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E-MailColin Wittmer is Deals Leader and John Potter is Deals Clients & Markets Leader at PricewaterhouseCoopers LLP. This post is based on their PwC memorandum.
Corporate profits and alternative structures provide reason for optimism
M&A activity has been hampered as dealmakers seek clear economic signals. The swings of COVID-era volatility have subsided but executives are still searching for equilibrium in a world with sizable valuation gaps, higher-for-longer interest rates and geopolitical-driven economic de-couplings.
While deals are still getting done, many executives have taken a wait-and-see approach, especially when it comes to the transformational deals that abounded in prior years. But hesitancy isn’t stopping the clock from ticking. Business reinvention is an imperative across industries; business-as-usual strategies need the catalyst of transformation to achieve the growth and profit expectations in current valuations. A combination of divestitures and acquisitions are increasingly the fuel to accelerated business transformation.
Savvy leaders that “transact to transform” now have a chance to create greater value and gain an edge on less decisive competitors.
Looking ahead
Valuation gaps between sellers and buyers also seem to be closing for all but the largest deals, providing another reason for optimism that dealmaking could pick up in 2024.
Several factors make this period of profit recovery different from previous earnings recoveries. Private equity (PE) funds are sitting on more than $1 trillion in dry powder and are under increasing pressure to deploy that capital and deliver returns to limited partners (LPs). Forces that affect PE dealmaking, therefore, could have a notable impact on the pace of M&A recovery.
On the regulatory front, PEs are seeing increasing scrutiny over roll-ups, in which they buy companies in similar industries to build a larger business platform with greater market share. PE firms have seen the value in successful roll-ups over the last 15 years, but this strategy faces challenges due to the complications of potential regulator vetoes.
Heightened U.S. government concerns about international deals in sensitive sectors such as technology mean that dealmakers will have to keep a close eye on Washington. These pressures also spotlight the political uncertainty in the 2024 election cycle, which could influence dealmaking for both PEs and corporates.
Besides security concerns, recent geopolitical fluctuations are also impacting commodity costs. While higher commodity costs generally restrain economic growth, in some sectors, such as energy, those rising prices could provide companies with more cash for deals.
While PE has a great deal of capital, relatively high interest rates and other headwinds are slowing the pace of deals. PE firms are using alternative capital structures and private debt along with more traditional bank and leveraged financing. Often, that means rates are 200-300 basis points higher. There is considerable creativity with deal structuring, with PEs often collaborating with corporates (and nonprofits in the healthcare sector) to put together joint ventures, minority investment stakes and other less common structures.
Alternative deal structures
Despite market uncertainty, companies still need to achieve business goals — including transforming their organizations to remain relevant in the future. Higher capital costs are prompting many companies to explore creative ways to achieve strategic goals.
Joint ventures, minority investments, licensing agreements, supply-distribution deals and other structures give leaders more options. For acquirers, it may allow them access to technology or markets without the overhead of a full-blown acquisition. For sellers, it can be a source of new revenue or, for PE firms, allow the partial return of capital at a time when market conditions for IPOs are not ripe.
These alternative deal structures aren’t visible in market data yet, but we are hearing and participating in many more discussions as clients navigate the higher cost of capital.
Sector spotlights
The US 2024 Deals outlook includes a closer look at individual industries in our sector reports. Below, we spotlight three sectors that will be worth watching in the first half of 2024.
Deal drivers
Capital allocation
Interest rates translated to a higher cost of capital in 2023. That helped dampen deal activity by increasing hurdle rates and challenging deal funding. Private credit, which is flourishing, has helped fill some of the gaps. We’re also seeing more companies explore creative dealmaking opportunities, which can include everything from joint ventures to operating alliances to licensing agreements. Companies also are exploring strategic divestitures as a way to reallocate capital to their core business. Corporates with strong balance sheets likely will have opportunities due to less competition from private equity players who have pulled back due to the higher cost of capital. Divestitures aren’t the only opportunity for corporate buyers. While the IPO market saw signs of life in the second half of the year, there are still plenty of erstwhile unicorns that may not be able to find an exit in capital markets more focused on profitability than growth.
Example:
A financial technology company refinanced $4.8 billion in syndicated debt after its private equity owner took out a net asset value (NAV) loan for a cash injection and pledged $1 billion in preferred equity.
Opportunity amid uncertainty
Many dealmakers are still trying to figure out where the new baseline is after a rollercoaster few years that saw dips during the pandemic followed by record-setting M&A in the post-pandemic recovery, followed by yet more declines as inflation and higher interest rates encroached on the economy. A widely anticipated recession hasn’t yet arrived thanks to strong consumer spending and a robust labor market. In a sign of the uncertain times, a downturn, while less likely, still can’t be ruled out as we enter 2024. The uncertainty is presenting challenges but also opportunities. Once-sky high valuations are starting to drop. Acting during a downturn or a volatile period can help companies acquire their top targets for less — making it easier to create total shareholder return once the economy picks back up.
Example:
A chip designer had a successful IPO in September as it returned to the public markets after spending several years as a private company. The IPO performance backs up the thesis of VC investors who are still putting significant money to work in semiconductor startups.
Necessity for business reinvention
Corporate leaders are transforming companies with deals to keep them competitive in a fast-changing environment. Five megatrends — climate change, technological disruption, demographic shifts, a fracturing world and social instability — are reshaping business. Although these forces aren’t new, their scope, impact and interdependence are growing, with varied magnitude across industries and geographies. Companies that proactively manage their portfolios to invest in new capabilities and enter new markets will have an advantage.
Example:
Large financial institutions are looking at ways to deal with new impending capital requirements from regulators. As a result, we’re seeing multiple financial institutions undertaking portfolio reviews to identify non-core businesses that can be divested. While fundamental deal drivers support an uptick in banking activity, the exact timing depends on a reduction in marketplace volatility.
Resilience and innovation for growth and sustainability
The supply chain shockwaves didn’t stop pulsing after the world reopened post pandemic. Wars, both trade and shooting, have upended logistics from Eastern Europe to the Pacific Rim and most recently to the Middle East. Companies are trying to pivot even as they navigate resiliency challenges created by factors as disparate as climate change and cybersecurity. Deals need to be an integral part of companies’ value creation strategies to mitigate these risks and ensure consistent, safe operations.
Example:
Cleantech startups continue to attract venture funding, despite difficult conditions for companies seeking seed and venture capital. Those companies likely will, in the next few years, end up in IPOs or be acquired by corporates seeking to address climate risk in their own businesses.
The bottom line
A soft landing for dealmakers looks more likely due to decreases in inflation. A strong job market and substantial household savings have helped buffer the economy so far. But higher-for-longer interest rates, geopolitical shifts and increased regulatory activity are contributing to continued uncertainty in M&A activity. Regardless of the current conditions, business reinvention is still a medium-to-long-term corporate imperative for many companies. Due to higher interest rates, corporates with cash have a window of opportunity to make transformative acquisitions in technology, sustainability and business reinvention. We also expect firms to use divestitures to focus portfolios and raise capital that can be used for transformation activities or to reinvest in core businesses.
