After a record year in 2021, the M&A market that started 2022 strong has ebbed from its torrid pace as economic and geopolitical uncertainty flowed. Headlines tend to focus on that drop-off, but the bigger picture shows an active market. Just like a car that slows from 100 mph to 60 mph is still moving fast, so was the first half of 2022. The 2021 deal volume was not a sustainable annual average, and that context is important. Focus not on volume being up or down, but how to get the right deals done well to drive strategic growth and capital returns. Buyers are still trying to close and integrate existing deals such that the capacity of their legal and outside advisors remains pressed.
Going forward, the established pattern of M&A activity tends to grow during economic expansions, should continue once near-term uncertainty lifts. And economic contraction – either through inflationary and borrowing rate pressure, real wage challenges, consumer spending variability or other factors – will influence transactions but not stifle them. There’s still an abundance of capital in the system for both corporate and private equity (PE) to fund deals. That capital has more opportunities for M&A investment as valuations moderate with market volatility. And as that volatility inhibits IPO volume, alternative sources of capital or transactions may be more likely, including PE suitors. The increasing need for speed in business transformation provides another reason for dealmaking optimism. Some of the same forces creating market uncertainty – the lingering pandemic and geopolitical turmoil – also are driving dealmaking imperatives. Whether a company needs to transform its capabilities, supply chains or go-to-market approach, the market is impatient and one of the fastest ways to accelerate transformation is through M&A.
In an active M&A environment, value isn’t defined by the price of a transaction, but what you can unlock through a carefully considered value creation strategy. From navigating uncertainty to returning to capital discipline and increasing resilience, companies can and should take aggressive action to improve their odds for deal success.
What’s old is new: supply chain disruption. Companies spent the past couple of years trying to address supply chain issues caused by trade tensions and the global pandemic. While some pandemic-related problems have abated, continuing lockdowns in China have perpetuated supply chain backlogs. Russia’s first quarter invasion of Ukraine exacerbated the problem, which in turn helped drive inflation higher in the US and abroad. The Fed responded by raising interest rates, creating further uncertainty. Capital market volatility and proposed new SPAC regulations also should be factored into dealmakers’ calculations.
The result: Companies are responding defensively by acquiring suppliers, either outright or in joint ventures (JVs), closer to home or in more geopolitically secure locations. For example, due to the pandemic, large healthcare providers are looking to reduce reliance on medical supplies produced overseas. In consumer goods, companies are acquiring distribution centers in order to control the volume and the speed of that part of the supply chain.
Market volatility is forcing sellers to reassess their own forecasts and valuations of the past few years, both in terms of the variability that can be expected, and the longer term CAGR. One example is in fintech, which until recently was being priced on steep revenue projections. Potential buyers are engaging in more due diligence to see where and when the revenue will come from and adjusting their valuations accordingly.
Private equity has plenty of dry powder and won’t wait for the market to find its bottom before taking advantage of lower valuations. The dynamics are more complicated for corporate acquirers. While many have cash on hand, they also are facing both higher borrowing costs and declines in their own stock prices – factors that change the math on larger deals.
Regulatory uncertainty also is limiting megadeals, especially in health care. Not only is the Biden administration more aggressive on the antitrust side than its predecessor, but some states also are flexing their regulatory muscles. That’s created uncertainty around whether deals will close and how long it will take for those that do. One way that dealmakers are navigating this environment is roll-ups. Buying smaller practices and combining them into something bigger draws less scrutiny than combining two companies that are already large, although federal regulators are keeping a wary eye on that strategy as well.
Companies’ need to increase their resilience and security will likely continue to drive deals in the later half of the year as firms protect value by mitigating risks and confirming operations are consistent and safe. The pandemic already forced many companies to consider just how resilient their operations were. The conflict in Ukraine is also testing resiliency and security in a different way, as exemplified by the challenges and opportunities facing the agriculture and energy sectors. First, sanctions are forcing many companies to divest operations in Russia. Rising commodity (especially food) and energy prices (oil and natural gas) as well as changes to distribution are also connected with several key grain producers around the world contending with climate-related declines in cultivation.
The shifting energy dynamics have been a shock to the system at a time when many companies were trying to reduce their carbon footprint. With rising energy prices, there is renewed interest in oil and gas operations. Liquified natural gas, in particular, is in demand as European countries focus on alternative sources. While there are still issues around permitting, efforts to increase European energy resilience should continue to drive deals in the US.
Building resilience often involves addressing technological deficiencies, including through acquisitions.
After nearly a generation of low interest rates, dealmakers will need to exercise capital discipline once again. The low interest rates of the past 15 years have given executives a leverage luxury that their corporate forefathers lacked. Now, they’ll need to replicate the prudence and skill displayed by earlier generations of dealmakers who were faced with both higher levels of inflation and interest rates. The former is already tightening margins thanks to higher labor, energy and other commodity costs.
With hurdle rates already going up, executives need to be more deliberate with their capital choices. The right combination of acquisitions and divesting to reinvest can drive return on capital even in an environment with higher capital cost and inflation. For instance, consumer market companies now need to be more disciplined when focusing on scale as a strategic investment, not just on brand or supply chain country of origin. They’ll be looking to divest business units that lack returns in order to deploy capital where it yields appropriate results.
In this new environment, companies can gain strategic advantage by reassessing their portfolios against their core strategy. With the cost of capital increasing, unaligned businesses can be divested and the proceeds reinvested into core operations. Even profitable non-core business units are good candidates for divestiture, as their future may be brighter with a different owner.
Companies will continue to leverage M&A activity and JVs to quickly transform their business in the second half of 2022. Transformational M&A can provide access to new capabilities and talent that are critical to creating value over a shorter time frame than organic growth. A recent PwC Pulse Survey found that 60% of C-suite executives cited digital transformation as their organization’s most important growth driver. Another 47% said that pursuing corporate M&A, JVs and alliances was “very important.” To create value through M&A, companies need to pay particular attention to three sometimes overlooked drivers: purpose (through environmental, social and governance (ESG) efforts), culture (diversity & inclusion and human capital) and digital capabilities. JVs also can be an attractive alternative because they remove the pressure that public companies face in making deals work on a cost synergy basis. Many JVs take a page from private equity firms, which look ahead to an exit strategy of assuming control or spinning off the unit in a few years.
In the automotive sector, companies are grappling with ESG imperatives by striking deals to invest in electronic vehicle technology, such as battery production. That sector isn’t alone. Energy is another sector that is being transformed through decarbonization – a continued shift to a portfolio that includes greener energy assets. Many different kinds of companies, led by the video game industry, are experimenting with the metaverse. And consumer markets companies are trying to transform with the help of acquisitions that can boost their data collection and predictive analytics.
Private companies eyeing a move to the public markets are finding a more challenging environment than they would have a year ago. Market volatility is forcing potential issuers to reassess valuations, causing many to postpone them until the turbulence subsides. At the same time, proposed new regulations issued by the SEC have dampened the enthusiasm for SPACs. Banks, in particular, are viewing SPACs as more of a liability if they’re listed as the underwriter. Even deals that close are likely to take longer as banks enhance their due diligence process to mitigate the additional risk.
These developments provide an opportunity for PE firms, which can be leery of excessive valuations, to deploy their war chests. In addition to buying private companies that normally would have opted for an IPO, PE firms also have an opportunity to participate in more take-private deals since valuations have dropped.
While volume has slumped substantially, successful IPOs that create value are still possible under the right circumstances. Traditional IPOs have outperformed the S&P 500 for eight of the past 10 years, and the investment community will likely continue to support high-quality issuers with proven management teams, growing markets and existing profitability. Potential issuers also need to keep in mind that ESG initiatives now figure prominently in value creation. With ESG measures being evaluated with the same critical eye as operating financials, organizations are much more likely to achieve higher valuations with a rigorous and standardized reporting regime.
There’s uncertainty in the market right now, but that creates opportunities in addition to challenges. To put themselves in a better position to create value, dealmakers should:
