July 25, 2018
It’s interesting how much can change in just one year. Around this time in 2017, I was struck by how US deal value was somewhat depressed, down several percentage points from the previous year. Yet M&A volume was going strong, driven in large part by an increase in middle-market deals. There still were a handful of megadeals – transactions of $5 billion or more – but not enough to turn most heads.
Now look at 2018. As the latest PwC Deals Industry Insights shows, megadeals are on a torrid pace, with an average of two deal announcements a week.* That has sent M&A value through the roof, threatening to easily eclipse last year and approach record levels. But that brisk activity with the bigger market caps isn’t carrying over to the mid-caps, as overall volume is down by double digits.
A few things may explain this inversion. Valuations on the whole remain robust and don’t show signs of relaxing. Add the competition for some assets, and we’re seeing acquirers pay bigger premiums; megadeals are up not only in number but in average value. But high valuations put pressure on the hurdle rate, challenging organizations to find the path to create value. Some may choose to stay on the sidelines.
We’ve also seen significant regulatory change, with companies still determining how they can benefit from the sweeping tax overhaul passed in late 2017. As Bob Saada, PwC’s US Deals Leader, recently noted, savings from a lower tax rate and other provisions won’t drive deals by themselves, but they can be part of the equation as companies re-evaluate deal models.
Buyers also continue to watch the government’s position on antitrust. The federal court ruling in favor of AT&T’s bid for Time Warner seemed to be a positive sign for other large vertical acquisitions. But the Justice Department’s recent appeal of the verdict could lead some to again pause on deals or explore other investments and partnerships instead of M&A to get exposure to other markets.
It’s also reasonable to see last year’s pace – especially the first half – as simply unsustainable. There are only so many businesses to be sold! The first quarter of 2017 set a record for M&A volume, capping a largely upward trend that began four years earlier. When you add expectations that the current economic cycle, which is already very long, won’t endure forever, some regression is understandable as companies may be cautious about overextending themselves.
Prudence could pay off. But with no sirens immediately sounding on the economy, I’d argue this is the time to position your company for future – especially if conditions do indeed worsen in the next year or two. We’re seeing this approach in some industries; software transactions in the technology sector include large firms scooping up companies that were poised to go public. It also may be a motivator in some transactions that have crossed industry lines.
Tech helps drive deals across industry lines
Roughly 40% of deals in the first half of 2018 have been investments outside the acquirer’s industry. The heavy focus on technology in cross-sector deals is understandable. We especially see this in consumer markets, media and telecommunications – areas where innovative technology can make a huge difference for reaching customers and improving their experience. That increasingly means using analytics to identify interactions and better understand the key value levers in a business. Those revelations can be crucial to unlocking new possibilities for a company and increasing its reach in a market.
Along with those sectors, others such as financial services and healthcare are investing in technology that harvests data to give them more customer insights. We’re also seeing cross-sector interest in tech take other forms. In the power and utilities industry, for instance, companies are exploring how they can boost their battery capabilities, which can be crucial for storing wind and solar energy.
Technology is driving cross-sector deals in other ways, too. The automotive industry is being reshaped by both electric and autonomous vehicles. That’s leading some smaller manufacturers to consider the need for a captive finance company, moving them into the financial services space.
Companies that make acquisitions in different sectors need to be clear on what they expect from targets in terms of performance and returns. For example, an acquired business that already is showing a profit may think keeping the same pace is fine. The new owner may have other ideas, however, seeing potential for more revenue with certain changes. This factors into almost any transaction; many buyers expect the deal to ultimately boost their bottom line. But getting on the same page can be more difficult when the players have been operating in different arenas.
M&A and other investment options amid tariffs
Another wrinkle in the deals landscape is the fractious political environment, as policy changes have raised concerns about the cost of doing business in certain markets. Some tariffs may have little impact, but others could disrupt supply chains in some industries, forcing companies to reconsider operations and investment decisions. US oil and gas companies, for instance, may have to work harder to find buyers for their growing production if tariffs curb demand from China.
If tariffs by the US and other countries continue, some companies likely will explore other ways to operate in different regions. We’ve already seen one example with Harley-Davidson saying it will move some production of motorcycles it sells in Europe to plants outside the US to avoid tariffs. Cross-border deals are down this year, but that could change as companies that don’t have facilities in a country tied up in a trade war may try to acquire local businesses to reach their customers.
How easy it will be for foreign companies to buy into the US market remains to be seen. The government’s Committee for Foreign Investment in the US has taken a heavier hand on deal reviews in recent months. At the same time, we’ve seen the share of M&A value from foreign acquirers fall substantially the past two years. Foreign buyers have accounted for almost 20% of the deals so far this year, with consumer markets and technology seeing the most action. This outpaced the US investment abroad, with about 15% of deals involving non-US targets, led by technology and consumer.
Favorable conditions vs. an unclear future
In this environment, previous deal models could be tested, and leading companies are doing more scenario analysis to reflect the potential outcomes. Adjusting supply chains could help mitigate additional costs, or alternative sources of supply could be available through an acquisition.
There’s still a shortage of deals, but there’s no shortage of interest in doing deals. Companies that reshape their portfolios in some cases will look to unload certain businesses; General Electric is one high-profile example. Investors should grab these opportunities while they can, with the right return expectations. Between the amount of cash at corporations and PE firms and the still-low cost of borrowing, the ammunition for more deals – including megadeals – is there, even with today’s high valuations.
Delivering the value and returns is paramount. Lower entry multiples would be convenient, but with today’s competitive landscape, waiting is potentially as risky as making an aggressive inorganic growth play. Strategic acquisitions now could put companies in a better position for the future. Delivering on value creation is the winner’s circle.
* All figures from Thomson Reuters with PwC analysis, unless noted.