August 11, 2017
By Curt Moldenhauer
In our New Deal Frontier series, we’ve outlined why the US is certain to be a top attraction for businesses that will sidestep trade barriers by pursuing cross-border investments. In our last blog, All roads lead to America, we argued momentum for inbound M&A in the US likely will continue thanks to America’s depth of digital assets, its cities’ independent economic clout and its relative stability.
We’re not ignoring emerging uncertainties in the US, notably around policy and regulation. We know President Trump has promised to shake up business as usual. Less is known about the shape and form of new policies that, despite a Republican legislative majority, remain stuck in the gridlock of Washington politics. Witness the International Monetary Fund recently cutting its US growth forecast, citing lack of clarity about policy direction as one of the reasons.
All of this affects business leaders and their deal making. A recent economic study confirms that policy uncertainty does indeed have a negative effect on M&A. Still, underneath this general finding are nuances – and opportunities – to which global dealmakers should pay close attention. Studies analyzing M&A trends show that economic recovery and flourishing capital markets have been the common underlying drivers of each successive M&A wave – including the current one. Therefore, given the strength of the US economy and the availability of capital, we think deals will still get done.
What will change is the shape and form of those deals. We believe that while policy uncertainty is affecting the M&A wave that started in 2013, it’s not about to end it. Think of it another way: We’re not getting calls from CEOs saying, “We’re not going to do that deal because <insert regulation here> might change.” Instead, they’re saying they might do different kinds of deals. Given that, here’s what we expect:
1. Dealmakers will go vertical instead of horizontal. Vertical integration is making a comeback, in part because it is a hedge against policy shocks. Nowhere is the rush for vertical integration more apparent than in the tech industry. Softbank’s $32-billion acquisition of London-listed semiconductor company ARM Holdings last year reaffirmed its strategy to operate as a vertically-integrated tech conglomerate. By buying ARM, Softbank — which is making a series of IoT investments — moved backward into chips that will power billions of connected devices. Also consider ScanSource, a $3B global technology distributor, whose recent acquisition of Intelisys, a master agent for telecom, cloud & carrier services, allowed it to bridge the master agent channel. With the deal, ScanSource is able to improve margins and get new revenue streams by owning the upstream partner in the value chain.
Deals for vertical integration are occurring across industries. In the pharma sector, for example, we are seeing a slew of mergers between contract manufacturing companies and distributors, for example, laboratory supplies company Avantor’s $4.38-billion acquisition of VWR Corp to acquire a global distribution network.
2. Dealmakers will become commitment-phobic but not relationship-averse. Economists have found that businesses planning “irreversible” investments (e.g., high fixed assets relative to total assets) tend to hold back more in times of economic policy uncertainty. That makes sense; mergers usually are intended to be forever. But with heightened uncertainty, other kinds of investments become more attractive.
These days, it’s not unusual to see companies pursuing more alliances and joint ventures (JVs) instead of more permanent deals as they adapt to shifting conditions, whether or not they stem from policy uncertainty. Take Google’s strategic alliance a few years ago with Italy-based luxury eyewear company Luxottica to design and distribute its Glass wearable tech. (Luxottica has since announced a vertical merger with the French lens-making group Essilor.)
For years, US-based businesses have forged successful alliances and JVs to grow in emerging economies amid policy uncertainty – whether it’s SAIC General Motors Corporation Limited founded in 1997 in China or global retail brands’ more recent preference for JVs in India in a tough regulatory environment.
Foreign investors in the US, too, are turning to partnerships rather than outright mergers to fuel their expansion. This is particularly apparent in the tech industry. US-based peer-to-peer lender Lending Club and Chinese online marketplace Alibaba, for example, have formed an alliance to connect American businesses to Chinese suppliers.
3. Dealmakers will target middle market, private companies. Recent PwC analysis, based on Thomson Reuters data, shows that while overall US deal value has dipped year-on-year, the total number of deals is up. More specifically, we are seeing fewer mega deals ($5 billion or more) and more middle market deals that are $1 billion or less in value. Mega deals made up more than half of US deals activity last year compared to about a third this year, a decline that is being offset by a greater number of smaller deals. In fact over the last 12 months, middle-market deal value in the US has surpassed $400 billion; last time this happened was in the M&A peak year of 2014.
This does not mean that public blockbuster deals are dead; Amazon and Whole Foods, anyone? But another recent, less flashy announcement, Wal-Mart’s bid for Bonobos, signals the greater attention being given to the middle market. In part, that’s a practical matter: Not only is there less political grandstanding over these smaller but vital companies, but the deals tend to close faster, reducing the risk of uncertainty.
To be sure, there are some regulatory changes that will change deals behavior. For example, the US Treasury has effectively taken the air out of the trend toward “tax inversions,” in which American buyers acquired foreign companies and moved their headquarters to cut their tax bills. A future tax-advantaged repatriation of foreign income could also boost liquidity for deals in the US. And immigration constraints could limit domestic growth in key sectors, including technology, making deals less attractive.
But overall, we don’t see deals disappearing or necessarily exploding in the age of Trump. We just see them taking a different shape.