The year 2018 has been a very good one for mergers and acquisitions activity in the U.S. Will global political tensions, trade wars and volatile markets change that trajectory for 2019?
The short answer is no, particularly as regards middle-market and lower middle-market companies.
Compared to year-to-date activity during the third quarter of 2017, domestic M&A activity increased by more than 30 percent during the third quarter of 2018, for a total of $1.67 trillion YTD—the highest U.S. YTD value on record, according to Mergermarket, a company that tracks global M&A activity.
And 2019 could look even better.
“We’ve got significant liquidity that’s on the sidelines, liquidity that is either on the balance sheets of corporations or is capital that’s been raised by the private equity community to invest and put to work,” said Gerry O’Meara, head of M&A at SunTrust Robinson Humphrey. “We still have a lower-growth environment. When you couple that with what is still a constructive debt market, we believe we’re going to see elevated levels of M&A going into 2019.”
Even though global M&A activity slowed during the third quarter of 2018, this year has so far registered the second highest global value on record: $2.72 trillion across 13,575 deals. The highest global M&A value—$2.94 trillion—was posted in 2007.
“From our perspective, business confidence remains very high, which we believe is very constructive for the M&A market,” said George Calfo, managing director at SunTrust Robinson Humphrey. “In terms of volume and strategic conversations and activities, we see continuing momentum going into next year and as far as we can see at this point.”
Here are five trends that are anticipated to influence domestic M&A activity in 2019:
1. Liquidity is driving acquisition demand despite higher interest rates.
“People have been willing to be very aggressive, because the need to deploy capital has sort of overwhelmed a more conservative approach historically,” said Calfo.
In the past economic cycle, many companies used excess capital to repurchase their own shares or pay down debt, O’Meara noted.
Given the current low-growth environment, he added, a number of companies are looking externally to grow via acquisition.
This year’s tax law changes have generally been favorable for corporations, further increasing liquidity.
Calfo acknowledged that rising interest rates impact the math in terms of returns and financing costs, but he doesn’t expect to see a decline in volume in the middle market.
“If there is material movement in valuation, rates or financing, we could see a shift in the general thinking of finance professionals, but we think we’re going to carry good momentum into next year,” he said.
2. Demographics are favoring more M&A activity
Any discussion about M&As should take into account the fact that most private companies in the U.S. are owned and led by baby boomers.
Approximately one-third of baby boomers expect to transition the ownership of their businesses within the next five years, according to a survey of 500 business owners with annual revenue of $5 million to $250 million conducted by Wakefield Research for SunTrust. The majority (77 percent) plan to transition their businesses within the next 10 years.
SunTrust data suggests that many private companies are frequently receiving inbound solicitations from private equity firms and investment banks that want to represent them, said O’Meara.
Almost half (42 percent) of business owners in the survey said they have considered purchase by a private equity firm or a third-party investor as a transition strategy.
Added to the enticement of being solicited by buyers is the lingering impact of the decade-old financial crisis.
“There’s a psychology of folks that survived the financial crisis. What we observe is that the scar has not really gone away,” Calfo explained.
“Frankly, they look at their work horizon and they don’t see the ability or the desire to work another 10 years if we find ourselves in another difficult economic situation.”
3. M&A activity is expected to be healthy across all sectors
According to O’Meara, innovation-heavy sectors like technology and healthcare should continue to see heightened M&A activity because of the many disruptors in those industries.
O’Meara also anticipates across-the-board activity in all sectors because of high levels of liquidity.
“The present business environment favors scale,” Calfo pointed out. “Many of our clients and prospective clients see their supply chains consolidating, they see their customers consolidating and they see their competitors consolidating. They’re asking themselves what all that means for their competitive position. I think across all sectors we’re going to see activity.”
4. Trade wars may eventually impact valuations
The impact of trade wars and new tariffs is very specific to particular industries and companies and their business models, O’Meara noted.
At the same time, most people are paying a lot of attention to the potential for higher input costs and the impact of those costs on their margins.
“Generally speaking, input costs have been relatively benign, although they are starting to increase,” said Calfo. “I was with a company recently, though, which has been impacted by the tariffs and trade war rhetoric. They’ve seen margin degradation throughout the year because steel and other metals are a significant input cost to their manufacturing business. The owners have some concern about whether that margin degradation is going to have a material impact on how prospective buyers view their business.”
There could well be a negative impact on valuations if margin degradations are constant, O’Meara cautioned.
5. Tax reform has been a net positive for M&A activity so far
When 2018 began, there was much debate about whether the new interest deductibility rules would have a chilling effect on M&A activity, and on highly leveraged transactions in particular.
That hasn’t occurred, Calfo said. “We’re still seeing elevated leverage levels relative to history, particularly on good, fast-growing, high-margin businesses,” he said. “We were watching for more negativity, but tax reform has been a net positive for the M&A market.”
Overall, O’Meara anticipates a good year for M&A performance in 2019.
There’s certainly more volatility associated with large transactions, he said, and these are the transactions that generate the headlines. But, he added, the middle market should remain steady, with M&A activity remaining robust.
The bottom line? The combination of plenty of cash that needs to be spent, business confidence and demographics should overcome any wisps of headwinds from trade wars and slowly rising interest rates.