PricewaterhouseCoopers Forecast: M&A Market Heats Up
Automotive, retail, utilities, energy and healthcare seen as the hottest sectors. Financial services heating up after a slow first half.
NEW YORK, July 5 -- Corporate M&A activity will remain strong during the second half of 2005 as companies seek growth through acquisitions in consolidating industries such as automotive, retail, utilities, energy, healthcare and financial services according to the Transaction Services group of PricewaterhouseCoopers. However, the combination of a stalled junk bond market and potentially higher interest rates could pose a problem later in the year.
"Without a doubt, U.S. corporations plan to continue their rapid pace of acquisitions," said Bob Filek, a PwC Transaction Services partner. "Sectors that have had strong stock appreciation are bullish, and feel a need to sustain their growth levels through acquisitions. Look for these companies to use their stock as currency. Deal multiples and premiums paid thus far are not excessive, given where we are in the cycle." Filek notes, "While U.S. buyers are primarily focusing on domestic targets, Chinese companies are watching the U.S. too, and are beginning to make offers for U.S. companies with strong brand names and assets."
Greg Peterson, Americas leader of the TS private equity practice, noted that private equity firms remain active in the U.S. market, competing successfully on large, high profile deals that were once the sole province of major corporations. "Going forward, the targets won't necessarily be carve- outs of large multinationals. The big funds will pair up to take the whole company private, as is already happening with SunGard and the proposed Neiman- Marcus transaction."
Unlike corporations, private equity funds are doing more cross-border transactions, with virtually all the major firms setting up shop not only in Europe, but also in Asia. "We're seeing some differences in how corporations and private equity firms approach the Asian market," Peterson observed. "Instead of looking for least-cost manufacturing, private equity firms are assessing whether an Asian business can stand on its own and are asking themselves, 'What industries and companies are likely to dominate going forward, and where will people spend their new discretionary income?'"
Reflecting their newfound status as global players in the M&A market, private equity firms are going wherever they see the best opportunities, regardless of where they're based. "Deals are being financed on a global basis, with credit and underwriting risks and yield curves becoming more homogeneous around the world. You can see this in the industry statistics. Four years ago, private equity transactions represented only about 13 percent of domestic M&A value. Today it's over 20 percent and growing, with multibillion dollar deals becoming more commonplace," Peterson added.
Increasingly, private equity has access to non-U.S. financing, and many firms already have, or are creating, captive sources of mezzanine financing. "We anticipate the bigger-is-better investment strategy of the major funds to continue, at least so long as financing options remain strong," Peterson said. At the same time, hedge funds are increasingly playing all along the capital structure continuum, competing with private equity for control positions on some deals, making pure arbitrage plays, and contributing to -- or taking advantage of -- volatility through increased participation in public markets.
Filek and Peterson predict M&A activity in six sectors will remain active for the balance of the year:
* Automotive's ripple effect. One of the bigger stories behind the well-
publicized problems at U.S. automakers is the effect sluggish sales of
their cars will have on suppliers of platforms and parts. While Tier 1
and especially Tier 2 suppliers have been consolidating for some time,
the carmakers' credit crunch could accelerate this trend, leading to
more distress sales and restructurings. This presents an opportunity
for private equity firms with a proven record for taking the costs out
of automotive companies.
* Shopping for bargains in retail. Although the pace of dealmaking may
cool a bit, retailing will continue to be a hot sector for private
equity due largely to its inherent value as a real estate play, rather
than its fundamentals. The goal is to cut costs as rapidly as possible,
leverage the value of the real estate, and find a way to exit, without
diminishing the customer's shopping experience.
* Hitting oil on Wall Street. Big Oil's inventory of international
development projects may enable it to delay replacing reserves and
instead spend its cash flow on dividends and buybacks. But independents
will return to the M&A market because they need reserves and can't count
on growth by the drill bit. And since it currently costs
$8.50-$9.00/bbl to buy reserves on Wall Street through acquisitions,
versus in excess of $10/bbl. to grow through exploration, the economics
are attractive.
* Power and utilities will continue to consolidate. Since organic growth
averages only about 2 percent a year, while Wall Street expects 5 to 6
percent, companies are looking to buy additional synergies and
customers; cost cutting and rate increases will get them only so far.
We expect to see "super regional" consolidation continue in the second
half, as management looks for transactions that are immediately
accretive to earnings, do not damage their credit, and offer synergies
that benefit both customers and shareholders.
We do not expect a rush among private equity firms to acquire regulated
utilities. But private equity will play in unregulated and merchant
sectors, and bid on the assets that regulators require merging utilities
to shed.
Passage of the proposed energy bill, which would repeal PUHCA (Public
Utility Holding Company Act), should bring clarity to the renewables and
wholesale electric markets. The repeal of PUHCA, which places certain
limits on the acquisition of regulated utilities, may spark further
consolidation, the entry of foreign buyers, and the use of non-
traditional financing. It should also change the role of state
regulators.
* Financial services begins heating up. This follows a slow first half,
largely attributable to temporal issues such as Sarbanes-Oxley
implementation, a higher-than-usual level of regulatory scrutiny, and
acquisitive companies digesting recent deals. In banking, recent
transactions such as the Legg Mason/Citigroup business swap, Capital
One's acquisition of Hibernia, and Washington Mutual's acquisition of
Providian reflect this pick-up. The long-term strategic desire among
U.S. and overseas banks to diversify their geographical markets and
products will continue to drive U.S. bank transactions in the second
half.
In insurance, we see three main trends: (i) the broker/agent segment
will be active as major insurance brokers look to exit certain wholesale
businesses that have been the subject of government investigations, (ii)
foreign owners will continue to shed U.S. businesses and invest the
proceeds in Europe and Asia which offer the prospect of better returns,
and (iii) private equity will make its presence felt on mid-sized life
and property and casualty deals, especially those offering the
opportunity to become a strong niche player. Although we do not expect
activity from the start-ups created in the wake of 9-11, these companies
will become a factor in 18 to 36 months, regardless of whether they
consolidate, exit the business, or recapitalize.
* Healthcare M&A expected to continue at a strong pace. Significant
interest from private equity coupled with corporations making strategic
acquisitions to meet growth objectives is driving this activity.
Demographics, growth in government healthcare spending, and continuous
technology improvements are creating new investment opportunities with
attractive return potential. Hot sectors include Medicare managed care,
home health, disease management, information technology and specialty
pharma.
Filek and Peterson believe financing remains the M&A wildcard for the rest of the year:
* OK, for now, but ... The junk bond market has weakened since the end of
last year, and the downgrades of U.S. automaker debt have caused further
dislocation as the market tries to adjust. Commercial lenders and
mezzanine funds have picked up the slack so far, and their willingness
to put money to work has supplied sufficient fuel to drive M&A momentum
this summer, according to Filek. That said, private equity firms are
keeping close tabs on this market. Concern over the flattening yield
curve and the possibility that long term rates will eventually rise
might cause banks to pull back from their aggressive stance on
acquisition finance. That would take the momentum out of the M&A
market, particularly for private equity investors.
* Enter the hedge fund. The wildcard in the U.S. M&A market is the hedge
fund. It remains to be seen how much impact these funds will have on
the broader acquisitions market, just as it was hard to predict how
mega-buyout funds would affect the market when they debuted in the late
1980s and early 1990s. Hedge funds clearly have lots of capital and are
willing to deploy it aggressively. In fact, some suggest their
increased participation in the high yield market has contributed to its
increased volatility.
But will hedge funds be comfortable with "less-liquid" investments, and
do they have sufficient appetite for the pre- and post-deal spade work
necessary to become a successful corporate owner? Or are they still
primarily in arbitrage, offering to buy a company in which they have an
interest primarily to spike the value of that interest?
* The Sarbanes-Oxley factor. As the first year for Section 404 compliance
draws to an end, expect more deals to close in the first quarter of
2006, rather than on December 31, 2005. Sarbanes has not appreciably
slowed the pace of deals or significantly delayed their closing.
However, Sarbanes compliance can affect the value of a target and the
amount of time a buyer has to remediate and report on an acquisition.
Section 404 (which holds management responsible for internal financial
reporting controls) may also affect the number of IPOs as companies
delay going public until they are more established and have the
resources to meet Section 404 requirements. This may already have
occurred in Q1 '05 when the number of IPOs was flat compared to the
previous year, but their average value was up 25 percent. This
contrasts sharply with the IPO boom of the late '90s when many small
companies went public regardless of their structure or control
environment.
The availability of acquisition financing is subject to many unknowns. As Filek noted, "What would happen if several more major corporations descend into junk status? What would happen if the Fed raised short-term interest rates above the 10-year Treasury? What would happen if another large hedge fund discovers it's harder to get out of an illiquid acquisition than an arbitrage play? Any one of these factors could choke off M&A financing for a brief period."
The Transaction Services group of PricewaterhouseCoopers
( http://www.pwc.com/ustransactionservices ) offers a deal process that helps clients bid smarter, close faster, and realize profits sooner on mergers, acquisitions, sales and financing transactions. Dedicated deal teams operate from 16 U.S. cities and some 90 locations in North America, Latin America, Europe and Asia.
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