Fundamentals Are Strong Despite Market Uncertainty
It's no secret that global uncertainty continues to cast a dark cloud on the U.S. economy. Ignoring for a moment the lingering storm, several current characteristics of the merger and acquisition (M&A) environment support sustained increases in middle-market transaction activity. For example, strategic buyers are pursuing acquisitions with more than $2 trillion of cash on their balance sheets. Financial buyers are seeking opportunities to exit existing portfolio investments to generate returns for their limited partners while simultaneously seeking to invest more than $450 billion of committed and available capital in new platform and add-on acquisitions. Credit markets are providing ample senior and subordinated debt capital to fund quality deals, interest rates remain at cycle lows, and disparate growth trends in developing regions from those in developed regions provide unique opportunities for cross-border M&A.
Despite these characteristics, however, the storm of uncertainty cannot be ignored. Myriad economic challenges exist that have caused M&A activity to remain relatively flat during the first six months of 2012 compared to the same period in 2011. The U.S. economy was unable to exceed its baseline
2 percent growth of annualized Gross Domestic Product (GDP), the Eurozone officially shifted from stagnation to contraction during the second quarter of 2012, and China’s GDP grew at its slowest pace (~7.8 percent) since the great recession. Further, consumer sentiment fell to its lowest level of the year. Couple these macroeconomic trends with an ongoing overhaul of the U.S. financial system and the upcoming November elections, and the level of uncertainty in the broader economy has been pervasive.
Another trend that impacted the M&A environment during the first half of 2012 was that the financial buyer community completed fewer deals compared to the same period the prior year. This was the result of several factors, including (1) the prevalence of the strategic buyer and the increase in competition for quality businesses (many sellers were waiting on the sidelines earlier this year), and
(2) the subsequent higher valuation multiples and greater levels of equity capital as a percentage of the overall capital structure required to win deals. This trend bodes well for sellers in competitive sale processes, but it’s also a recipe for lower returns to private equity groups, meaning fewer deals were completed by this buyer category. In fact, the number of transactions involving a financial buyer dropped 32 percent in the first half of 2012 compared to the same period in 2011.
As market uncertainty begins to dissipate and financial buyers continue to feel pressure to put committed capital to work in advance of expiring investment periods, M&A is poised to see increased activity. In addition, sellers seeking to take advantage of likely rising capital gains tax rates in 2013 have already launched sale processes targeting year-end closing dates to benefit from lower tax rates. These factors, combined with favorable fundamentals — availability of equity capital, ample debt capital, low interest rates, and buyers using acquisitions as a primary growth driver — provide the necessary ingredients for a robust M&A environment.
As with any storm, the current clouds of uncertainty will pass. Sellers should take advantage of what’s considered to be a healthy M&A environment and begin planning for a sale, while buyers should consider taking advantage of current financing markets to benefit from favorable deal structures and terms.