M&A is Booming, but has the Reset Already Begun?
While Covid-19 has and continues to impact economies, the M&A market has been a winner. The global market topped over USD 5 trillion for the first time in 2021 - But there is change in the wind. We might not see the effects for a number of quarters, even within the next 18 months, but make no mistake, it’s on the way.
Despite macroeconomic headwinds, global M&A activity burst into 2022 riding high on the activities of last year. According to Dealogic data, the market blew past its 15-year high in 2021, surpassing ~USD 5.5 trillion, with volumes up more than 60 %.
While 2022 is likely to be another positive, perhaps even bumper year, a reset mechanism might already be in play.
Several factors contributing to this are inflation and a steeper discounting mechanism, heightened and persistent geopolitical risk, cyber and data security and (perhaps) waning confidence. Collectively these, and the ongoing global Covid-19 experience, are likely to play a dampening role in M&A activity.
Inflation indubitably began to rise in second half of 2021, and classic monetary policy dictates that rising inflation is countered by rising interest rates.
Until recently (because the Russia/Ukraine conflict* may change this), the Federal Reserve and other central banks, with the exception of China and Japan, were jawboning to raise rates in 2022. Thus, it is logical that the market will start to move into an environment where rates will impact the economic cycle – recession. But this will take some time to unfold.
For M&A, there are two vectors linked to inflation.
Firstly, it flows through the P&L creating cost pressure. This leads to earnings pressure, which causes a burden on earnings growth and thus impacting valuations. At the same time, as inflation goes up and central banks tighten monetary policy, rates rise and so does the cost of funding/debt financing. This vector of rising rates directly impacts M&A volumes and market sentiment.
Many companies have heavily streamlined operations coming out of “post Covid”. So, there is not much room to further squeeze out efficiencies in operations. Therefore, rising inflation and rates environment create further squeeze on earnings. M&A deal making to develop synergies in this environment is tough.
Perhaps a mitigant is there is a high level of cash sitting on corporates and sponsors balance sheets globally. Given this dynamic, companies and sponsors with more cash on hand will have greater incentive to use the cash to do M&A, because inflation is eroding the value of carrying cash. It will also separate the “haves” and the “have nots”
Nevertheless, as companies continue to chase deals, assets prices will also continue to increase. Paying peak prices or a premium just ahead of a deceleration, in a volatile market, is not ideal.
A steeper discounting mechanism is also at play. With all the liquidity on hand, it makes sense to acquire assets that have high visibility on cashflows, such as infrastructure companies. Conversely, the ‘duration effect’ means that companies which see cashflows much further down in time, are more likely to have seen a rapid reset. This is most punitive for new economy stocks. Look at the reset we have seen in valuations of technology companies!
In an economic cycle where rates are increasing but all the streamlining has happened, the M&A environment is less robust, as recessionary pressures, lower ability to capture synergies, and operational streamlining has already been factored in.
Volatility has also picked up over the last 24 months, even if we exclude the Covid-19 context. Volatility impacts confidence, and the M&A market, besides analytics, is heavily driven by confidence.
For China, other factors are at play facilitating a reset; domestic promotion, domestic M&A, and an environment leading to stronger competition within the country is emerging – squeezing out the more marginal players. So, while not the same kind of reset that we are seeing in other regions, it is a reset non-the-less. For sure, China outbound volumes are experiencing this phenomena.
That said, you might consider that this is not a typical cycle, and that rather, we are emerging from the shock of the pandemic, which halted the global economy; the current environment may in fact be reflationary – getting us back to 2019 levels.
Either way you look at it, it is a cautious time to do deals.
Looking ahead, I remain positive on certain secular trends and sectors for 2022 M&A activity. Namely, sectors with high cashflow visibility; the intersection of technology and classic sectors like digital infrastructure and healthcare; ESG and energy transition related activity; and, M&A activity leading to the creation of ecosystems, rather than episodic M&A.
2022 may well be another bumper M&A year, although there will be some moderation compared to last year. According to Natixis research we anticipate c. USD5,300bn of M&A in 2022. Two years from now though, it could be an entirely different story.
*While clearly there will be global economic ramifications, I would first and foremost like to acknowledge that we are primarily concerned and appalled by the unforgivable humanitarian impact of the situation, and we hold hope that matters will be resolved quickly and with minimal impact on human life.