2022 M&A Outlook

 

NOTE: THIS BLOG IS NOT FINANCIAL ADVICE NOR INVESTMENT ADVICE AND DOES NOT REFLECT THE VIEW OR OPINIONS OF MY EMPLOYER

January 1st, 2022

2021 was another year filled with uncertainty, rapid developments, and volatility in daily life and financial markets. As of December 26^th, 2021, there were 279.8 million (mm) global cases of COVID-19, which is up approximately 236% from this time last year. With 5.4mm deaths, which is up approximately 198% from this time last year. The mortality rate was roughly 2.2% in 2020 and 1.9% in 2021.¹ The recent Omicron variant (SARS-CoV-2) which was first discovered in South Africa on November 24^th, 2021, has been the major new discovery that is causing renewed apprehensiveness. We know this variant has been found in 90+ countries and was responsible for 73% of all new infections in the United States by December 18^th, 2021. Additionally, the new variant is estimated to spread 2-3x faster than the Delta variant, however, preliminary studies have found that Omicron cases are less likely to lead to hospitalization compared to the delta variant.² Individuals are being encouraged to continue to get vaccinated and get additional booster shots to protect from Omicron and other COVID-19 variants. Currently, there are approximately 4.5Bn individuals vaccinated which represents 56.5% of the global population.^1,3One of the persisting issues is that emerging market countries aren’t getting vaccinated as quickly with full vaccination rates in select countries as follows: South Africa (27.0%), Kenya (7.5%), Ethiopia (1.3%), Côte d'Ivoire (5.9%), Philippines (41.0%), Mexico (57.0%), Pakistan (30.0%), and India (42.0%).³ The threat of the new variant spreading causes fears about renewed restrictions, borders closing, and supply-chain delays. On December 20^th, 2021 the first Omicron-related death was announced, and 73% of all new cases were linked to the new variant, the S&P 500 Index was down –(1.7%) on the day.^4,5Overall, the global markets provided robust returns in 2021 with the following returns⁵:

Leading the way was the French Benchmark the CAC 40 Index which posted a YTD return of 27.65%, and is its first record high since the dot-com era, which was fueled by a demand for luxury goods and a recovery in energy and banking products. In addition to strong returns during the year, the market also exhibited less volatility than in 2020 compared with 2021. Measured by the Volatility Index (VIX) which represents the market's expectations for volatility based on 30-day forward prices of the S&P 500 Index, with VIX values that are greater than 30 representing high volatility and values less than 20 representing stable and moderate volatility. In 2020, the annual average VIX was 29.1 with 2021 decreasing to an average of 19.7. For comparison, 2008 had an average of 32.6 with a high of 80.9.⁷

Altogether, markets saw muted volatility and strong returns fueled by the reopening of the economy which was supported by mass vaccine rollouts. However, the rise in the nascent Omicron variant has caused renewed fears and uncertainty for 2022.

2022 is expected to have many significant factors at play that have the potential to drastically impact M&A activity. These factors include the resurgence of the coronavirus, market volatility, capital allocation requirements, fiscal stimulus, monetary policy, all-time high valuations, supply-chain issues, inflation, and market sentiment.

Coronavirus & Market Volatility

Firstly, as mentioned the Omicron variant and the renewed fears of closures have put a temporary slowdown on business activity. Decision-makers will wait to see the direction from key stakeholders such as governments, central banks, and customers before they plan any transactions. Further, volatility in markets can impact transaction decisions and structures. As shown by the VIX there has been a recent increase in volatility, which can cause participants to consider how they structure transactions. For instance, using stock vs. cash as transaction currency will be more closely examined with higher volatility. If a target is taking stock as consideration, they should consider a fixed exchange ratio and consistent trading liquidity to ensure they don’t lose too much value to volatility and they are able to sell when the time comes.

Capital Allocation Requirements

Companies and investors are holding record levels of dry powder. According to S&P Global, private equity firms are holding US$2.3 trillion of dry powder⁸, with some major companies holding the following cash balances:

With record levels of dry powder, institutions have several ways to allocate that capital. For companies, they can issue dividends, buy back shares, reinvest in organic growth, inorganic growth, and more. For 2021, companies are expected to repurchase a total of US$850Bn up 63.6% YoY.⁹ The growth was much higher than usual due to a significant pause in share issue programs in 2020. Companies have begun to continue these programs, for example, McDonald's ($MCD) announced a 7% increase in its quarterly cash dividend to $1.38/sh. and also announced the resumption of its share repurchase program.¹⁰ Additionally, banks in both the U.S. and Canada have been cleared for the resumption of buybacks and dividends. Recently, the “Big 6” Canadian banks all raised dividends and announced buybacks this quarter. In the U.S. banks may hesitate to be as aggressive with the proposed 1% tax on the amount companies spend to buy back shares in connection with Biden’s new $2 trillion spending bill. Citibank recently paused buybacks for another reason related to a new capital rule related to dividend risks and management of its Common Equity Tier 1 (CET1) capital ratio. With new expectations, new regulations, and the resumption of dividends and share buybacks companies have a lot to consider. Private equity firms also have decisions to make with record levels of dry powder and increased competition from vehicles such as special purchase acquisition companies (SPACs). These new funds will also be seeking robust returns as history has shown that vintages outperform through years following economic downturns, with returns in the 17%-21% internal rate of return (IRR) range in 2002 and 2009, compared with the long-term average IRR of 16%.¹² Returns are something that is paramount for all capital allocators and investors. It is something that must be considered in all M&A transactions as shareholders do not want to see companies overpay for targets that do not provide strong future returns. Shareholders are looking for accretive deals that make both financial and strategic sense. A tool being used more frequently is internal IRR hurdle rates which make it compulsory for companies to prove future returns prior to proceeding with transactions, these internal IRR hurdle rates can range from 10-20%+/-. The Financial Times found that companies raised a record US$12.1Tn from capital markets in 2021. With the current low cost of capital environment and record levels of capital, shareholders are going to look for management to put that capital to work to generate strong returns on that capital.¹³

Fiscal & Monetary Policy

Governments and central banks in developed nations had started the process of withdrawing COVID-19 related policies as the economy began to recover. However, the continuation of COVID-19 has caused some governments to reintroduce fiscal stimulus as businesses and individuals continue to battle the financial burdens of the pandemic. For instance, in the United States, the Biden Administration extended the freeze on student loan interest payments until May 1^st, 2022.¹⁴ The U.S. Federal Reserve (FED) is currently buying US$80Bn in Treasuries and US$40Bn in Mortgage-Backed Securities each month. The FED’s balance sheet has increased from US$4.4Tn to US$8.8Tn.¹⁵ The Federal Open Market Committee (FOMC) did indicate that it would begin tapering at a rate of US$15Bn a month. However, this is expected to increase as FED chairman Jerome Powell indicated, “We are phasing out our purchases more rapidly because, with elevated inflation pressures and a rapidly strengthening labor market, the economy no longer needs increasing amounts of policy support”, no number has been stated but Citigroup expected the tapering to reached US$30Bn by January.¹⁶

Additionally, there are fears of interest rate increases following the beginning of tapering. Many major banks now assume as many as three interest rate hikes in 2022. In the most recent FED meeting, 12 of 18 FOMC members also expect three rate raises next year as the FED works to battle rising inflation. Currently, no action has been taken by any major central bank outside of the Bank of England (BoE), which recently increased interest rates by 15 basis points (bps). The base policy interest rates at major central banks below represent the current and previous rates based on their most recent rate decisions respectively:

Governments and Central Banks are in a difficult place currently. Inflation is rising rapidly, with the U.S. reporting an annual CPI increase of 6.8% and a Core Inflation (excl. Food & Energy) increase of 4.9% YoY.¹⁸ While the real economy is still struggling with the resurgence of the coronavirus, restrictions, hiring bottlenecks, and supply-chain issues. Governments and Central Banks need to combat inflation while ensuring that individuals and businesses have the support that they need. From an M&A perspective, companies have raised record levels of capital ahead of potential increases in the cost of borrowing. However, they must closely monitor how government stimulus, rate hikes, and tapering impact the business environment and acquisition targets. The effects on B2B business, consumer spending, hiring delays, and supply chain issues can materially impact the transaction timeless and deal accretion.

Valuations

It is no secret that valuations have hit record highs. Public market comparables are trading at extremely high with the annual gains in the stock market and recent precedent transactions have also seen much higher takeover multiples over the past year. This has been fueled by a low cost of capital, fiscal stimulus, monetary policy, enhanced liquidity in public markets, and competitive bidders for precedent transactions. Below, I’ve put together a table for some prominent deals across industries. The list is not exhaustive and is just for illustrative purposes across sectors:

Some common trends from these deals are the record sizes of the transactions. Recently both BMO and Oracle paid large sums to acquire Bank of West and Cerner respectively. Acquirers are hungry to complete transactions are willing to pay high premiums to complete deals and generate growth. Another observation is the activity by private equity acquirers, Apollo acquired Great Canadian Gaming, Athene Holdings, and Michaels Companies over the past year+. The record levels of dry powder are allowing private equity firms to continue to pay high premiums and the record levels in the stock market and low cost of capital are opening the doors for companies to utilize both cash and stock in M&A at high premiums.

Supply Chain, Inflation, & Market Sentiment

Throughout the year there were many supply chain bottlenecks that delayed shipments globally. This year featured everything from ships blocking the Suez Canal to mass congestion at ports around the world. 2021 saw robust production reductions, increased demand for eCommerce, and labor shortages which resulted in backlogged ports and delayed transportation. The Omicron variant and supply chain issues can potentially lead to persisting inflation in 2022. In 2021, prices already rose at the sharpest pace in 40 years.¹⁸ As economies progressed through the pandemic, many items from used cars, groceries, gasoline, rent, and more saw rapid price appreciation. In 2022, it is expected that inflation will remain persistent with landlords locking in higher rents, food manufacturers announcing price increases, microchip shortages, along with a new wave of lockdown fears. It was found that investors are also fearing inflation's impact on 2022 returns, in the recent CNBC Delivering Alpha investor survey, the consensus from the 400 participants was that returns would be muted, and inflation will cause a major roadblock. CNBC found the following results from this survey:

This survey concluded with the consensus that the S&P 500 will end “up less than 10%”. Overall, the renewed lockdown fears, supply chain issues, persisting inflation have caused market participants to be cautiously optimistic after a record 2021.

Outlook

Altogether, 2021 was a fantastic year for both public market returns and M&A. However, the rise of the Omicron variant, unsustainable inflation, looming tapering and rate hikes, record-high valuations, and market volatility have introduced fears for 2022. In contrast, companies and investors have record levels of capital, and if the Omicron variant is not as severe as some expect it could result in a swift recovery. Overall, 2022 is expected to see muted M&A results as shareholders will be looking for strong return potential on capital coupled with mixed forecasts in the macro-environment. Investors and strategic acquirers will continue to look to create value however there are several material considerations in this dynamic business environment.

NOTE: THIS BLOG IS NOT FINANCIAL ADVICE NOR INVESTMENT ADVICE AND DOES NOT REFLECT THE VIEW OR OPINIONS OF MY EMPLOYER

 Reference

1. John Hopkins University. Coronavirus Resource Centre. December 26th, 2021. Source. Accessed December 26th, 2021. 

1. The New York Times. Omicron: What We Know About the New Coronavirus Variant. December 23^rd, 2021. Source. Accessed December 26th, 2021. 

1. The New York Times. Tracking Coronavirus Vaccinations Around the World. December 26^th, 2021. Source. Accessed December 26th, 2021. 

1. CNN. The Omicron variant is now dominant in the US. December 21, 2021. Source. Accessed December 26th, 2021.

1. Koyfin. Source. Accessed December 26th, 2021. 

1. Bloomberg. CAC 40 Posts First Record High Close Since Dot-Com Era. November 2^nd, 2021. Source. Accessed December 26th, 2021.

1. FRED Economic Data. CBOE Volatility Index: VIX. December 23rd, 2021. Source. Accessed December 26th, 2021.

1. City A.M. ‘PE to PE’ deals soar as firms rush to offload $2.3 trillion post-pandemic dry powder. October 4^th, 2021 Source. Accessed December 26th, 2021. 

1. The Wall Street Journal. Companies Plan to Pour Even More Cash Into Buybacks, Dividends in 2022. December 22nd, 2021. Mark Maurer.  Source. Accessed December 26th, 2021. 

1. McDonald’s. Mcdonald's Reports Third Quarter 2021 Results. October 27^th, 2021. Source. Accessed December 26th, 2021. 

1. Reuters. Citigroup pauses buybacks briefly due to new capital rule -CFO. December 8th, 2021. David Henry. Source. Accessed December 26th, 2021. 

1. Bain & Company. Global Private Equity Report 2021. Hugh MacArthur. Source. Accessed December 26th, 2021. 

1. The Financial Times. Companies raise over $12tn in ‘blockbuster’ year for global capital markets. December 28th, 2021. Eric Platt, Nicholas Megaw and Joe Rennison. Source. Accessed December 28th, 2021. 

1.  CNBC. Biden Administration extends the student loan pause through May 1—but advocates call for all student debt to be canceled. December 22^nd, 2021. Abigail Johnson Hess Source. Accessed December 28th, 2021. 

1. Reuters. Explainer: Federal Reserve's taper: How does it work?. November 3^rd, 2021. Lindsay Dunsmuir. Source. Accessed December 28th, 2021

1. CNBC. Powell says Fed will discuss speeding up bond-buying taper at December meeting. November 30^th, 2021. Jeff Cox. Source. Accessed December 28th, 2021

1. CNBC. Inflation surged 6.8% in November, even more than expected, to fastest rate since 1982. December 10^th, 2021. Jeff Cox. Source. Accessed December 28th, 2021

1. Washington Post. Prices climbed 6.8% in November compared with last year, largest rise in nearly four decades, as inflation spreads through economy. December 10^th, 2021. Rachel Siegel. Source. Accessed December 28th, 2021

1. CNBC. Investors fear inflation most in 2022 and see lower stock market returns, CNBC survey shows. December 29^th, 2021. Yun Li & Patricia Martell. Source. Accessed December 29th, 2021