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Record cash reserves and a desire for growth will accelerate M&A in 200624/05/2006. Source: PricewaterhouseCoopers. 
 Private equity and hedge funds will continue giving corporate buyers stiff competition - but concerns remain about 'ripple effect' from automotive's problems, says PricewaterhouseCoopers.
Industry consolidation will intensify in 2006 as corporate and financial buyers move aggressively to take advantage of high cash levels, low interest rates and a wide range of opportunities, according to the Transaction Services group of PricewaterhouseCoopers. That classic M&A formula follows the pattern begun last year when deal activity rose sharply as companies strove to lower costs and build revenue. 2005 witnessed an increase in deal size, as proceeds from deals involving US companies climbed 25 percent from $654 during the first three quarters of 2004 to $817 billion, even as deal volume remained fairly constant.
"Cash available to corporate and financial buyers is at record levels," said Bob Filek, a Transaction Services partner. "What isn't spent on stock buybacks and special dividends will likely go to M&A, as companies struggle to maintain competitiveness in an economy that's still growing fast. Retail, energy, utilities and technology are well-positioned for continued strong M&A activity in 2006 and will attract both strategic and financial buyers."
Filek added, "The only cloud we see at this point is the ripple effect from the possible restructuring of one of the major automotive companies. This would hurt the economy, cause a major economic dislocation--at least in the Midwest--and have a negative impact across a wide range of industries--not just automotive suppliers, which employ a lot of people, but steel, capital goods, healthcare, finance and even consumer durables."
Private equity's share of the domestic M&A market will continue to expand in 2006. Looking back on the past year, Greg Peterson, Americas leader of the TS private equity practice, noted that three powerful trends converged. "First, private equity groups have the clout to compete with large corporations for virtually any deal they want. Second, hedge funds have sufficient pools of capital to initiate, co-invest or compete with private equity funds for deals. And third, the presence--for the first time in this decade--of an IPO market with both the sustained strength and industry diversification necessary to provide a viable exit for portfolio investments, even though direct sales to strategic buyers remain the preferred exit for most private equity investors."
Retail, energy, utilities and technology are particularly well-positioned for sustained M&A activity in 2006, according to Filek and Peterson.
Retail. Big box retail consolidation, already well advanced, will continue to accelerate as smaller competitors struggle to adapt. Private equity will continue to participate, with the twin objectives of capturing strong cash flow and grabbing attractive real estate. Grocery chains are likely to be the focus next year as mid-tier companies struggle to survive in an increasingly competitive environment.
Energy. 2006 could be the biggest year for energy M&A since the late '90s, depending on how companies deploy huge cash reserves from record commodity prices. While integrated oil companies are not likely to do mega-deals until prices settle, independents will begin increasing their acquisition activity, if only because they need bigger balance sheets to offset the risks--both political and geological--of drilling in those parts of the world where opportunities for bigger projects exist. In this price environment, any mega-deal is not likely to be done without simultaneously entering into substantial hedging contracts.
National oil companies--which play by different rules, get financing from their governments, and are not afraid to do deals at current prices--could be the most active players in the mega-deal market, at least until commodity prices move off record highs. M&A in the refining sector could also be active in 2006, as sustained high margins not only trigger possible consolidation among the few pure refining companies remaining, but also continue making the sector attractive to private equity firms and foreign companies interested in buying into the US market.
Utilities. We expect the consolidation of regulated utilities to continue, yielding a small number of "super regional" companies. While corporate deal volume may be low, transaction size should be large. There are several reasons for this:
- The US utility industry remains fragmented, leaving room for consolidation.
- Ongoing "back-to-basics" strategies have yielded companies with strong balance sheets, good credit ratings and predictable cash flows.
- More companies now have the ability to finance acquisitions.
The long awaited repeal of the Public Utility Holding Company Act (PUHCA) finally occurred with the passage of the new Energy Act. A key element of the repeal of PUHCA eliminated the structural barriers that have historically kept non-regulated utilities from investing in the sector. The impact of PUHCA's repeal remains to be seen. State commissions have stepped up their involvement on transactions, with all stakeholders keeping an eye on how pending regulatory actions involving several major utility deals are resolved.
Significant deal activity in power generation will also persist, with private equity and hedge funds continuing to play a major role. Non-gas fired power plants (i.e., coal and nuclear) may fetch a premium leading to increased asset sales in this robust market.
Technology. Corporate spending on technology, anemic since Y2K, is finally rebounding as companies look to replace five-year-old equipment and aging software. Because customers prefer packaged solutions to one-off products, technology companies need scale to remain competitive, and those lacking it are probably good candidates for divestiture or acquisition. Four trends to watch include:
- Enterprise software consolidation arising from changing customer behavior and anticipated platform shifts, along with activity from the sector's two biggest players, as they continue to vie for applications dominance, and strengthen their offerings in key vertical markets like retail and financial services.
- "Going private" deals in software and services as private equity buys mature, out-of-favor businesses with substantial free cash flow and/or restructuring needs.
- Portals purchasing companies that add functionality and broaden their range of advertising-funded services, as competition in interactive media continues to intensify.
- Further consolidation of networking equipment makers as demand increases and data, voice and video communication continues to converge.
Although M&A activity should not pick up significantly over current levels, two other industries worth watching are financial services and healthcare:
Financial services. On all fronts, the new variable is growing private equity interest, particularly in banking and insurance service providers. Although banking deals got off to a slower than expected start in 2005, deal volume picked up in the second half and continues at a healthy pace, thanks to strong earnings from higher interest rates, and the continued strategy of overseas banks to expand their US markets and product offerings.
In insurance, we expect the following trends in each of the three key sectors:
- Property & casualty insurers and reinsurers have sustained significant hurricane losses, but anticipated rate increases have led to robust capital raising and a number of well capitalized startups. Consolidation is questionable.
- Among life insurers, an increase in investment yields and, thus, likely spreads, should fuel improved growth and earnings and a need for raising capital. Consolidation among companies that don't have critical mass in all areas of the business is inevitable, and interest from Canadian and even European investors is a possibility.
- As for agents/brokers, most of the Spitzer-driven activity among wholesale brokers has ended. But acquisition activity among bank agencies continues at a modest pace.
Healthcare. Deal pricing is likely to continue at record levels, given the significant liquidity in the market and the fact that favorable demographic trends, new technologies and a stable reimbursement environment continue to make this sector attractive to investors. Sectors likely to experience strong deal activity include acute care and psychiatric hospitals, home health, hospice, diagnostic services, healthcare information technology and managed care. The one wildcard that could slow the sector down is a regulatory change reducing reimbursement to healthcare service companies.
Other factors influencing M&A activity in 2006 will include:
Cash glut. Cash available for deployment at the S&P 500 and the top 50 private equity firms totaled $1.9 trillion, an increase of $147 billion or 8.5 percent since the end of last year. This reflects strong earnings across industry sectors, as well as successful fund raising efforts by the top private equity firms.
The default rate. With senior debt lending multiples at 4.1x EBITDA, up from 2.4x in 2002, and total lending approaching 6-7 x EBITDA, there's plenty of cash to do acquisitions. Typically, banks won't stop lending until default rates climb, and that hasn't happened. In fact, both charge-off and delinquency rates on commercial loans continue to fall and are at their lowest levels of this decade.
A third class of funds. Historically, hedge funds primarily invested in shorter-term, more liquid exchange-traded opportunities while private equity did private, long-term control deals. But today, firms in each group are entering the traditional domain of the other. Some private equity firms are broadening their investment strategies to include distressed debt and loan origination. And some hedge funds are acting like private equity firms, creating "side pockets" to lock up some of their investors' funds for periods longer than the traditional hedge fund timeframe, or acting as "shadow investors" by purchasing equity at auctions where a member of a private consortium wants out and can't get a bidder at the right price. While we believe these trends will accelerate in 2006, we don't believe private equity and hedge funds will merge. Rather, the result will be a third group of hybrid funds that comprise both liquid and illiquid investments.
More IPOs likely. Big companies will continue to spin off assets to lower debt, reward shareholders and take out cash, while private equity firms will prepare portfolio companies acquired in the last three years for favorable IPO exits. Although the number of non-US IPOs may increase in late 2006, such activity will be nowhere near the highs seen in the late 1990's. Sectors with the most IPO activity are likely to be financial services, technology, energy and biotech. One twist: Look for more private equity-backed IPOs to be pulled in favor of sales to strategic buyers, giving investors a more desirable full exit.
Has China reached a new tipping point? Interest in Asia--especially China--could accelerate in 2006 as the growth in consumerism, access to Internet services, higher education, and high quality products meet continued low labor costs. While Internet and technology companies will lead the way, the trend will begin spreading across industries. Strategic and financial buyers will move in to enhance their presence and make investments related to the 2008 Olympics. But the preferred transaction structure will be a sourcing arrangement or, in some cases, an alliance. Not M&A.
Foreign buyers staying home for the most part. The total value of European acquisitions of US companies more than doubled this year, rising from $29.3 billion in 2004 to $70.0 billion, despite virtually no increase in the number of deals. However, this is still well below the peak of $113.4 billion reached in 2001. European companies and private equity firms remain focused on attractive deals in their domestic markets and across Europe, as demonstrated by the fact that in 2005, Europeans invested more than ten times as much in Europe as in the US.
However, one European industry bucking this trend is aerospace and defense, which will continue to witness an increase in cross-border M&A next year as European companies take advantage of increasing industry globalization, the US defense budget and a favorable exchange rate (for as long as it lasts) to pursue growth strategies focused on US platforms and acquisitions, not only in the defense sector, but also in commercial aerospace. The proposed relaxation of regulatory restrictions on investment in US airlines is likely to trigger investment in this sector.
Asian companies invest seven times as much in other Asian companies as in the US. However, Asian investments in the US, which have grown steadily since 2000, tripled to $45.8 billion in 2005. Chinese companies will continue to pursue US targets that give them access to well-known brands as well as the technology transfer and natural resources they need for continued economic growth.
Peterson believes private equity investors will continue to be aggressive in 2006. "Investors who got active early in the last three-year cycle are in a good position. For them to hold back on deals and not deploy their money could be akin to putting themselves out of business, absent any visible signs that the economy is slowing. Bottom line, if the next three years are robust and you're not invested, you'll miss the boat." Peterson added, "What's striking about the current M&A environment is the level of activity by both financial and strategic buyers across every single major industry group. The only exception, at this point, is automotive suppliers, where even the more aggressive private equity funds have adopted a wait and see stance."
Filek noted that similar catalysts are at work with corporate acquirers. "Looking ahead, 2006 should be a great year for M&A. The combination of high cash reserves, readily available debt, and the imperative to increase revenues while lowering costs is powerful. A comparison with past M&A cycles suggests we should be leaving the richest part of the cycle where the best deals are in terms of returns. Could the 'sweet spot' in this cycle last longer than in earlier ones, given the growth we continue to see in valuations? Assuming no drastic change in monetary policy under new Fed chairman Ben Bernanke, it may. Things are aligned very well right now."
The Transaction Services group of PricewaterhouseCoopers (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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