February 9, 2016
By Ahmad Shamim and John Toriello
The record setting M&A environment we’ve seen over the past several years was fueled by a robust financing market. Easy access to debt, strong equity markets and record levels of cash gave dealmakers plenty of support for transactions and high priced targets. In fact, 2015 saw a record number of mega deals – 65 percent of all deal values were counted as mega deals (transactions valued over $5B) with 15 transactions getting past the $25 billion mark.
While M&A value was at record setting levels, buy-side activity was largely one sided. Corporate buyers accounted for more than 92 percent of all deal value, using their strong balance sheets to finance deals but also driving up valuations. In that competitive buy-side environment, private equity (PE) firms tapped the debt markets for add-on acquisitions (over 60 percent of all PE activity in 2015) and smaller deals (transactions valued at $25 million and below made up 50 percent of all PE Deals in 2015).
But the financing fuel for deals is starting to evaporate. With many banks building up their reserves on loans made to the oil and gas industry and recent volatility in the global equity markets impacting investor strategy, late last year we witnessed several lenders opting to pull, postpone or sweeten deal terms as a result of lackluster demand for loans into highly leveraged transactions. At the same time, regulators are monitoring bank lending standards and capital ratios, which put further pressure on investment banks to take on less risk in underwriting. And, January’s highly volatile market has created an environment where only the highest quality, top rated financing deals are getting done.
- Mid-Market PE Offers More Cash
Tightening markets will have the most impact on mid-market PE firms who may not be able to lean on their longstanding relationships and track records with lenders to secure financing. With borrowing more difficult, mid-market PE shops will have to increase their equity contributions for acquisitions and target younger companies. This will lead to the pursuit of riskier, early stage deals to generate strong returns that justify larger equity commitments. To make these deals work, we’ll see more of an emphasis on upfront due diligence.
- Corporates Remain in the Driver’s Seat
Corporates have the benefit of their balance sheets, synergies and high credit ratings to fund deals. This will continue to give them the confidence to reach valuations on targets where fewer PE firms are willing to go. At the end of the day, higher values can be rationalized with synergies and long term growth projections compared to financial sponsors who intend to unlock value in a shorter time horizon.
- PE Gets More Innovative
We anticipate that PE buy-side activity will remain increasingly focused on alternative ways to deploy capital. For one, we expect to see more joint ventures and alliances between PE and corporates for deals. The “If you can’t beat ‘em, join ‘em” approach presents opportunities for PE firms to get around auctions and align incentives with sellers, meaning closing the deal and transitioning the company post-close will be simpler to optimize. These partnerships will come in different forms including partnering on corporate asset disposals – e.g., a carve out where the seller stays invested – and teaming with corporates for new investment opportunities, especially large scale roll-ups.
While the financing market is currently challenging, dealmakers have successfully adapted to these types of cyclical changes before. For the bull run in M&A to continue, both corporates and PE will have to navigate a financing market that is wary of risk and high leverage deals.
Stay tuned into our blog for more insights as we continue to watch the financing market dynamics impact the deal environment.