M&A: Thoughts on the Cycle, Uncertainties, and Resolutions

FactSet’s U.S. Mergers and Acquisitions (M&A) data suggested continued weakness in the M&A markets as 2022 progressed. After running down roughly 20% in the first half, deal counts were down 40% year/year by November with some acceleration in the decline as the year ended. The more solid first half was due in part to transactions already in motion heading into 2022. Deal values ran about 50% lower year/year in 2022’s second half, which points to average deal size declining in line with typical downcycles.

Source: FactSet

Looking to M&A Advisors for Cycle Clues

We can look to public advisor and bank commentary for investment banking trends and issues. When entering a downcycle, M&A intentions are often in place, relatively solid M&A news continues, and advisers continue to report profitability. The first half of 2022 then didn’t look too threatening as conversations on large cap M&A—the driver of profitability for advisers and bankers—continued.

As a typical downturn continues and uncertainties grow, fewer M&A deals are announced. Publicly-traded advisors will often then highlight continued conversations (albeit no mandates), wide buyer/seller valuation differences, extended timeframes for deals to close, more caution in bank and private credit (especially for large deals), and economic uncertainties.

Indeed, in third-quarter conference calls the investment banks were increasingly indicating that deal backlogs, despite active conversations, were not being maintained. It was said that the M&A environment had stabilized in summer 2022 but also that September brought more economic uncertainty, inflation, interest rate changes, and unresolved energy challenges that led the business to turn down further. At the same time, bank lending was said to be more selective, private credit more cautious, and emerging markets more sharply slower.

Buyer/seller valuation differences, however, were said to be closer, and the impact of higher interest rates for the financially stronger firms didn’t seem to be an issue. The level of rates was acceptable relative to a longer-term history of rates, albeit a period of stability in rates was needed to build confidence. Just when would rates peak and at what level? At the same time, financing for larger deals was seen as more difficult to get given reduced market liquidity and credit concerns at banks—and even at stronger at private equity houses.

Late fourth quarter advisor announcements about reduced bonuses and likely layoffs continued the evolution of this downcycle. Concerns about advisor profitability might have contributed to an initial reduction in employee compensation plans, but the extent of the recent layoff indications could be indicative of how long M&A advisors expected the downturn to last.

In terms of duration, it makes some sense that a firm wouldn’t lay off a meaningful number of bankers if the downturn was expected to last only a year. The cost to rehire would be a negative.

Uncertainties and Potential Resolution

Cycles are oscillations between optimism and pessimism, with the waxing and waning of uncertainties and risks indicating degrees of pessimism. When a downturn might end hangs over most downcycles in the early stages. As those uncertainties are resolved or reach their nadir, the environment looks towards the next upcycle.

Key uncertainties that could be considered in the current down cycle—which appears more complex compared to previous cycles—include:

• Interest rates and inflation have increased the cost of financing. The market continues to debate both the peak in Fed rate increases and how far those rates will pull back and stabilize again thereafter. Assuming rate increases finish by the end of 2023 with some stability thereafter, we may see this key uncertainty easing in 12 months. The stock market is already looking for—and is willing to rally equities—on expectations of rates peaking.

• Energy markets, though seeing prices moderate, remain uncertain due to the Russian war in Ukraine and its knock-on effects on trade, price-cap policy attempts, and trade flows. While Europe seems in better energy shape than feared a few months ago, a lot of uncertainty remains. How will the next few months of winter transpire? This uncertainty for M&A is particularly acute outside of North America. Though the situation could be a real wildcard, many anticipate the war to end in the next year. Much will depend not just on when but also how the war ends in terms of the world’s stance on global relations and reparations.

• Economic activity. The trajectory of the slowing U.S. economy is, as usual, a great source of debate, with opinions ranging from a mild recession to a much steeper one. Consumer spending has held up, though some believe inflation will take its bite as consumer reserves are spent. Time also weighs on corporate financial health in a downturn, so this part of the economy is seen at varying degrees of negative inflection. Concerns about Europe’s economy with higher energy costs, China’s economy with Covid policy changes, global territorial tensions, and globalization in general all provide plenty to debate in the current economic cycle.

• ESG evolution. Though ESG greenwashing discussions have heightened in recent months, they likely won’t make the ESG framework go away. In M&A transactions, ESG will remain a consideration in terms of risks, ESG synergies, and know-how. At the same time, ESG standards should become less blurry as guidelines are further focused and unified, a more consistent view of material risks develops, and technologies advance. ESG considerations will continue to affect the defensible value of a business, both positive and negative. Ultimately, companies must show they have identified and understand risks and mitigations as elements and potential issues in getting deals done. Enhanced SEC guidelines on ESG disclosures (expected 2023-2024) and new European standards (International Sustainability Standards Board expected 2023) could raise the bar on incorporating ESG in deals.

• Trade/supply-chain uncertainty is still high. A multi-year trade adjustment in many markets is likely, with greater concerns for security of supply for energy, semiconductors, and battery materials. High-volume imports will need to be evaluated for security, inventory (ties up capital), and ownership control (purchase assets or invest?), where possible.

• Corporate balance sheets in total were relatively strong heading into this downcycle, however that strength was concentrated in larger companies and the tech sector. As a result, a wide swath of companies might see deteriorating credit conditions due to higher interest rates and lower cash flows in the slower economy.

• Restructurings versus M&A. To adjust to the downcycle, bankers in their conference calls have suggested a rising number of restructuring conversations for financial structure and asset ownership. Uncertainty tends to favor financings using more equity, more earn-outs, and EBITDA valuations over revenue. Uncertainty also often leads to smaller, lower absolute risk deals. Along these lines, there could be more divestitures of smaller business units rather than entire companies. The statistics should continue to show smaller deal sizes. Overseas markets have recently been noted as having strong interest in restructuring ideas.

• Private capital is concurrently flush with cash and available committed capital while in some cases working through underwater investment valuations and longer timeframes to monetize assets. With strong underlying financials there may be less motivation to force a transaction into a weak market. That said, GP and LP desires for cash flows from private capital pools may come into play. Until valuations recover, holding underwater assets may constrain other activity. However, relatively strong capital access could enable private capital firms to complete smaller transactions while opportunistically resuming larger deals.

• Policy dimensions. We see policy as an evolving factor in three dimensions this year. First, rising regulatory enforcement on antitrust needs further consideration in certain transactions. Second, policy uncertainty may persist throughout the new Congress in 2023 and the 2024 presidential election. Third, a minor policy theme might be the ESG “need” to allocate more capital to infrastructure for carbon reduction and climate adaptation. Countering arguments of potentially lower returns will be arguments of reduced corporate risk and continued license to operate.

Conclusion

M&A in 2022 was a solid down year with negative trends accelerating in the second half. While the uncertainties are different and perhaps more complex in this downcycle, the M&A market will eventually adjust to them and, as the uncertainties diminish in time, recover into another upcycle.

In 2023, we may see more buyer/seller agreement on valuations, clarity on the trajectory of interest rates and inflation, better ESG standards and disclosures, the end of the Russian-Ukrainian war, and perhaps some stability in corporate cash flows. Altogether, these positives could put the market on better footing heading into 2024 before the next U.S. presidential election.

Though more restructuring transactions are important to keep investment banker books full, these can often be lower margined and/or smaller in size. Other business areas the publicly traded banking houses mention as improving to offset lower M&A activity include advisory activities on debt, private capital fundraising, shareholder interactions, activist defense, capital markets, equity sales and trading execution, and wealth management.

Sean Ryan contributed to this article.

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