Time For Action
22 September 2006 Stephen Barrett
Corporates need to take a tactical view of what could be only a short-term opportunity. Stephen Barrett, international chairman of KPMG's Corporate Finance practice, explains why.
Merger and acquisition (M&A) activity around the world is currently running at a high level. But there are early warning signs that the current M&A boom, already slowing, could plateau - even tail off - next year.
Corporates are therefore faced with a window of opportunity in which to take advantage of the present climate, and their own liquidity and stability, to execute strategic deals.
At the same time they can steal a march on an over-stretched private equity sector that has made off with an increasing proportion of the world's M&A deals in recent years.
This picture emerges from KPMG Corporate Finance's Global M&A Predictor - a brand new six-monthly forecast of M&A activity based on forward price to earnings (PE) valuations and net debt to EBITDA ratios across 1,000 leading companies internationally.
M&A MARKET SLOWING
The Global M&A Predictor appears to indicate that the M&A market is currently suffering slight deal fatigue. This can be seen in PE valuations which have fallen over the past six months from 17.7x to 16.8x, and by a net debt to EBITDA ratio which has nudged up from 0.83 years to 0.96 years.
But if the rate of M&A growth has slowed slightly, it is still heading in an upward direction in the near term. Data from capital markets consultancy, Dealogic, shows that deal numbers in the first half of 2006 are up on the previous six months, amounting to the sixth successive increase in half-yearly global M&A volumes in a row.
Given current benign debt market conditions combined with sound corporate balance sheets, there's every reason to look forward to further increases in activity in the short to medium term, albeit at a slower rate.
Looking ahead and sounding a cautionary note, we have identified a number of 'flashing lights' or warning signals which suggest that a tougher market lies ahead. We are concerned, for example, that risk is not being properly assessed and priced by many buyers. We are seeing finer and finer pricing driven by the rush to lend, which presents dangers. Also banking covenants might be becoming less onerous and too relaxed. These signs could all be precursors to a backlash.
HITTING BACK AT HEDGE FUNDS AND PRIVATE EQUITY
Whilst the ability of companies to raise debt remains strong and prices look some way off their peak, KPMG suggests that there is an important opportunity for corporates to take a tactical view of the marketplace and close some compelling strategic deals, which could break the recent siege laid to the world's M&A markets by private equity houses and hedge funds.
KPMG's optimism about M&A deal volumes and values is fuelled by a number of factors currently being observed by our corporate finance advisory teams.
Company balance sheets are healthier than ever before – illustrated by a solid net debt to EBITDA ratio of 1.0x globally, while earnings expectations remain positive. In sharp contrast to private equity and consumer borrowing, the majority of corporates are conservatively financed. An overstretched private equity sector – in which some players are leveraging up to 11 times debt to EBITDA - may now seek more joint deals with corporates in order to secure better operational benefits.
Corporate balance sheets look very healthy, indicating that they have behaved more responsibly than ever at this stage of the cycle. Companies nevertheless want to do deals, and they want to acquire to achieve growth.
Liquidity in the debt market is very high and debt pricing remains competitive, illustrating a continuing appetite to lend. And the global macro-economic environment is positive, with major money markets benefiting from a period of relative political stability.
For these reasons the corporate sector should take advantage of this unusual environment before underlying trends take hold which could result in a deal activity plateau – and thus fewer good buying opportunities - in the second half of 2006.
M&A ACTIVITY BY REGION AND SECTOR
Analysis by KPMG's Global M&A Predictor on a regional basis suggests that M&A activity in the three major world regions – Asia Pacific, Europe and the Americas – should continue rising in the short term.
Europe has held up relatively well during the last six months, compared to the other major regions, with forward PE valuations down only slightly from 14.9x six months ago to 14.6x. Net debt to EBITDA underwent the most significant rise of the key regions from 0.7x six months ago to 0.9x - although this level still indicates significant debt capacity.
Within the region, the strong sector performer was utilities up from a PE of 13.8x six months ago to 15x, with consumer goods and healthcare slipping back the most, due to the continued muted consumer environment. Net debt to EBITDA rose from 0.7x six months ago to 0.9x, with industrials and consumer goods rising the most, contrasting with utilities which continued to strengthen its balance sheets through continued non-core asset sales.
Dealogic data showed that deal values in Europe rose for the sixth successive half-year period, but the volume of deals rose only marginally from the second half of 2005.
This latter development, combined with low relative, stable, valuations, and more highly leveraged balance sheets than six months ago, suggests that bid activity in this 'slower growth' region could be stalling.
KPMG continues to believe that Europe has the positive fundamentals required for further M&A activity. Whilst private equity has been instrumental in returning M&A activity to the strong levels observed at the start of the Millennium, we are now seeing companies regain confidence for strategic bids.
This is particularly true in Germany which has seen a recent string of overseas acquisitions. The strong appetite of European players continuing to look abroad for new market opportunities and the buoyant economies of Russia and Central and Eastern Europe are likely to be key drivers.
In the US, forward PE valuations fell from 18.9x six months ago to 17.6x, with basic materials and technology the biggest fallers (PE of 16.7x from 17.9x, and 21.8x from 25.2x respectively). In contrast, consumer goods and consumer services held up well, with oil and gas rising, helped by the deal activity in the first half of the year.
Net debt to EBITDA rose from 0.8x six months ago to 0.9x, with all sectors seeing balance sheets deteriorate marginally. Industrial is the most highly indebted with KPMG forecasting a net debt to EBITDA ratio of over 3x.
KPMG's Global 1,000 data shows that Asia Pacific's forward PE valuation fell from 21.2x six months ago to 18.9x, with net debt to EBITDA (a critical measure of a company's financial leverage) rising from 1.0x six months ago to 1.2x. When viewed alongside falling global private equity valuations and moderately tightened balance sheets, this suggests that deal activity is slowing at present.
The decline in equity valuations over the past six months, as evidenced in KPMG's Global 1,000, is possibly a kick back by some buyers against aggressive vendor pricing, with a more realistic price for assets now being sought. Once some equilibrium is reached, we envisage a reacceleration in the volume of deals being carried out.
Although, the recent round of private equity fundraising has reinforced the firepower at the disposal of some of the world's leading private equity houses, we continue to believe that conditions over the next year are ideal for a corporate fight back.
WHAT TO DO NEXT
KPMG recommends companies consider using their balance sheets in more imaginative ways to fund M&A activity. CEOs and CFOs should look for financial and operational flexibility and explore the innovative financing options pursued most recently by those in the retail and property sectors.
KPMG expects to see more of these intelligent deals from many of the world's leading companies as benign market conditions for corporate M&A continue to prevail.
Despite early signs that the pace of global M&A activity is close to peaking, KPMG's Global M&A Predictor suggests that there is still considerable scope for corporates to forge strategically compelling deals, before the cycle takes a pause for breath.
Corporate confidence is high, balance sheets are strong and, given the astute management of the corporate sector, there is plenty of room for companies to drive further growth in profits from revenue and cost synergies. In addition, macro-economic conditions are favourable.
Now could be the right time for any company willing to take first mover advantage and do the intelligent deal.