2019 has been a banner year for mergers and acquisitions. On the heels of a record-breaking 2018, strategic buyers and private equity firms with cash in their pockets continued a robust spending spree. In the first three quarters of this year, in North America, approximately 8,000 deals have closed with a value of nearly $1.6 trillion, according to Pitchbook.
Enjoy it now, because the 2020 outlook is hazy. If we see economic shocks, market downturns or dramatic policy changes, dealmakers could go on the defensive in a heartbeat.
There are three levers that dramatically move M&A activity: stock market multiples and volatility, global economic conditions, and elections and resulting policy changes. All these factors will be in play next year and will shape the M&A landscape for midmarket companies.
Let’s look at each.
Stock Market Multiples and Volatility: One of the strongest indicators of M&A success for private midmarket companies is how larger public companies that look like them are performing in the stock market. In the last 10 years, multiples in the S&P 500 have remained relatively consistent. According to Macrotrends, in October 2009, the average PE ratio was 20.33. The latest data available from March puts the S&P 500 PE multiple at 21.09, relatively unchanged.
What has shifted dramatically in the past 10 years are interest rates. In October 2009, rates ticked in at 5.11%. Today, rates are down to a range of 1.5% to 1.75%. The 2009 data shows that there was, essentially, no real risk premium for risk assets, such as U.S. equities. Today, these assets provide a return of 3% to 3.25%. This suggests that risk assets A: are not out of line with historical ratios and B: provide a much higher return than bonds. This is good for market multiples and M&A.
Global Economic Conditions: Happenings in the major global economies have always been good indicators of what to expect in the U.S. M&A ecosystem.
In the States, monetary policies determined by the Federal Reserve play an important role in businesses’ investment confidence and decision-making. Interest rates, set by the Fed, are a key indicator of how strong (or weak) the economy is. While we’ve seen a few reductions this year, Jerome Powell, chairman of the Fed, has indicated that the board does not expect to drastically cut rates in the next year. That’s a good thing for M&A — investors like stable interest rates and indications of confidence in the U.S. economy.
In addition, while Powell has not (yet) used the term “quantitative easing,” the Fed appears to be starting to do just that by gradually buying bonds and increasing liquidity. The driver for this move isn’t concern about the domestic economy, but about who U.S. companies trade with: Germany and Japan, for example, have negative interest rates and really anemic GDP growth. Powell is looking to inoculate the U.S. economy against the ills that affect big trading partners.
Events in broader markets will also offer clues to the direction global M&A is headed. Once results come in from the U.K.’s Dec. 12 election, we should (hopefully) have clarity on Brexit, and that will have a material impact on European markets and global trade.
In addition, even a modest Phase 1 trade deal with China would help both U.S. and Chinese markets. Note that China-driven M&A in North America this year is almost nonexistent — down more than 90% from its peak in 2016, according to Pitchbook. In fact, the U.S. government has stepped in to prevent some cross-border deals. Regulators forced Beijing Kunlun Technology Company to sell the U.S.-based developer of dating app Grindr. Now, it appears that video app TikToc, which is also owned by a Chinese company, is under the same scrutiny.
The Committee on Foreign Investment in the US (CFIUS) has expanded its blacklist to include many high-profile Chinese tech companies — another factor in cross-border M&A drying up.
Easing global trade tensions would drive business investment. Whether that happens depends largely on the next item.
The 2020 Election: A presidential election cycle automatically brings uncertainty. But this time around, political discourse has been polarizing, to say the least. The M&A industry — particularly private equity’s role — is starkly in the spotlight. In mid-November, for example, the House Financial Services Committee held a hearing dubbed “America for Sale? An Examination of the Practices of Private Funds.”
In general, this is a partisan divide, with many Republicans pro private equity and most Democrats against. In fact, Democratic presidential contender and vocal PE critic Elizabeth Warren may be to thank for the recent rise in scrutiny. Warren has a plan for the industry as part of her “Economic Patriotism” proposal and has introduced legislation in the Senate called the “Stop Wall Street Looting Act of 2019.”
The bill would impact the corner of the financial industry that makes money buying, selling or financing other companies. PE firms would be required to make changes, including paying taxes on fees and dividends received from transactions, sharing responsibility and liability for the target company’s debt, changing the structure of payouts in the case of bankruptcy and making annual disclosures of information regarding transactions. Warren also wants to close the carried interest loophole and reinstate sections of the Dodd-Frank Act.
It’s clear that should this bill become law – unlikely unless both the Senate and the White House flip — there would be a chilling effect on M&A activity, at least until the ramifications for stakeholders shake out. The reality is, some of those in the “losers” column would be constituencies you may not expect. An example is union pension funds, which are chronically unfunded and challenged to get high enough returns. Unions are adding PE investments to their portfolios at a healthy clip, seeking to protect members’ retirement savings.
As the polls peak and dip as much as the market this year, pundits and analysts are trying to predict the future.
If PE firms become convinced that the White House and policymakers will crack down and impose new regulations, U.S.-based deals will slow, at best. Specifically, if policymakers raise the corporate tax rate back to 35%, we’ll likely see tax inversions, where American companies such as Accenture, Johnson Controls, ADP, Eaton Corp. and Medtronic PLC restructure such that they are owned by foreign entities, mostly to avoid double taxation and higher U.S. rates. In this case, companies would be acquired by foreign buyers, largely arbitraging a lower offshore tax rate with the United States’ higher tax rate; that would move jobs, deal flow and capital elsewhere.
This past year has proven the midmarket’s strength, with strong multiples, accelerated consolidation and record cash on balance sheets. Unless there is a Black Swan in our midst, the midmarket will remain a favorable place to be.
Overall, my prediction is that the M&A market will not have a blow-off-the-top 2020, but will remain steadfast and consistent. There’s too much uncertainty both domestically and globally to predict either a buyer’s or a seller’s market.
What could change this assessment? No Chinese trade deal in the first or second quarter of next year, volatility in interest rates, contained turmoil in Europe with no Brexit resolution, the prospect of significant policy changes coming out of Washington, or some combination of these.
Right now, I see no immediate prospect of turmoil within the M&A ecosystem based on our pipeline. So prepare by figuring out what your company is worth, even if you’re not ready for a sale. You never know when a great opportunity could rise out of the mist.
Marty Wolf has been involved in more than 175 IT M&A transactions during the last 20 years, creating over $5 billion in value. In addition to his responsibilities as president of global M&A advisory firm martinwolf M&A Advisors, which he founded in 1997, he actively manages transactions, has been directly involved in the divestiture of seven Fortune 500 divisions, and closed transactions in over 22 countries in segments including IT services, IT supply chain, and SaaS. Marty also acts as counselor and trusted adviser to CEOs of select IT firms. He has advised on take-private strategies and corporate carve-outs, as well as defended firms in hostile tender offers. He is a columnist and frequent speaker at IT and M&A conferences. Contact Marty via email.