The Active Deal Landscape and What’s Ahead for M&A
Coming off an unparalleled year in mergers and acquisitions (M&A), the upward trend in deal volume is poised to continue. Now fully immersed into the first quarter of 2022, business leaders and analysts are wondering whether a “new normal” has been reached in the deal cycle, having moved away from the most disruptive effects of the pandemic. As businesses move forward to realize new potential, M&A dealmakers can anticipate several interconnected factors shaping the year ahead.
No one could have predicted the pandemic or its specific impacts, and no one can predict what unforeseen event may arise in the year ahead. The only certainty is that the deal community will continue to adapt and find ways to create value.
Predictable M&A paths are a thing of the past
As dealmakers, no one expected the pandemic and related effects to last as long as they have. While some companies experienced a “COVID bump” in their valuations, others barely succeeded in maintaining their pre-pandemic worth. Now entering the third year of the pandemic, the concept of the “COVID bump” has waned.
Traditionally, approaches to financial and operational diligence would analyze the prior two to three years. This analysis is the foundation of forecasting the future and ultimately drives valuations of the underlying assets. Given the volatility driven by the pandemic, assumptions regarding the future state may vary unlike any other time. Buyers and sellers will always layer in their perspective on the future state of the industry, but what is certain is that there will always be a gap in expectations – with or without a pandemic.
Inevitable deal hurdles call for nimble tactics
Companies are continuing to struggle with underlying issues in managing their businesses. Supply chain disruptions, raw materials sourcing, and profound labor shortages have made it difficult to normalize current earnings. This has led to a greater appreciation of those organizations that have mitigated their risk through contingency plans. Even when factoring in mitigating efforts, those hurdles continue to affect the bottom line.
Another hurdle affecting the ultimate realization of deal value is the lack of post-deal close integration. Organizations can find it extremely difficult to simultaneously integrate multiple acquisitions made in 2021 while continuing the buy-side momentum. This has the potential to erode the value of identified synergies and deal thesis.
Further stressing the M&A continuum is the sheer volume of deals. Access to quality diligence providers became limited, often leading to an extended time frame to get deals closed.
Dealmakers need to move forward while minding major unknowns
Amid disruptive forces and risks such as supply chain, labor shortages, and retention, inflation has become the current unknown. It can be difficult to normalize companies’ financial results relative to inflation and expectations of future results. During inflationary periods, companies attempt to pass on incremental costs of labor and materials to their customers. Further, the impending rise in interest rates must also be considered. As interest rates rise, and the cost of debt becomes more expensive, the impact on deal activity can be significant, whether it is the impact on cash flows or a temporarily misaligned expectation of sellers and buyers regarding valuation. The M&A market loves certainty. By not knowing where interest rate increases stop, it will make some organizations pause. Alternatively, rising interest rates can serve as a short-term deal accelerant given that the current rate environment is low, and organizations will want to get their transactions closed.
Private equity deals are typically heavily levered, and rising interest rates can affect them greatly. With capital structures even marginally changed, senior debt becomes more inaccessible. An example of this occurred during the 2008 financial crisis, where private equity organizations created debt funds to fill the void left by traditional lenders. However, there remains considerable capital to be deployed, and deals will continue to occur in any environment. The difficulty lies in getting those deals done and —as with other historical disruptions— a commitment to an investment thesis and an abundance of diligence through the transaction process will allow opportunities for success in ways previously unimagined.
Looking forward, 2022 is poised to be another volatile year for M&A. The continued backlog of deals will provide early momentum to the year. In addition, future interest rate increases can further accelerate the activity, while the deal community may briefly pause to reassess relevant factors that arise. Continued emergence from the impact of COVID will allow for a return to “normal” or, at a minimum, continued progress to a “new normal.” No one could have predicted the pandemic or its specific impacts, and no one can predict what unforeseen event may arise in the year ahead. The only certainty is that the deal community will continue to adapt and find ways to create value.