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Patience, creativity key to navigating M&A logjam

  • LBO loan costs up 300 basis points, equity piece of deals now exceeds 50%
  • Selling sponsors must be more creative in terms of exit channel, structure
  • Despite some positive signs, rebound not expected in 2024

Rising debt costs and stubbornly elevated asset valuations continue to stymie M&A deal flow, but advisors told last week’s Milken Institute Global Conference in Beverly Hills, California that they expect easier financing conditions and pressure on sellers to drive more activity eventually.

The impact of interest rate hikes on the ability of financial sponsors – which account for over half of M&A volume – to deliver the 20%-plus IRRs generally expected has been “shocking,” said Ron Eliasek, chairman of global technology, media and telecom investment banking at Jefferies [NYSE:JEF].

He noted that the cost of a typical leveraged loan in 2023 was around 10%, having never reached 7% in any of the prior 15 years. As a result, the equity-debt split in leveraged buyouts flipped from 30%-70% to more than 50% equity last year – the first time it has accounted for the majority.

Alan Tannenbaum, CEO and Group Head at BMO Capital Markets [NYSE:BMO], countered that the “complete shift” in the sponsor market should be temporary. He continues to see investors snapping up companies with a view to utilizing more attractive financing packages when markets normalize in 12-36 months.

“Ultimately, for that market to thrive the way it has, 50%-plus equity checks is not sustainable,” Tannenbaum said.

He added that, until rates come down, sponsors cannot rely on financial engineering for returns. “[At] 10% cost of capital, if you lever a company 6x, you’ve destroyed your EBITDA and your ability to grow and invest,” Tannenbaum said.

There was general optimism that M&A will pick up. Andrea Guerzoni, global vice chair for strategy and transactions at EY, observed that private equity activity is already rebounding, with deals worth USD 80bn transacted in April alone.

Twenty transactions of USD 10bn or more have been announced in 2024 to date, a significant increase on last year, he added. Further, an EY survey of 1,200 CEOs found that 71% are considering divestments, typically spinoffs or carve outs.

Pressure on financial sponsors to exit existing investments is arguably a greater driver of M&A than corporate divestments – and industry participants advocate looking beyond the traditional channels.

Roughly a quarter of the 28,000 companies worldwide currently in buyout fund portfolios have been held for longer than five years, according to Anu Aiyengar, global head of M&A at J.P. Morgan [NYSE:JPM]. To avoid a deal glut, she suggested that financial sponsors consider partial monetization scenarios.

Continuation funds are not the only option. Aiyengar has seen sponsors merge companies with those held by other private equity firms to remove costs or placing assets in special purpose vehicles and raising capital around that – an arrangement sometimes referred to as an evergreen IPO or a private IPO.

“[There are] various versions of saying that I’m going to go raise capital on an asset but the company is not going public,” she said.

Guerzoni was equally dismissive of the traditional IPO route, citing structural problems that have led to a sharp reduction in the number of public companies over the past 20 years. “We should probably be more creative regarding other ways of negotiating deals outside of the official stock market,” he said.

The greater complexity and creativity required to get deals done is ultimately beneficial to the advisory community, but Andrew Bednar, a partner and CEO at Perella Weinberg, believes it traces back to a more fundamental problem: valuations remain too high.

Sellers that paid 11x or 12x EBITDA for a business now trading at 7x or 8x are unable to countenance exiting at a lower multiple. “You can’t get anywhere near the leverage that you could get five or six years ago, so that creates an incredible inhibitor to transactions,” Bednar said.

Meanwhile, sponsors are willing to consider all options to get deals done because they have so much dry powder. Pointing to USD 4trn in private capital commitments and USD 6.5trn on non-bank balance sheets in the US and Europe, Bednar estimated that dry powder exceeds the GDP of Germany and Japan combined.

Eliasek of Jeffries, who also flagged the impact of dry powder on valuations, suggested that the combination of selling pressure and more favorable financing conditions will lead to robust M&A activity in 2025 or 2026. Bednar is of a similar mind. “It’s not going to get done in ‘24 – it’s not a ‘24 story,” he said.