be described as fewer available workers per available job.
What to make of this trend?
The gradual upward slope tells the story of a sluggish recovery following the Great Financial Crisis: we didn’t pass the “1 open job per unemployed person” threshold until late 2017. In retrospect, the post-GFC jobs gap circa 2013 looks as remarkable as the post-Covid labor gap of 2023.
But there's more happening in the chart than recession and recovery. As Wu explains, “the cyclical story can’t be separated from a separate structural story — the ageing US population.”
We see this most clearly in the labor force participation rate.
Although the participation rate is meaningfully lower now than at the start of 2020 - more than 1 percentage point lower, amounting to 2.5 million fewer employed people - most of the reduction is actually not a result of Covid.
The WSJ points to a recent paper from Bart Hobijn at the Federal Reserve Bank of Chicago and Ayşegül Şahin at the University of Texas, which found that:
The number of workers missing due to COVID is overstated because the bulk of the 1.2 percentage point decline in the participation rate since the start of the pandemic reflects a continuation of its long-run downward trend that was already part of projections.
The long term participation rate chart clearly reflects the Baby Boomers' entry to the workforce in the 1970s, and their phased withdrawal beginning in the new millennium.
And that withdrawal has accelerated. The WSJ again:
With the median Boomer turning 66 last year, they “are now in an age bracket where there is a huge drop in participation,” points out Dr. Şahin. Indeed, in December the participation rate among 66-year-olds (unadjusted for seasonal swings) was about 38%. Compare that with 64-year-olds, who, despite being just two years younger, had about a 46% participation rate.4
The thing about aging is that it's easy to see coming, and really hard to do anything about. (Really expensive too!) It's not impossible to imagine ways for America's workforce to grow again: more immigration, a Japanese-style increase in women's labor participation ... a decrease in video game quality? More likely though, the number of people leaving the workforce will continue to exceed the number entering. Today's extraordinarily tight labor will become tomorrow's new normal.
Some predictions from a callow youth
In the Financial Times, Wu discusses the inflationary implications of the “forever labor shortage” premise:
[if the premise holds] The low-inflation world of the 2010s probably isn’t coming back. Employers will have little choice but to pay workers more, keeping inflation hotter and rates higher. Of course, plenty could still happen in the meantime: perhaps a supply-expanding productivity bump or a breakthrough in immigration politics. But it is a very different base case than many investors were contemplating just years ago.
He also makes a point I would be remiss not to echo, that “big topics like this are hard for a markets column [nb- to say nothing of a hobbyist blog]. We can’t proclaim them too loudly on them, but we can’t ignore them, either.”
From the perspective of a prospective SMB operator, an aging and shrinking population is sort of like the weakening Gulf Stream: we recognize that it’s significant, but are more concerned with whether it will rain or not in the next thirty minutes.
Reflecting on the topic has led me to a few tentative conclusions. Some counsel for a bias towards action (a generally sound policy in any case):
Wage driven inflation could persist at higher levels and for longer than commonly expected. Potential acquirers who are waiting for debt financing to become cheaper again can’t bank on a return to the interest rate environment of 2021, or even 2019.
While there will always be good businesses for sale, the number of good businesses being sold as part of the Baby Boomer retirement wave can decrease surprisingly quickly.
Other conclusions point towards caution (also sound as a general policy):
The societal level story of retiring workers is connected to the familiar organizational level story of key man risk, best illustrated with this tweet:
Corporate profit margins remain high. A “forever labor shortage” is not completely synonymous with “forever inflation,” but to the extent those two futures diverge, margin compression would probably have something to do with it.
Regardless of what type of company a searcher thinks is being acquired, he or she is actually getting into the hiring business.
Reader, you won’t be surprised to hear that I’m not 100% sure about any of this. I’m decades away from my own retirement, and in the meantime am frankly too busy to do anything in the way of substantive research.
Gotta love the FT for adding that extra British “u” even in a story about the US labor market.
It wouldn’t, right?
Especially, it stands to reason, owners of the sort of wealth-generating businesses that catch searchers’ attention.
Though the peak retirement years for small business owners likely differ from the overall workforce, this steep two year drop off in labor force participation is a reminder that transitions can happen much quicker than you think.