External Market Impact On M&A

When deciding to sell their business, sellers generally focus mostly, if not entirely, on internal factors. Revenue is growing and predictable. Earnings are improving as a result of increasing revenue and internal controls. Backlog is up. Customer concentration is low. This fictitious company paints a very compelling picture and is no doubt an attractive candidate for acquisition. However, while those are all important aspects and contributors to value, there are other factors that are beyond the seller’s control that not only impact the value of the business but also impact how sellable it is. In this piece, we will discuss some of the external market factors that impact M&A transactions. These factors are in no way comprehensive. The research wasn’t exhaustive. The intent here isn’t to create a definitive list of external influences. Instead, it is to demonstrate how important factors that are well beyond our control impact M&A deals. As a result, sellers should consider moving quickly if the factors within their control are positive.

Interest Rates

Interest rates, while still hovering around historical lows, will rise over the coming 18 months. Why is this important? Buyers, both financial buyers like Private Equity Funds, Independent Sponsors and Family Offices, and strategic acquires alike, use leverage to fund their deals. Many buyers will fund 40-60% of the cash at closing by way of debt in some combination of senior and junior debt instruments. When the cost of debt increases, buyers are faced with two options: 1. Use more equity, either out of their fund or from the corporate balance sheet to fund the transaction; or, 2. Lower the multiple they use to value the company. Given that the cost of debt is far cheaper for most buyers than their cost of equity, they generally favor using as much debt as is practicable. Most Private Equity funds are averse to using more equity and will instead, lower the valuation multiple. Compression of transaction multiples is coming, after a historic run. It is simply a matter of when.

Regulatory Environment

While we are in a much-publicized period of regulatory retrenchment, some industries are facing increased regulation. Many more are facing a changing regulatory environment. Whether there is more regulation or simply shifting regulation, the changes create both risk and uncertainty for buyers. Risk and uncertainty can impact the desirability of a company/industry and certainly can affect valuation.

Global Economic Concerns and Geopolitical Issues

Global economic issues can impact the M&A environment both generally and for specific industries. At the moment, we face a great deal of uncertainty related to trade with our largest trade partner, China. Tariffs are impacting companies across sectors by increasing manufacturing input costs, reducing the speed to market, and decreasing the demand for their products. Unrest in the Middle East, uncertainty in North Korea, Brexit, Russia, and all the alike contribute the geopolitical risks that impact M&A.

Industry Consolidation or Convergence of Industries

Industry consolidation can have a considerable impact on valuations. If you are in a fragmented industry that is in the early days of consolidation, this can have a very positive impact on the value of your business. However, if that consolidation began years ago, you may have missed the window. That doesn’t mean you can’t sell your business, but it will be more difficult to identify the buyer and may have an impact on valuation. The same can be said when industries converge. For example, the manufacturing and technology sectors have converged. Convergence of industries, depending upon where we are in that cycle, can create either risk or opportunity.

Changes in the Workforce Dynamics/Millennials/Gig Economy

The ready availability of a talented workforce can significantly impact industries and businesses. Due to workers having very little switching costs to move from one company or industry to another, construction and landscaping businesses have found it increasingly difficult to attract and retain talent. Specific industries that require talent to be aggregated in the same room for the entire workday face different challenges. The Great Recession, coupled with a generation of workers that place a premium on their time, has led to an enormous gig economy. It is not out of the question that the gig workforce overtakes the traditional workforce in the next decade. This shift will impact every business in ways we couldn’t possibly understand yet.

Political Trends and Risk/Elections

The constantly changing domestic political landscape impacts the M&A environment in numerous ways. We have uncertainty around healthcare. Any provider of healthcare or any business dependent upon reimbursement faces at least a measure of uncertainty. Immigration has become a hot button issue in the US. Wherever you fall on the issue, there is little doubt that American businesses rely on non-citizens to supplement the citizen workforce. Buying decisions are often postponed with looming elections. Tax planning is difficult when an administration change could entirely change the tax code…again. Political unrest creates uncertainty. Uncertainty is interpreted by buyers as being the equivalent of risk and manifests itself in the form of lower multiples.

Dry Powder in PE Funds/Excess Cash on Corporate Balance Sheets

An economy on an unprecedented run of success has created enormous cash reserves in the corporate coffers. Strong performance by private equity funds has made raising subsequent funds easier. Also, outsized multiples have reduced the number of investments many PE funds have made, so they too have tremendous stores of dry powder to deploy. Abundance of capital to deploy into transactions certainly should help with valuations. PE funds, in particular, have only one mandate: buy businesses, grow them, and sell them 3-5 years later for a meaningful return. As such, there is no risk of them using their capital for other projects. The same can’t be said, however, for strategic acquirers. Corporations have many competing uses of their cash. If the environment for M&A turns unfavorably, businesses may pursue growth through organic initiatives. For example, they may opt to forego M&A deals in favor of greenfielding new territories, launching new products, building out new technologies, or exploring alternative revenue models. Alternatively, some may view the best use of their cash is to distribute it out to owners in the form of a dividend.

In summary, there are many outside influencers on the M&A market that simply cannot be controlled. While companies can put mitigation strategies in place, they cannot exert control over external market forces. When the key factors within a potential seller’s control are favorable, it behooves them to seek out a talented M&A advisor, like one from Benchmark International, to assist them. We can help them to ride the tailwinds, overcome the headwinds, and navigate the obstacles.

Author
Dara Shareef  
Managing Partner
Benchmark International

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