Rick Lacher, Managing Director at Houlihan Lokey, discusses upcoming trends in the US M&A market.
We’re clearly seeing regulatory risk being factored into the deal process, both in terms of the willingness to pursue deals, and negotiating the economic allocation of risk if the transaction does not go ahead.Rick Lacher, Managing Director, Houlihan Lokey
Do you think the increased expense in financing might affect the way that deals are structured going forward?
I think we will start to see this play out within the private equity market in particular. PE firms clearly have a lot of dry powder and are keen to deploy it – they will still be chasing deals. Yet PE relies heavily on high-yield market financing – large, syndicated deals – and that market has been extremely quiet lately. Capital markets do tend to move at lightning speed, however, so we could see that shift quickly.
What we might see is a focus on deals that are better candidates for private lending, because this market is still active. It’s expensive, however, and rising interest rates will make it even more so. While there is still financing available, its rising cost will start to have an impact on deal structures. I think that we will start to see PE firms trying to fill the gap with equity, meaning that equity as a percentage of overall deal value will increase. That’s how they’ll try to bridge some of that gap.
You say that PE firms are under pressure to deploy dry powder, yet the financing environment is challenging. What do you see as the main qualities PE firms need to show to prosper in this environment?
I think we’re going to see private equity firms become very active, but they’re going to be very selective as there are not enough quality assets to go around. I think PE is very adept at navigating those situations. Firms that do well are going to be the ones who can spot a deal, make a decision, move very quickly, and be smart about how to start extracting value from the deal so they can realize the returns. The ones who move quickly and create more value from synergies are the ones that will really shine. This might mean that the deal timeline gets protracted because they need to spend time figuring out what their game plan is, as well as raising the financing. Good, insightful due diligence is going to be even more important within this context – operational, financial, IT – all of it focused on value capture.
In addition to financing, regulatory reviews are certainly stretching deal timelines. We are seeing clients manage this challenge in different ways. As a partner to PE sponsors, it’s been challenging, and very interesting, trying to help them navigate today’s uncertain landscape.
And what challenges do you expect corporate buyers to face over the coming year? How do you see these differ from PE firms?
Some of the challenges are the same. But on the corporate side, there’s a real distinction between the haves and the have nots. There are a number of companies who are over-leveraged and struggling in this inflationary and interest rate environment – almost running on fumes. Despite the best intentions, they really don’t have an ability or the wherewithal to participate in an M&A strategy right now, other than to potentially divest.
There are also corporates that have been able to keep their balance sheets healthy through the pandemic and disruption and are ready to transact. We’re going to see these corporates using M&A proactively to shed non-performing parts of their portfolio, and grow strategically.
In an environment where a recession seems highly possible and there’s more pressure on cost, I think that, across the board, companies even in high-growth sectors such as tech, are thinking about cost and are worried about the profitability of their revenue stream.
2022 has seen a softening of M&A levels compared to the historic highs of 2021. Do you expect deal activity to continue to trend down in 2023?
What a difference a year makes. M&A activity has seen a clear slowdown across the globe – both in terms of value and volume. In the US specifically, concerns over rising inflation, interest rates hikes and, the war in Ukraine are certainly causing both buyers and lenders to become more cautious. The gap between buyers and sellers is increasing and, as a result, more and more deal processes are being elongated or are not reaching the finish line.
There does appear to be more caution in the market. It has been interesting that the dealmaking market has not been as busy as expected so far this year, despite the huge amount of capital available. Do you expect to see a pick-up in activity over the remainder of the year?
It’s important to note that despite a number of factors applying downward pressure on the market, there is still a healthy level of activity based upon historical standards. Having said that, I don’t think we’re going to see a meaningful pick up in M&A activity for the rest of this year and the first half of ’23 will likely be slower than the first half of ’22.
In certain cases, there is downward pressure on valuations based on financing availability and potential uncertainty with respect to the future. Ultimately, this is going to create gaps between buyer and seller expectations, which tends to result in a slowdown or pause in deal activity.
Overall, I think that we’ll continue to have a healthy level of activity, but due to the downward pressures in the market, it is not going to be anywhere near the historic highs we witnessed in 2021.
While we’ve seen volumes going down, it seems that large-cap deals with a compelling strategic rationale are still going ahead. Do you expect to see a continuation of this trend?
Large firms, whether corporate or private equity, have substantial capital and available cash to deploy in transactions. On the other hand, volatility in the stock market and a decline in valuations – whether performance or multiple related – are reasons why targets may be hesitant to consider a transaction, which complicates the dealmaking environment.
I think we’ll continue to see corporate M&A activity as strategics may take advantage of targets with depressed stock prices, but it will be sector specific. For many potential targets, the timing won’t be quite right, and they will be waiting for a bounce back in their stock price. In certain cases these dynamics are creating an increase in the number of potential take-privates where a large shareholder wants to purchase the equity it does not own.
We are also seeing an increasing number of proposed spin-off transactions, where companies are considering splitting up their business due to a lack of synergy or looking to arbitrage a multiple difference that should be realized if their different business units are separated. It’s also a way of testing the market – announcing a spin-off is effectively code to say that a business is looking to sell a division which may be dragging down its overall valuation.
The other trend we’re seeing is that companies that are pre-revenue or pre-profitability are no longer able to go public by merging with a SPAC. This is causing SPACs to turn their attention to corporate carve outs to determine whether there is an opportunity to merge with a business that is embedded in a public company. For the public company, it can be a tax-efficient way to exit a business while still retaining part ownership.
So again, we’re seeing a range of creative methods to put capital to work.
What challenges are you seeing coming from regulation?
We’re clearly seeing regulatory risk being factored into the deal process, both in terms of the willingness to pursue deals, and negotiating the economic allocation of risk if the transaction does not go ahead. We went through a process recently where we had two different bidders – one carried CFIUS risk and the other did not. Ultimately, we decided to partner with the one which didn’t carry the regulatory risk. I think that these types of issues are increasingly front and center in the dealmaking process. In certain cases, large firms are willing to take the regulatory risk.
About ten years ago, ATT tried to buy T-Mobile and effectively bet five billion dollars it could convince the regulators to bless the transaction. I do not believe you will see that type of aggressiveness in today’s market. These regulatory risks are real and may cause smaller businesses to shy away from deals. Announcing a deal can cause havoc to your employees, customer base and vendors. Sellers are generally hesitant to go down that path unless they have a high degree of certainty.
Continuing on the theme of regulation, ESG is a hot topic in the market. Are you seeing tougher regulation in the US, in relation to ESG risk on deals?
We’re seeing a lot of focus on ESG, either by those who want to see it, and those who believe it shouldn’t be a factor. Florida recently passed a law eliminating ESG from investment decisions and New York is telling firms they need to be more aggressive. I haven’t seen much ESG-related focusin my deals. It is a theme that bankers may use to market a business, but not something that I believe is truly, meaningfully impacting the M&A market.
Are there any trends on the horizon that you think will affect the dealmaking environment in particular?
An important trend to consider is the fact that we’ve gone through a period of extremely low default rates. We’re seeing activity picking up in our restructuring practice, driven by an increase in default rates and debt prices trading down reflecting potential stress in the credit. When there’s dislocation in the regular M&A market, we tend to see an increase on the restructuring side of our business. We are working with a handful of companies on a M&A option, which if that option does not pan out, the company will have to be restructured.
When companies are restructured, it’s not unusual for the creditors, who are likely controlling the equity, to want to increase scale through acquisitions and industry consolidations. Many times when industries go into decline (for example, offshore drilling) and restructurings increase, you tend to see M&A activity in those industries. I do think we will start to see a pick-up in this type of M&A.