PricewaterhouseCoopers Outlook: M&A Activity to Continue at Accelerated Pace
Wednesday, June 27, 2007
Mergers and acquisition activity will continue to accelerate through 2007 as deal values soar, according to the Transaction Services group of PricewaterhouseCoopers. Deals involving U.S. targets totaled $845 billion during the first five months of 2007, 53% of the total for 2006, and 10% more than deal value in the entire first half of 2006, according to Thomson Financial.
"We are moving deeper into an accelerated M&A rally, with larger transactions from bigger corporate buyers on the horizon," said Bob Filek, a partner in PricewaterhouseCoopers' Transaction Services group.
Aggressive lending by banks and institutional investors coupled with rising corporate profits and reasonably low default rates are key factors driving this increase. Filek expects to see an increase in overseas acquisitions by European and U.S. firms as we move into the next stages of the current cycle.
Private equity firms will continue to be a large and permanent fixture in the M&A landscape on both the buy side and the sell side. According to Thomson, private equity accounted for 48% of M&A value and 20% of volume during the first five months of 2007, compared with 32 and 17%, respectively, for all of 2006.
Since the current recovery began in 2003, private equity's share of U.S. deal value rose from 20 to 48% while its share of deal volume increased from 17 to 20%. The accelerated rate of growth in deal value reflects private equity's capacity to do bigger and bigger deals as competitive lending practices and infusions of capital from institutional and overseas investors have pushed liquidity to new heights. Funding for deals is coming from far more diverse sources than in previous cycles with hedge, mezzanine and pension funds providing an increasing portion of M&A capital along with high yield and leveraged loans. Furthermore, lenders are bearing less risk, as some 60 percent of buyout loans made last year were packaged and sold as collateralized loan obligations (CLOs) last year, according to Standard & Poor's Leveraged Loan and Commentary.
"Public to private deals continue to fuel the market. The level of activity will depend on the amount of liquidity available to finance deals and the availability of targets that offer sufficient upside potential relative to purchase price," said Greg Peterson, a partner in PricewaterhouseCoopers' Transaction Services group. Peterson sees public to private opportunities in many sectors, including defense, software, financial services, telecommunications and media.
On the IPO front, financial sponsors [which include venture capital and mezzanine funds as well as private equity] brought 41% of all new companies to market during Q1 2007 and raised 55% of all proceeds, up from 20 and 18 percent, respectively, during Q1 2006, according to PricewaterhouseCoopers' U.S. IPO Watch, a quarterly survey of IPO activity on U.S. exchanges.
Filek believes this M&A market may surprise on the upside, noting, "History shows that default rates trend up as the peak of M&A activity approaches, but default rates are still holding at moderate levels. While a liquidity crisis or rapidly rising interest rates could change that in a hurry, things look strong into '08." Currently, the default rate on U.S. speculative-grade loans remains at its lowest level since the early '80s-1.3% compared with 1.9% last year. However, 50% of all new high yield debt issued in the first two months of 2007 was rated B- or lower, compared with 32% in 2006 and 36% in 2005, according to Standard & Poor's Global Fixed Income Research. The average size of the most speculative loans has increased to $581.2 million in 2007 from $351.6 million in 2005. The vast majority of defaults over the last 70 years have been speculative grade loans.
Peterson predicts any eventual slowdown is likely to be a soft landing, rather than a hard crash like the one occurring in 2001. Large private equity funds, which are more diversified than they were at the start of the decade, are well positioned to profit from a downturn. While buyouts may eventually slow and returns upon exit may be lower, other private equity transactions such as distressed debt deals and workouts are likely to increase. Other market dynamics that will cushion any slowdown include diverse and expanded funding sources for M&A, a steady stream of targets for both value and growth plays, and the many roles hedge funds are playing in the M&A market.
Other themes that will characterize the M&A landscape in the second half of 2007 include:
Creative financing -- Increasingly, private equity and corporate buyers are finding it mutually beneficial to pursue industry targets together through new joint venture vehicles. Corporate partners bring deep industry knowledge, the potential for synergistic growth and an additional avenue for sharing risk to these relationships. For their part, private equity firms offer more flexible financial arrangements than traditional sources, expertise in enhancing the corporate development function, and motivation and capacity to improve the acquired business.
These arrangements offer corporate partners several benefits. They can test the viability of a new business at lower risk, purchasing it from the private equity investors if it is a good fit, and exiting with the private equity partner if it is not. As an added benefit, some structures result in equity accounting, which means the corporate partner does not have to consolidate the venture on its books. In some instances, acquisition vehicles take the form of publicly traded companies.
Pension funds are increasing co-investment in private equity deals and are beginning to invest directly, while hedge funds are finding many ways to participate. These include forming private equity side pockets, co-investing with other acquirers, buying out owners who do not get their price in an auction, and investing in distressed debt and equity tranches of CDOs [collateralized debt obligations].
Along with new acquisition vehicles, private equity firms are relying on other capital structures that could provide some shock absorption should the economy soften. These include lighter covenants, longer grace periods, and more flexible debt structures such as "PIK" options and toggle notes, which allow a cash-constrained borrower to roll the monthly payment into the principal and thus buy more time. According to Peterson, "There may be some alteration in debt terms but, as always, the market will adapt as needed."
Cross-border deals - Cross-border transactions will pick up this year with heightened activity across U.S., European and Asian markets. History tells us that riskier cross-border transactions tend to get done in the later stages of an accelerated deal cycle. As they eye riskier transactions, buyers must add rigor to their deal processes, conduct stringent due diligence, and resist the temptation to pay too much for targets.
Middle-market acceleration -- While middle-market M&A has shown consistent strength due in part to the volume of cash deals, it tends to fly under the media's radar. However, funds have become more efficient in this market segment as new capital enters the arena and middle-market deals become more competitive. Succession issues disproportionately affect mid-tier companies and often require liquidity events as second and third generation entrepreneurs seek to diversify assets and try new ventures. Breaking with tradition, funds are regularly trading assets among themselves, buying from and selling to each other in an effort to further deploy capital. Deals that are smaller by historical standards and in industries traditionally not attractive to private equity are drawing attention, as a wave of new investment seeks a home.
At this stage of the cycle, most industries have been part of the M&A boon. Sectors that continue to present opportunities include two of the ones that fell furthest in 2001:
Financial services -- The financial sector continues to reinvent itself. In the coming year, watch for continued foreign interest in U.S. banks and wealth management firms. Predictable cash flows in many of the industry's sectors continue to attract private equity firms. Interest in sub-prime mortgage lenders will likely remain slow until the regulatory and market uncertainty is settled. Activity in various insurance sectors will likely continue given strategic buyers desire to build scale.
Pharmaceuticals and biotech -- As the large pharmaceutical companies struggle with slowing growth and a weak product pipeline, restructuring will begin to play out. Watch for aggressive biotech companies to take center stage as they leverage their deep pipeline to make strategic moves, including acquisitions. Private equity will find opportunities in slow-growing old line pharmaceutical companies that offer stable cash flows similar to those of consumer products companies.
Technology -- As technologies mature, we are seeing a separation between mature, lower-growth businesses with stable cash flows, and more innovative growth companies. Mature technology companies are prime targets for consolidation either within their respective sectors or by private equity firms. Vendor-mandated consolidation and convergence will continue to drive acquisition activity as telecom equipment and networking companies position themselves for the next upgrade cycle. Enterprise software, online services and Internet sectors should be particularly hot.
Media -- Evolving technology continues to offer consumers with more outlets and ways to access media. As convergence among both traditional media distribution platforms and technology companies progresses, traditional companies continue to innovate to adapt to this changing, challenging landscape, while new, smaller players develop ways to exploit changes in the industry. Companies will continue to try various combinations, creating platforms to better leverage and distribute their content. Over the past few years, this dynamic has driven acquisitions to harness new opportunities, mergers to build scale, and transactions to rationalize non-core assets. This trend continues with announced deals during the first five months of 2007 ahead of the same period last year. Brisk activity is expected for the rest of the year as private equity continues to participate and companies look for ways ultimately to monetize their assets.
Filek observes, "The coming year could be very interesting in terms of the number and value of deals, as well as the creative methods buyers may use to structure them. M&A activity is on course to exceed last year's levels so long as financing remains plentiful and the default rate remains acceptably low. As we go deeper into the M&A cycle, riskier deals will get done. Buyers should do their diligence with rigor and avoid letting emotions close the deal."
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