The closing year began with greater optimism, as corporations and private equity (PE) firms had significant cash on hand and credit became increasingly more available. However, corporations moved cautiously, and a lack of confidence and clarity delayed them from entering the market in a more robust way, according to the consulting firm.
Global M&A activity, which trended downward during the first half of 2010, saw a slight resurgence in the third quarter when four of the year's ten top deals were announced. This was followed by a slow fourth quarter as European sovereign debt concerns deepened, driving down the value of Europe-bound deals to a five year low, the Wall Street Journal reported, putting a drag on global M&A. Overall, there has been a slight recovery led by PE and emerging market deals.
"The past year was characterized by a two-speed recovery, with momentum building in emerging markets versus limited deal activity in developed markets," says Richard Jeanneret (LinkedIn), Americas vice chair for Ernst & Young Transaction Advisory Services. He noted that emerging markets witnessed a surge in M&A activity in 2010, with inbound and outbound BRIC (Brazil, Russia, India and China) deal value reaching almost $372 billion by the middle of this month, up more than 46 percent over 2009.
The Year PE Staged a Comeback
Private equity rebounded this year with acquisition activity recovering off of 2009 lows. By mid-December, PE firms had announced 1,778 deals valued at $196 billion. Improved credit conditions have fueled an increase in deal activity, evidenced by increasing buyouts of larger transaction sizes as 2010 unfolded.
Banks are more willing to lend in this environment, and there appears to be a fairly robust market for new deal financings and re-financings, according to E&Y. High yield debt is providing a viable financing alternative, as the market, particularly in the US, is at record issuance levels.
Exits from portfolio companies are clearly a focus, since PE firms faced limited selling opportunities in 2008 and 2009. The IPO market was receptive for PE backed companies in 2010, and firms took advantage of the opportunity as listings increased. However, a number of these listings were a de-leveraging event with an objective of adjusting capital structures too heavily weighted with debt.
The IPO market remains an alternative for exit, however in recent months getting to the finish line was more difficult and uncertain. With some of PE's highest profile buyouts from 2006-07 on the "auction block," Ernst & Young expects to see a number of PE-backed listings in 2011. Secondary transactions represented a large portion of exits during the year, a trend the consultancy expects to continue as firms look to sell businesses held longer than the average holding period, with other PE funds hungry for deals.
Results from a soon to be released Ernst & Young study found that the strategies PE firms utilize to achieve outsized returns have remained consistent, even in the face of recent economic challenges.
"Top performers stayed true to the PE model — backing the right management team, aligning incentives and driving operational excellence exemplified by the use of such tools as '100-day plans,'" said Jeffrey Bunder, Ernst & Young's global private equity leader. "A continued laser-like focus on operational improvements during the downturn resulted in increased exits in 2010, a trend we expect will continue in 2011."
This year also ushered in significant changes in the regulatory and tax landscape that had implications for PE. New regulations passed in the US and Europe (Dodd Frank Act and AIFM Directive, respectively) will require an increased focus on fund operations, coinciding with an increase in demands for transparency by limited partners. The global tax landscape remains challenging as well. As jurisdictions tackle growing deficits, they are inclined to alter corporate tax rules in an effort to increase revenues locally.
Fund-raising remains difficult and the number of firms marketing new funds continues to grow. Ernst & Young said that 2011 will probably be characterized as a race for capital commitments.
The consultancy expects continued momentum in PE into 2011. While sovereign debt issues in Europe and broader concerns about the global economic recovery represent substantial headwinds, a number of factors will continue to drive acquisition and exit activity for PE. Dry powder — reported to be in excess of $436 billion — availability of leveraged financing, increasing valuations, attractive opportunities in the emerging markets, and the need to exit portfolio investments will all provide the platform for a robust 2011 for PE, Ernst & Young said.
"As companies emerge from the financial crisis having cut costs significantly, a focus on growth has returned," says Steve Krouskos, global and Americas markets leader for Ernst & Young Transaction Advisory Services. "The first step is a renewed focus on organic growth, the second step is acquisitions. All the fundamentals are there. Confidence just needs to return."
Already, unsolicited bids are picking up, totaling 8 percent of global M&A in 2010, the highest percentage in over 10 years. "This is perhaps an indication of early stages of an M&A market recovery providing significant opportunities for those looking to drive growth," says Krouskos.
Cash, Credit and Confidence
Other factors at work in the current market include:
Cash — Fortune 1000 companies have $1.9 trillion in cash on hand, an increase of almost $600 billion since before the economic downturn three years ago.
Credit — In an Ernst & Young survey, over half (58 percent) said credit/capital conditions were better now than six months ago. Access to capital to fund deals has also improved. A third of respondents (36 percent) state that access to funding is not a problem for their companies, compared to 26 percent in April of this year.
Confidence — Confidence, a key driver of M&A, remains shaky, however. Only 41 percent of companies are planning on making an acquisition over the next six to 12 months, down from 57 percent in April of 2010. In the longer term, M&A is on the corporate agenda, with the majority of companies (54 percent) planning to do deals in the next one to two years.
"Confidence has been the primary restraining factor in deal activity over the past year," said Jeanneret. "Investors face uncertainty stemming from regulatory changes, austerity measures, unemployment, fears of inflation and European fiscal woes. Confidence and clarity are the missing pieces of the puzzle. Cash is burning a hole in the proverbial corporate pocket. But confidence and a lack of clarity on these issues are lagging, and economic uncertainty is holding M&A activity back."
In addition, Ernst & Young said that the new transactions landscape is defined by the following factors:
A Focus on Organic Growth — Economic uncertainty has led more companies to grow their businesses organically and in some cases temporarily put M&A on the back burner until confidence returns. An Ernst & Young survey revealed that 75 percent of companies are now more focused on organic growth as their capital allocation priority, compared to 66 percent six months ago.
Fewer "Do-or-die" Transactions — M&A in 2011 will be less focused on the urgent need to unbridle underperforming or noncore assets, and more about strategic deals. The number of bargain-basement deals will decline as valuation multiples have improved throughout the year. Corporations find themselves on firmer footing and more focused on strategic, carefully planned and executed transactions.
"One Foot on the Accelerator, One Foot on the Brake" — Boardrooms are cautious right now, but paradoxically 50 percent of companies are ready to execute an acquisition at short notice — up from 36 percent a year ago. Corporations are much more confident that when the time comes, they can get a deal done better and faster.
"We are seeing a new level of preparedness among corporates," said Jeanneret. "It's a function of sitting on the sidelines for so long, patiently watching the market, knowing where the values lie and having access to cash and credit. There is a lot of pent-up demand. Corporates have one foot on the accelerator and one foot on the brake looking for strategic fit when the time is right."
The Central Bank of Brazil predicts GDP to grow more than 7 percent this year and almost 6 percent in 2011. Two key sectors that are appearing on investors' radar screens are energy and infrastructure.
Since Petrobras announced in 2008 that it had found a new oil deposit that could contain more than 50 billion barrels of oil, several more finds have emerged, and oil exploration potential offshore Brazil presents a huge opportunity. Under phase two of Brazil's Growth Acceleration Program (PAC 2), the government has announced $526 billion in public and private investments over 2011-2014. These investments will focus on logistics, energy and social development. The plan has a special focus on developing Brazil's infrastructure.
In recent months Brazil's infrastructure spending needs have stepped up to another level thanks to successful bids to host the 2014 World Cup and the 2016 Olympics. Brazil's need for hotels, stadiums, airports and supportive transport routes just scratch the surface of upcoming infrastructure demand. Some analysts estimate that up to $85 billion will need to be spent on Brazilian infrastructure in the next three years. Brazilian companies could be on the crest of a wave of economic growth generated by these opportunities as well as the developing middle class' purchasing power. Companies not only in the oil and gas industry but also those in civil construction, mining, iron and steel works stand to benefit.
The Chinese economy continued to be strong. The World Bank's forecasted GDP growth for 2010 is expected to be about 10 percent. This reflected the continued strength of the domestic consumer and the government stimulus package to promote infrastructure and investment in the Western provinces.
The availability of liquidity continued and has resulted in strong levels of M&A activity domestically (around $57.5 billion in deal value and 1,450 deals announced in 2010 as of mid-December). The global shift in capital flow is visible in the significant rise in overseas investment by Chinese companies with over $17 billion in outbound deal value announced by the middle of the month, up from almost $15 billion in 2009. Brazil is a target of significant interest.
Foreign direct investment (FDI) is predicted to reach a new record level, although much of the FDI in 2010 included greenfield investments in addition to traditional M&A investments, a large part of which includes joint ventures with Chinese companies.
In response to regulatory changes and industry pressures, certain sectors experienced high levels of M&A activity in 2010.
Technology — Technology M&A has reached $121 billion in 2010 as of December 1, almost in line with 2009 levels. Deal activity was buoyed by cross-border M&A and a resurgence of PE activity. Strategic business initiatives — driven by trends such as the global shift to a smart economy, increasing demand for smart mobility, and the blurring of industry boundaries — are expected to continue to sustain the growth trajectory for global technology M&A.
"In technology, look for companies to continue to make strategic deals, and in some cases multiple deals in a short period of time, as they seek to take advantage of evolving trends and new technologies," said Joe Steger, global technology leader for Ernst & Young Transaction Advisory Services. "Growing demand for connectivity and real-time access to actionable information over mobile devices is transforming the sector and propelling the globalization and convergence of technology platforms with other industries, spurring deal activity."
Energy — A bright spot in the M&A landscape, almost $253 billion in global energy deals were announced in 2010 as of December 1, 2010 — already 27 percent higher than 2009, making 2010 one of the most active years for energy transaction volume since 1998, according to Thomson Reuters .
"Continued loosening of credit markets and strong oil prices have driven a clear uptick in upstream transactions over the past year," said Jon McCarter, oil and gas leader for Ernst & Young LLP's Transaction Advisory Services.
In addition, new drilling techniques have pushed down the cost of natural gas and electricity. With prices depressed, investors are looking for gas plays with high liquid content, and stronger players in the power and utilities space are looking to take advantage of lower valuations to acquire weaker players, driving a spurt of activity in the space.
Ongoing regulatory and legislative uncertainty has potential to slow the pace of negotiations, although this sector will continue to see a robust level of activity into 2011.
Healthcare — In 2010 M&A activity in the healthcare sector accelerated. Deal value climbed more than 150 percent to $86 billion through December 1, versus the previous full calendar year. This increase was driven by private equity and relatively available and affordable financing in this space. There has been activity in virtually all subsectors of healthcare, including hospitals, physician practices, home health and hospice, and managed care.
Healthcare reform has also been a major deal driver and should continue to drive activity in 2011. Investors are looking for targets that will benefit from increased volumes of insured patients with limited direct reimbursement/pricing pressure and companies that improve quality or reduce costs of health care delivery.
"We expect to see more auctions in the healthcare sector, as competition for quality targets is increasing. We also expect continued PE activity, with PE firms using portfolio companies to make acquisitions or partnering with corporates in transactions to gain valuation advantages through synergy opportunities," said Chip Clark from TAS' healthcare sector.
Financial Services — Over $173 billion in financial services M&A has been announced in 2010. As of December 1, this is almost 4 percent above the total volume of announced M&A in 2009.
"Uncertainty over Dodd-Frank legislation could suppress M&A volume in the near term. But once implementation begins, both divestitures and acquisitions are expected to pick-up in the financial services area as the various sector participants pursue changing strategic business models," says Nadine Mirchandani, global asset management sector leader for TAS.
Ernst & Young concludes that as the year comes to a close, the tailwinds are forming that will propel leading companies back into the market in 2011, realizing opportunities for "game-changing" strategic deals. The emerging winners will be those that drive long-term growth through innovation, globalization and an entrepreneurial mindset, E&Y believes.
"Companies are lining up on the runway with engines revving," said Krouskos. "With record-breaking levels of cash on hand and confidence slowly returning to the markets, we expect to see deal activity continue to increase in 2011, albeit in a moderate, targeted way.