On Wednesday, April 5, the Federal Reserve released meeting minutes from mid-March, further signaling that the market will see two additional rate hikes this year, in addition to the quarter-point increase recently publicized.
It is all too easy to interpret this announcement as the end of the latest era of cheap money, which helped spur mergers and acquisitions activity in 2016, a momentous year for deals and dealmakers.
Still, M&A professionals, who have long capitalized on cheap debt to fund deal activity, are taking the Fed news largely in stride.
While interest rates are indeed inching up, they remain at historic lows and are expected to rise gradually and over an extended period as the Fed looks to avoid shocking the system. Only several years of consistent interest rate hikes will materially impact borrowing costs and subsequent deal activity — a timeframe that is still in the distance.
Additionally, with the mega-deals of past years long gone, most activity is taking place in the upper middle market, with less leverage being utilized in general.
Most importantly, the confluence of factors that helped make 2016 one of the most remarkable in M&A history is largely still in place, spurring corporations and private equity markets to transact.
These factors are the following.
Overabundance of Capital
After showing extreme caution following the Great Recession by hoarding capital to weather the economic downturn, many corporations and private equity funds have far too much on their books. Flush with cash, they’re under enormous pressure to deploy their resources as a means of buying growth and stalling disruptive forces, especially in industries like technology and health care.
The result is that even non-core assets are increasingly attractive targets in the market. Vast numbers of global private equity investors are looking to buy what corporations continue to divest. Even the energy space, where deal flow has slowed, has shown to be on the rebound with cash-rich players waiting for the right moment to swoop in.
Potential for GDP Growth
After eight years of anemic growth for corporate America, the Trump administration is seeking to double the growth rate for gross domestic product (GDP), from 2% to 4%. If such a windfall should come to pass, it could, combined with a focus on job creation spur true, organic growth vs. growth through M&A, as well as increases in both stock prices and overall management confidence.
While this would create options beyond M&A — in the recent past, companies and private equity had to rely on M&A for growth — it would simultaneously encourage dealmakers to transact, as their outlook becomes increasingly bullish.
Of course, it is up for debate whether President Trump can achieve this GDP goal and others outlined below. The prospect of failure became more real with the failure of the Republican health-care bill. Still, excitement over a potential boost to GDP is currently strong enough to offset uncertainty and anxiety surrounding Trump’s presidency among most M&A professionals.
Potential Tax Law Overhaul
With the market bracing for potential tax-law changes, including possible carried interest and personal income tax reforms, dealmakers may opt to wait on transactions in order to capitalize on forthcoming tax savings. However, any mere hints of real action regarding tax reform on the part of the administration likely will create an intense flurry of M&A activity — just as we saw in 2012, despite the fact that no tax changes materialized.
It’s also possible that to get deals done, investors will begin incorporating into purchase and sale agreements provisions for future refunds or payments based on any benefit or detriment arising from pending tax law changes. If such agreements become standard practice, the potential for tax reform will only encourage further deal-making.
The stated intentions of the president and the Republican Congress to relax the regulatory environment will potentially stimulate significantly more IPO activity, as going public is a more attractive option with less regulation. Certain sectors, like specialty pharmaceutical, biotechnology, and medical devices, will derive particular benefit from such a change, which is likely to bring about improved valuations and related M&A activity.
A Mighty Dollar
After some turbulence last fall, the dollar remains stronger than many other global currencies, encouraging dealmakers to engage in cross-border activity. Valuations outside of the United States look particularly attractive to U.S. firms, which can currently pick up assets at a discount.
In summary, favorable market conditions beyond the interest-rate environment, combined with enormous pressure pushing corporations and the private equity market to transact, are likely to keep dealmakers quite busy, at least through the end of 2017.
The real wild cards in play — factors exposing dealmakers to potential risks — aren’t rate-related at all. Rather, they’re tied to geopolitical uncertainties. Specifically, the rise of global populism has created headwinds for cross-border deals, with international mergers and takeovers creating opportunities for lawmakers to flex political muscle and impose capital controls.
Following a strong post-election rally, the U.S. stock market has cooled off some as it internalizes the extent to which the Trump administration will be able to deliver on key promises amid the distractions that keep surfacing in the news.
For now, these risks aren’t scaring off dealmakers, who are rushing to transact while market conditions are positive. They’re not prepared to wait for the other shoe to drop.
Further, while it’s difficult to see an environment of more expensive money as anything but bad news, the Fed’s decision to raise rates signifies a strong economy with an underlying climate that can support these increases. This reality might be difficult for the average retail investor to accept, but M&A professionals understand it all too well.
Paul Aversano is a managing director in the private equity practice at Alvarez & Marsal and global practice leader of the firm’s Transaction Advisory Group.