Public M&A – resilient in a time of stress?
Public M&A activity would normally be expected to track the rest of the global transactions market and therefore be experiencing a period of slow down. But evidence from the U.S., the UK and Germany suggests that the public market might prove more resilient.
Public M&A activity in the year to date certainly appears to be experiencing a period of slow down similar to the cooling-off we are witnessing in other parts of the global transactions market.
Volume of public company acquisitions is down by some 14% in the year to date (according to data from Refinitiv), while values are down by around 15%. The larger deals have helped to sustain values, while the biggest activity drop is in the middle market, which is in line with the rest of the transactions market. The market in the first part of the year has perhaps been flattered by a small number of high value deals, particularly in the U.S., but the number of deals is generally down.
But we believe a range of different factors might be providing support to public M&A deals and that there is a good chance that deal activity will continue amidst wider uncertainty in the market, particularly if the increase in private capital being deployed in public markets continues at the pace we are seeing in 2019.
Public M&A powerhouse
The U.S. market remains the powerhouse for public M&A and transactions there are continuing at a measured pace, even if we are no longer seeing the frenetic activity of recent years.
Towards the end of 2018, investor nerves did appear to have been shaken as the Federal Reserve looked poised to push ahead with a programme of incremental increases in interest rates throughout 2019. With the Fed eventually deciding to change tack and keep rates at their still relatively low level, confidence returned to the market.
Confidence has remained despite the political dramas dominating the headlines. Neither the machinations of partisan domestic politics, nor rising trade tensions between the U.S. and China, have so far sent M&A or equity markets off course.
Dealmakers have remained focused on the fundamentals, and principally on the business of achieving growth. At a time when economic growth has been running at an average of around 3%, many companies are hard pressed to justify the multiples at which their shares are trading based solely on expectations of organic growth. Many are therefore prepared to do acquisitions to achieve faster growth, with the encouragement of shareholders.
We’ve seen a clear example of this in the Anadarko situation, the shale gas company with valuable interests in the Permian Basin of West Texas and New Mexico.
Here Occidental, the oil and gas group, stepped in to top an agreed bid by its much larger rival, Chevron, with a giant USD38bn offer. Its offer won crucial backing from Warren Buffett’s Berkshire Hathaway group, which agreed to inject USD10bn into Occidental. It was also helped by an agreement from France’s Total to buy Anadarko’s African assets for USD8.8bn from Occidental, should the deal go through.
It is the sort of deal that we have not seen in recent years in the oil sector. But more widely it is evidence that buyers are still finding it possible to finance significant transactions, often in innovative ways, if the deal looks right.
M&A Insights | Q1 2019 download
Commentators have wondered for some time when the deal market would end its record-breaking bull run. The question is whether the latest data marks that turning point or a temporary pause for breath before the market picks up again.
Financial investors finding opportunities in public markets
Although deal volumes are down, public M&A transactions in the UK have continued, helped at the back end of 2018 by a dip in share prices that may have prompted a number of opportunistic moves. Although those losses have largely been reversed in 2019, some commentators believe that the UK market remains undervalued by comparison to other developed markets, particularly the U.S.
There have been signs that private equity and other financial investors are replacing corporate buyers of public companies to some extent, with these deals accounting for a larger share of the market than historically. Strategic acquirers continue to dominate the U.S. market, but financial buyers are playing an increasingly high profile role in public takeovers in both the UK and Germany. It is not PE funds alone; pension and sovereign wealth funds are also getting in on the action. With a broader range of investors interested in doing public transactions, we think this will also help to sustain activity in the months ahead.
Debt markets are a little tighter than in recent years. Nevertheless deals in key sectors – notably technology and life sciences – can still get readily funded, although in more challenged sectors, such as the retail sector, it is proving noticeably more difficult.
While Germany has fewer listed companies by dollar of GDP than either the U.S. or the UK – and, therefore, fewer targets - the public market has remained consistently active in the last two years and that continues, fuelled by high levels of accumulated corporate and PE cash.
As stock markets declined in the fourth quarter, commentators predicted that Germany would see a wave of take private deals by financial investors. However, the recovery of share prices in March and April has put those predictions in doubt for the moment, as we have seen with efforts by Blackstone and Hellman & Friedman to take Scout24, the digital classified advertising platform, private in a EUR5.7bn deal.
Here, investors seemed supportive of the offer when it was launched in February, pitched at an attractive 30% premium. The company’s shares have remained closely pinned to that offer price. But as stock markets recovered, the deal looked increasingly undervalued when compared with the growing market value of companies in the same index as Scout24.
Eventually, investors decided they would rather stay invested to see if there was further upside under the current management and, with the two funds unable to garner the necessary 50% acceptances, the offer failed in May.
Other deals have gone a similar way in recent months but it remains to be seen if this will become a persistent trend. Much will depend on how equity markets fare in months ahead.
However, with financial buyers having amassed huge amounts of capital, and looking to raise significant further funds this year, their appetite to take on bigger and far more complex deals seems to be growing. It is likely that competition for assets will only become more intense, although we would not be surprised to see funds clubbing together to take on even larger transactions.
China: the internationalisation of A shares continues
In China, we have seen a series of regulatory actions by China’s securities regulator, the China Securities Regulatory Commission (CSRC), following the appointment of a new chairman, Mr Yi Huiman. These regulatory developments aimed to boost the internationalisation of A shares and widen the access of foreign investors in the A-share market. It has been widely reported in the press that the global index provider MSCI is quadrupling the weighting of Chinese A shares in 2019, which may represent more than US80bn of foreign capital inflows to the A share market. Earlier this year, China also doubled the QFII quota (Qualified Foreign Institution Investor) to US300bn, paving the way for foreign investors to increase their exposure to A-shares.
But perhaps the regulatory development that will lead to the most significant impact on public M&A in China is the recent change in PRC law that removed an approval requirement (which historically had been difficult and burdensome to obtain), and eased investment by strategic investors in listed A share companies. A few transactions have been launched and completed by foreign investors under this new regulatory regime, which can serve as an example that public M&A transactions by foreign investors are much easier to implement under this new regulatory regime.
Further regulatory changes from CSRC are also expected, including a change in regulation to reduce the lock-up period from 36 months to 12 months.
Focus on national security and regulatory intervention
While investors remain relatively sanguine about the uncertain geo-political environment, national security issues increasingly affect the M&A market.
We see this most obviously in the U.S. where the scope of the review process by the Committee on Foreign Investment in the U.S. (CFIUS) has been broadened from its initial focus on foreign acquisitions of defence-related companies and assets. As the economy becomes increasingly digitalised, CFIUS reviews are now looking at a much wider range of deals, mostly in the digital sphere, with a focus on communications, technology, data and privacy issues.
That has been intensified with President Donald Trump’s recent executive order declaring a national emergency around foreign participation in the U.S communications infrastructure, an edict widely seen as being primarily aimed at curbing the involvement of Huawei, the Chinese telecoms giant, in the construction of next generation 5G mobile networks.
But increased CFIUS scrutiny of investment in the U.S. is having another effect other than making it much harder for Chinese buyers to do deals. It is opening the doors to other acquirers from other countries, who see an opportunity to make headway because they are seen as a safer bet from a CFIUS point of view.
A growing focus on national security is by no means just a U.S. phenomenon. Tighter rules are being applied (or are under discussion) in a wide range of jurisdictions.
New EU foreign investment legislation adopted in March 2019 and applying from 11 October 2020 marks the first time that the supra-national body has taken a co-ordinated approach to the vetting of investment from outside the EU on security and public order grounds across EU Member States. It represents a significant moment in the development of mergers and acquisitions vetting in the EU.
The EU has drawn up a very long yet non-exhaustive list of areas where investment might pose a threat to security or public order. They include critical infrastructure, critical technologies and dual-use items, supply of critical commodities (including energy, raw materials and food), access to or control over sensitive information (including personal data) and the freedom and pluralism of the media. In practice this means that no transaction or sector is automatically excluded from the scope of the new Regulation.
In addition, Member States are explicitly allowed to take into account whether an investor is controlled, either directly or indirectly, by a foreign government.
The UK has already boosted the government’s scope for intervening in takeovers in certain sectors (military/dual use products, computer processing units and quantum technology) and is in the later stages of consulting on significant further reforms that would allow it to ‘call in’ more transactions across a much broader range of sectors. Although this activity is not proving a disincentive to dealmakers currently, many are certainly having to think hard from the outset about how they will proactively manage any political intervention, not only about national security concerns where the UK Government may have formal rights to intervene, but also around issues such as the loss of R&D facilities and high value jobs and skills where political scrutiny, and possibly a request for firm commitments under the UK Takeover Code, can be expected. With the prospect of parallel UK and EU competition reviews on the horizon post (hard) Brexit, a holistic approach to managing merger control risk may be more important than ever over the coming years.
The German government has also exercised its powers – once again mostly focusing on Chinese investment – issuing the first prohibition of a proposed deal in 2018 and more recently moving in KfW, the development bank, to prevent a Chinese bidder from taking control of part of the German high-voltage power grid.
Growth opportunities in a declining market
Concerns about a slowdown in global growth generally, and in Europe in particular, do not yet appear to have significantly dented the confidence of dealmakers in either the UK or Germany. Even the prospect of a chaotic hard Brexit has not prevented deals being done. Indeed, there is a chance that if sterling comes under further pressure in the coming months this could create further opportunities for acquirers as UK assets become cheaper.
We may also see more competitive and hostile activity. Deals could become hostile if the target board considers the approach opportunistic, or they may become competitive if others recognise it as an opportunity as well. A number of recent UK public bids have been competitive, not least the takeover of the packaging group, RPC, the takeover of Earthport, the cross-border payments company, which provoked a bidding war between Mastercard and Visa, and more recently the takeover of KCOM.
Bidders also remain willing to take on transactions despite increased regulatory complexity. In the UK, for instance, acquirers in both big-ticket and mid-market transactions are showing a greater awareness of the need to prepare from the outset for greater regulatory intervention.
Another factor driving public deals is the move by big industrial groups and financial institutions away from conglomeration, with a growing number of businesses seeking to spin off and list businesses no longer seen as core.
That’s a particular trend in Germany. Siemens, as part of an ongoing break up of the mighty conglomerate, last year spun off its health equipment arm and is now looking to float its power business as a separate company.
Deutsche Bank has also floated its DWS asset management arm. And while the troubled industrial group, ThyssenKrupp, has just abandoned long-mooted plans to hive off its steel operations, it is still pursuing a float of its elevator operations, its most successful business, as it reassesses its strategy.
As acquirers assess potential public targets, in the months ahead, the onus will be on them to prepare carefully for any regulatory hurdles they may face and to pitch their offers at the right level at the outset of a deal. Target boards will find it hard not to engage with a bidder who sets a 30-40% premium, especially if market conditions show signs of deteriorating.
It would be unrealistic to think that public takeover activity is immune to the pressures on M&A transactions more generally.
However, whilst we don’t expect to see an explosion of public M&A activity, there are enough reasons to believe that activity in this part of the market will remain robust in the months ahead.