Global M&A and PE activity update: H1 2023
Six months into 2023, we are now looking at old tactics resurfacing, lost dollars and tipping points in the M&A and PE world. Rising inflation, interest rate hikes and stricter regulations are only a few bumps on the road to recovery in the industry. While PE investors are being cautious and strategics are pacing up, let us understand where the industry stands today to get a better view of the months to come.
Dealmaking has almost always followed economic cycles, be it during covid or the 2008 crisis. These times are no different for deals at least. M&A and PE activity was impacted drastically during Covid with the world coming to almost a halt. While the world adapted to work-from-home methods and immunising to covid, dealmaking recovered in 2021. However, 2022 came with a rough splash of war, inflation, hiking interest rates, completion of covid relief measures, and so on. Today, halfway through 2023, dealmakers are facing a slump similar to a decade earlier (excluding the covid impact). A nightmare for many who work on leverage. The worst part, the view going forward is also not very promising at least for another year. So what exactly is happening? Let us understand this in detail.
Looking at the above chart, we clearly understand the correlation of deal volumes with economic cycles or tense situations globally. Starting with the 2008 crisis, we are all aware of the market crash, unemployment and all the negative consequences globally. It was a classic debt bubble that burst and the trickle-down was felt throughout, including dealmaking which fell drastically in 2009. The recovery in deal activity was somewhat stable up to 2019. 2020 was an exception with Covid. While H1 2022 was going well, we have to note that problems started surfacing at ground level since H2 2022. And hence, we are still witnessing a slowdown in H1 2023. Deal volume so far is below the average for the 10 years proving the slow pace.
Before diving deeper into the factors causing this slowdown in dealmaking, paint a bigger picture of where we are, how we landed here and the outlook going forward.
As I have explained in my previous article that the relief measure (low-interest rate) implemented globally to recover from the 2008 crisis never really corrected because markets were never ready to accept a high or even normal interest rate regime since 2008. This encouraged increased use of leverage to execute deals thus encouraging LBOs (which accelerated PE activity). Additionally, booming stock markets encouraged IPOs (and even SPACs). This booming stock market also meant many listed companies were overvalued and hence encouraged more equity-based M&As. All these together lead to not only some of the best and largest deals in the world but also some truly bad investments, lack of good governance, corruption, hostile takeovers and misuse of cheap debt. This was collectively encouraged by the markets globally because, in the end, they showed returns, at least in the booming economy. This escalation was leading to an inflation bubble anyway and after about a decade since the financial crisis, some markets globally tried to introduce some monetary controls in 2018. But that was fiercely opposed and fears of massive market crashes held the governments and central banks tongue-tied across the world. But covid made the crash inevitable. With a little correction during covid and for welfare reasons, central banks introduced more relief measures (rightly so) escalating the inflation bubble that was forming. Hence, 2021 was a massive recovery (but misleading considering the weak foundation of the recovery). Ukraine’s war in 2022 and extremely high inflation compelled global central banks to take corrective monetary decisions leading to the much-needed slowdown today. Although banks worldwide are trying to avoid a recession, the recessionary consequences will be felt in my opinion because the economic cycle continues regardless of what one may wish for. All banks can do is try and reduce the impact or the duration of the recession. Now, debt is expensive, stock markets are cautious and hence, IPOs and LBOs are discouraged. But strategic M&A is still in the play for high cash companies but obviously with high caution. Considering this complicated dynamic where the cost of living is increasing but wages are not keeping up pace, and the compulsion to raise interest rates, a recession is highly likely going forward. But as we are all aware, the anticipation is mixed – some believe the world will be able to narrowly escape recession because of marginally increasing GDP while others believe a recession is inevitable. In either case, markets are very cautious and volatile while governments are becoming stricter with regulations. Hence, dealmaking seems to be struggling through at least H1 2024 even if we see some recovery happening in H2 2023.
Now that we have painted the bigger picture, let us dive deeper into the factors of clawing deal activity.
Starting with PE activity, as explained above, most of the PE houses have been relying on cheap debt for investments (LBOs). However, with rising interest rates, debt has become expensive. Usually in an LBO process, PE houses seek debt from various providers including investment banks. But, with slowing activity and a tight budget this year, investment banks are unable to provide the high line of credit they once provided. Bank loans and alternative sources have also become expensive. Apart from that, PE houses which invested by over-leveraging are struggling to generate enough cash flows to pay off the interest on existing debt leading to tensions that the portfolio company may default in repayments. (More on debt and debt sustainability here) Hence, PEs today seem to have shifted focus on fixing their portfolio (exiting where necessary even if the MoM is lower than anticipated in some cases) and investing in high-value, sustainable businesses which are tricky to get hold of (but they are still cheap to buy). The only problem they face is that sellers are not willing to accept the low valuation offers by PEs. But, majorly these factors have completely stunted LBO activity leading to less number of PE transactions.
When it comes to IPOs, H1 2023 witnessed only $63bn worth of IPOs which is way lower than other first halves where IPO activity is generally high. The last slump was seen during 2016. The reason again is simple, investors are still considering the possibility of a recession and hence, anticipating prices to fall in the future. Hence, investors majorly believe that IPOs right now are overpriced. As such, going for an IPO does not make sense if the possibility is high for the price falling than an increase in the months following the IPO. For example, IONOS, a German web hosting group of companies, was listed on the Frankfurt stock exchange in February 2023 and performed poorly (the price fell about 5% after the IPO) clearly proving the negative and cautionary sentiment in the market. On the other hand WE Soda, a world-renowned soda ash producer, also cancelled its London IPO this year. These are only 2 famous examples but there are many such stories out there worldwide. While bankers and companies are holding off till the end of this year, there may be some IPOs coming out in 2024. Will those be enough to flip market sentiment is something to watch.
Strategic M&A (i.e. a company acquiring/merging with another company instead of an investor investing in a company) is also slow-paced because of high caution, complicated takeover procedures due to increased regulation and scrutiny, and budget constraints. A classic example of an M&A stuck in regulatory procedures is the acquisition of Activision Blizzard by Microsoft as detailed in my previous article. There are also many examples of halted or cancelled M&A transactions because of either regulatory complexity or negative market sentiment.
On the positive side, healthcare has emerged as a stable winner during covid as well as in 2023 with many companies able to raise investments and also smoothly execute M&As. Middle Eastern nations, with a high amount of cash and a need for diversification away from oil, are also heavily investing throughout the world, going for IPOs and also executing M&As – rightly so they are grabbing assets for cheap while they can to keep their game up going forward. But these two positivities are not enough to help investment banks.
Major investment banks such as Goldman Sachs, Barclays, JP Morgan, and Credit Suisse (UBS) are a few famous banks which are cutting talent. But boutique banks with niche operations are grabbing the opportunity to hire talented personnel leaving these banks. Nonetheless, the job market is quite intense in banking, especially at junior levels and for MDs with weak client connections. These job cuts are indicating deep budget constraints and the struggle investment banks are facing today. At least until there is no clarity on whether a recession is on the horizon and how long it will last, jobs are going to be tight in the industry. Apart from this, we are also witnessing a change in rankings and activity among major players. For example, KKR which is renowned for executing multiple deals quickly has been overtaken by Brookfield; Goldman Sachs was overtaken by JP Morgan in M&A rankings; boutiques like Centerview Partners have increased activity and ranking higher; Morgan Stanley may rank one step lower in size once HDFC and HDFC Bank in India merge. These examples show a shift in the industry where niche players and companies with risk managed well are outperforming.
To conclude, deal activity has not recovered as anticipated in H1 2023. And the complicated global economic dynamic, with high inflation and high-interest rates, is keeping the markets cautionary of any major turnaround any time soon. It is a tricky situation where old methods of Value Investing, focusing on sustainability and strong cash flows, ethical practices and less reliance on debt are probably paying off. In H2 2023, it is crucial to keep an eye on the pace of strategic M&As which may be a band-aid to the situation for bankers, and following interest rate decisions to time the IPOs on time. Interest rates do not seem to be going down anytime till the end of 2024 and hence, LBOs may still be stunted till the end of 2024.
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