On the heels of the U.S. M&A market posting its worst quarter in many years, Baird Global Investment Banking sees this as the right time to look for signs of a future rebound in M&A activity. This piece summarizes how our analysis of past M&A cycles uncovered leading indicators of improvement in deal making. We also provide support for our building optimism about M&A normalizing more quickly than after previous periods of significant weakness given the rebound in economic activity and public company valuations, as well as the far larger role of deal-driven financial sponsors relative to previous M&A cycles.
By most measures, Q2 was the slowest quarter for U.S. M&A in two decades, causing us to take a deeper dive into the nature of prior downturns in the U.S. M&A market. The second-quarter deal count (down 45% vs. Q2 2019) fell to the lowest level since Q4 1996, while disclosed deal value (-83%) dropped to an 18-year low. Stalled deal making amid the COVID-19 pandemic reflected the lack of financial performance visibility for most companies, limited access to M&A financing, and disparate views on valuation among buyers and sellers after the sharp pullback in the U.S. public equity markets through late March. While we believe the insights in this piece apply to M&A activity in large markets such as Europe and Asia, our analysis focuses on the U.S. due to its leading contribution to the global M&A market (at about 60% of disclosed deal value over the past decade), the stronger performance of the U.S. M&A market at the beginning of prior upturns (3-4x the first-year growth in other markets), and the greater role played by financial sponsors in the U.S.
Although conditions remain challenging as we enter the second half of 2020, recent progress in the economy and capital markets has motivated us to find the pockets of strength that marked the start of more constructive periods for M&A activity following the last two major M&A downturns. Based on our evaluation of past cycles, deal metrics for financial sponsor M&A exits and M&A transactions with disclosed value of $200+ million represent potential leading indicators of an upturn in the U.S. M&A market. Over the three months leading into each market recovery, these ranked as the top two for deal count growth among all segments (topping corporate acquisitions/divestitures, sponsor platforms/add-ons, cross-border, public company, and smaller deals), supporting our confidence in their value for signaling better M&A trends.
A closer look at the rationale behind each leading indicator is warranted, beginning with financial sponsor exits. As detailed in the below chart, the number of sponsor M&A exits moved significantly higher at the tail end of both of the previous major downturns. Coming out of slower periods, private equity firms prioritized selling existing portfolio companies in an effort to achieve the strategic objective of delivering strong returns to LPs. In addition, monetizations of current holdings contribute to the success of raising the next fund. Accordingly, the prospects of healthier conditions ahead caused PE firms to focus on re-engaging a large number of previously delayed sale processes. A pickup in sponsor exits also suggested a better balance for valuation perspectives among sellers and buyers, a critical predicate for a broader upturn.
The above chart also highlights that a large wave of deals with disclosed values of $200+ million occurred before improvement in the overall M&A market in subsequent months. Note that the lower middle market accounts for most M&A activity, as $200+ million deals represented only 12% of all M&A transactions with a disclosed value during the last two downturns. The resurgence among $200+ million deals heading into more extensive upturns was consistent across strategic acquisitions and sponsor purchases, as well as throughout size segments, including $1+ billion deals. At the tail end of past downcycles, strategic and sponsor buyers were most ready to act on larger, coveted assets once sensing a more competitive M&A environment. We see better trends for bigger transactions as a positive sign of rising confidence levels among buyers and clearer visibility for the results of targets, ultimately translating to healthier deal making on a widespread basis.
While acknowledging that the eventual M&A rebound could look different from prior scenarios, we are closely monitoring M&A data for the leading indicator segments cited above. The rationale for an earlier recovery in sponsor exits should continue to apply to this M&A cycle, with PE firms even more focused on achieving liquidity events today than amid past downturns in view of ever-expanding portfolio holdings as well as recent median hold periods extending to five years, up from less than four years in 2009. In addition, shorter fundraising cycles could catalyze exit activity in the near term, as the average time between fund closings dropped to a 12-year low in 2019. The $200+ million deal category should also thrive in advance of a broader upturn given elevated levels of financial sponsor dry powder as well as the prominence of acquisitions on the agendas of corporate boards entering 2020.
Although M&A market fundamentals continue to be suboptimal, the backdrop for deal making appears to have improved over the last couple of months. Based on our current view of key M&A variables, we believe the headwinds keeping a lid on many transactions have begun to ease. Due to the favorable status of most M&A drivers pre-COVID-19, we expect a substantial number of transactions that have been put on hold to close eventually.
In assessing the potential for near-term improvement in M&A, it is important to note that in recent months, the pandemic has forced many sellers and M&A advisors to evaluate and implement different deal execution strategies and tactics, including:
- Using a more tailored initial outreach, including narrowing the process (in terms of number of buyers) earlier, prior to any management engagement
- Conducting management meetings/presentations/visits virtually
- Utilizing video or virtual facility tours
- Using virtual tools/format for the majority of due diligence
Many buyers still require in-person interaction and asset inspection before deal completion; however, most in-person activity is being deferred until the final stages of a deal process.
Differences in the nature of recent economic weakness relative to past U.S. recessions suggest potential for a faster return to normalized M&A activity in the current scenario.
- The deceleration of 2001-2002, which posted the two lowest GDP growth rates of the 1992-2007 period, followed an extended period of overexuberance best illustrated by inflated valuations for technology assets, with difficult conditions compounded by the events of September 11, 2001.
- The financial crisis of 2008-2009 stemmed from excess leverage, including in the real estate sector, translating to anxiety about the health of the financial system.
- This year’s contraction, which was primarily a self-induced response to the spread of COVID-19, likely will prove to be deeper than in prior recessions. However, the economy is on the road to recovery already, as indicated by most recent economic data as well as the powerful rebound in the equity markets, reflecting massive fiscal and monetary policy programs designed to mitigate the impact of the pandemic.
Another key distinction from past downturns involves the greatly expanded role taken by financial sponsors in the M&A market over the last 10+ years, with the enormous capital deployment capacity of this group poised to fuel an upturn in deal making following a period of assessing the impact of the crisis on portfolio companies. Private equity firms have dramatically increased assets under management since the previous M&A downturn, reflecting the combination of successful fundraising, greater acquisition activity, effective portfolio management, and steady exit activity.
- According to PitchBook, the percentage of control-stake M&A transactions with PE buyers rose from 26% in 2009-2010 to 39% in 2019.
- Committed capital that has not yet been invested (i.e., dry powder) has surged higher in recent years, as LPs have increasingly allocated capital toward larger funds; the amount of PE capital overhang now exceeds $1 trillion, roughly doubling over the past 10 years.
- From 2009 to 2019, the number of PE portfolio companies in the U.S. nearly doubled to exceed 9,000, in contrast to a significant decline for the number of publicly-listed entities. By their nature, PE-backed companies are highly likely to be involved in M&A transactions such as add-on acquisitions, secondary buyouts by other sponsors, and exit sales to strategic buyers.
This fundamental change in the ownership model, coupled with the mounting dry powder the sponsors can access, should drive a recovery in M&A activity if market fundamentals (particularly for LBO financing) improve further. In addition, our sense is that strategic buyers, which will be active participants in any substantial M&A rebound, are beginning to refocus on deal making in an effort to combat a reduced demand backdrop. Importantly, we believe the dynamics cited here are highly relevant to M&A on a global basis. We will follow up when the leading indicators noted above reveal the near-term potential for better trends in the overall M&A market.
We encourage you to reach out to Baird’s Global M&A team to discuss this analysis and related market dynamics in further detail.