Takeaways: Volatility, growth worries….what of them! Deal making surpassed 2007 figures in August regardless – or should that be ‘because of’ these concerns? While we all wait on the Fed, it seems like an opportune time to cast our eyes around the deal landscape, because there’s certainly plenty to ponder. Deal dynamics are very different to 2007, not just in financing, but also in motivation. That should give this run of deal making legs beyond the first rise in US interest rates – barring market paralysis – but can this pace be maintained?
The strategic imperative
Global M&A values reached an all-time high for August, at US$377b (including real estate), which keeps figures for 2015 running ahead of 2007 totals. Most of the action is in the US, where announced deal values have already eclipsed 2014. However, Europe isn’t exactly quiet. The first eight months of 2015 has seen the highest UK deal values since 2007 –mirrored elsewhere in Europe, notably Italy.
Of course, talk of 2007 raises awkward questions; but – as we’ve discussed here before – thus far, this M&A boom is a very different beast. Companies have been largely mindful of their credit ratings and leverage buyouts are notable by their near-absence. In 2015, activity is dominated by corporate buyers, with private equity largely left on the side lines. The reason isn’t a so much a lack of interest as the competition from highly motivated companies with financial and strategic advantages – and incentives.
Low growth and falling prices aren’t much of a motivation for PE to acquire, but are obviously strong drivers for companies to consolidate in sectors where earnings are under pressure. Disruptive forces are also pushing companies to go out and buy technologies and expertise that will enable them to compete in the longer term. Strategic buyers are, of course, able to leverage buoyant equity markets and their own cash piles, whilst also having the advantage of synergistic opportunities – all of which gives them more flexibility on valuations. The higher the valuation, the more difficult it is for PE to justify…. and reach, given US regulations on bank funding deals over 6x EBITDA.
Much of this record-breaking volume has also been fuelled by the mega-deal – transformative transactions well beyond PE capacity. Fifty-four deals with price tags above $5bn have been announced so far this year. Some that are well above, such as including Charter Communication’s $78bn bid for Time Warner Cable and Heinz’s $55bn purchase of Kraft.
We’re still arguably working through pent up activity and market conditions are changing, therefore this breakneck speed might not last too far into 2016. That said, the motivation to consolidate looks all the stronger if growth slows and costs remain volatile. If the Fed and or China don’t bring markets to a full-stop, we expect to see plenty more activity. The cost of capital will increase – but from a very low base – and if equity markets ease back, this should help with valuations and perhaps bring PE into the mix.
That’s not to say that structures won’t change. Ratings agencies are starting to express their concern on individual ratings and debt markets might not be as accommodating by mid-2016. Volatility and greater uncertainty might encourage more companies to conserve cash. We’re also increasingly seeing deals bump up against anti-trust boundaries. However, we expect still sector dynamics to remain strongly pro-M&A…which is going to increasingly test the limits.
Sector wise the motivation and structure of the M&A boom is very much horses for courses…
Oil & Gas companies have the most obvious motivation to consolidate and M&A activity is running at a record pace this year. It took a while to get going, price volatility raises hopes and complicates valuations – but new realities are beginning to dawn. Goldman’s $20 a barrel prediction has raised as many eyebrows as their $200 pre-crash forecast. But low prices do look set in and the potential for lower valuations has raised PE interest – most notably Blackstone and Carlyle, with the latter raising funds to target North Sea assets.
The mining sector is suffering similarly from low, volatile pricing; but historical hang-ups might bring a different reaction. Certainly, there is an opportunity for stronger players to pick up fire-sale assets and position themselves for growth – when it comes. However, M&A activity has been modest so far in 2015, focusing on the mid to low end and in low risk assets. Sebastien Jacques, head of copper and coal at Rio Tinto, provides one explanation, noting that the recent substantial writedown of assets bought in the last M&A boom is encourage mining companies to consider alternatives to larger acquisitions of tier-one assets, such as partnerships.
Two of the sectors that have led the M&A boom – Technology and Media & Entertainment – have similar motivations for their deal booms. In Q2 2015, our analysis shows that technology M&A set a 6th consecutive post-dot-com-bubble volume record. We’ve seen a number of transformative deals in 2015, in semiconductors in particular; but there is a strong deal pipeline across all areas where companies need scale and scope to position themselves for ongoing digital disruption and growth. Similarly, in media & entertainment, companies are responding to the pressure to keep up with revolutions in platform and consumer behaviour – and content demands.
As growth becomes more challenging, we believe the consolidation trend will extend further into other areas. In the UK, we expect the number of top tier UK contractors to shrink by at least half over the next five years, with 15 top groups reduced to as few as five. Existing groups are struggling to achieve margins above 2%. To improve, companies will need to consolidate, not only to create the necessary operational and investment advantages of scale, but also to meet demands for larger projects and an international footprint.
Don’t forget disposals…
The advantages of disposal are often overlooked in the excitement of acquisitions. However, our research shows that companies which divest selected businesses can create significant value for themselves and the entities created as part of the deals.
We looked at 200 deals with a value of £100m or more made by companies that are currently part of the FTSE 100 or mid-FTSE 250 indices, or have been in the past eight years. On average, share price value for the vendors and the carved-out entities were boosted by the transactions. After one year, share prices in the carved-out businesses that remained separately listed increased by 16.3%. Long-term value of the sellers also increased, with an average growth in share price after five years hitting 7.2%.
We’ve seen a number of deals recently that reflect how companies are increasingly divesting to redeploy capital and refocus attention on their core business by investing organically or by acquisition. A timely, well-executed carve-out can also increase confidence that the group is focusing its energies on the most profitable parts of its business. If global growth remains sluggish – and volatile, we expect to see more companies shuffling the pack.