M&A Momentum Sustainable

First Half Highlights

The drivers that we detailed in January have powered impressive M&A results during the first half of 2021, keyed by numerous deferred sale processes restarting as the economy showed signs of rebounding. Before looking at the primary factors impacting activity over the rest of the year, the global M&A market’s stellar YTD 2021 performance should be placed into historical context:

Expected Tax Changes Expanding Supply

A significant driver of M&A activity in the second half of 2021 will be the larger number of targets available for sale due to likely tax policy changes in the U.S. Anticipated changes with the most impact on the M&A market include:

• Increased corporate tax rate
• Higher capital gains tax rate
• Carried interest taxed as ordinary income instead of as capital gains
• Elimination of basis step-up upon the transfer of inherited assets

Although the timing and level of tax policy adjustments is still to be determined, the new tax regime could take effect upon enactment or at the start of 2022, with retroactive changes possibly a part of negotiations.

Sponsors Still a Driving Force

Sponsors are well positioned to capitalize on the larger target supply. Several factors are currently contributing to the major buying capacity of private equity firms:

• Strong exit activity, including the productive M&A liquidity events noted above as well as the constructive market for equity offerings.
• A rebound in fundraising during Q1 2021 providing additional dry powder, which is well in excess of $1 trillion.
• Healthy fundamentals throughout the leveraged finance markets, including a record pace of syndicated leveraged loan and high yield issuance to date in 2021, as well as 40%+ growth for deal completions by U.S.-based direct lenders in January-May.
• Even after plentiful loan volume in YTD 2021, the debt capital markets continue to have substantial lending capacity, driven by the ongoing expansion of the syndicated leveraged loan market (with outstanding loan volume doubling since the global financial crisis) and in private credit, where assets under management more than tripled over the last 10 years to nearly approach public loan levels.

Corporate M&A Momentum

Corporates have the buying power needed to participate fully in the M&A market over the rest of the year.

• Globally, companies entered 2021 with $7+ trillion in cash on balance sheets after focusing on enhancing liquidity during 2020.
• To date this year, corporate profits have exceeded expectations by a substantial margin, providing further support to future spending.
• The capital markets have been conducive, with follow-on offering proceeds up 30%+ in the U.S., while elevated equity market levels make the use of stock as M&A currency more attractive for acquirors, enhancing the accretive nature of M&A activity.
• The widespread availability of M&A financing noted above also applies to corporate acquirors, as issuance in the investment grade and high yield bond markets has remained strong amid low interest rates.

SPAC M&A Should Evolve

While SPACs contributed to the M&A market’s impressive performance to date in 2021, we are not as optimistic about their impact over the rest of the year. Of the nearly 600 SPACs that have come public since the start of 2020, more than 400 are still searching for an M&A target. In addition, another 200+ SPACs have filed for an IPO. In view of this, one might expect sustained strength in SPAC M&A through year-end. However, SPAC market conditions have chilled due to pressure on post-merger stock prices, tighter PIPE markets, and timing delays associated with shifting reporting requirements for SPAC-related warrants.

We expect SPAC M&A activity to evolve during the second half of 2021 and beyond.

• Due to greater wariness of higher-risk deals, SPACs and associated PIPE investors could increasingly target more mature businesses that are better equipped to operate as public companies. In a potential preview of this type of SPAC merger becoming more common, GS Acquisition Holdings recently announced a combination with Mirion Technologies, an industrial technology company generating EBITDA margins above 20%. The deal’s $900 million of PIPE capital will enable Mirion shareholders to realize $1+ billion of liquidity while retaining significant ownership.
• While the pool of prospective SPAC buyers remains large, sellers seem to prefer negotiating with SPACs that are less tenured and therefore have extensive runway to work through all aspects of a deal completion cycle; this dynamic could cause a growing number of pre-2021 SPACs to expand their focus in search of a suitable target.
• For perspective, among the 150+ 2020-2021 vintage SPACs that have announced an M&A agreement, the median time between IPO and deal signing was less than five months (well under the required two years), with more than three-quarters of the deals announced less than six months post-IPO.
• Given the need to broaden their horizons, U.S.-listed SPACs, which account for the vast majority of global SPAC capital, are increasingly pursuing European businesses; eight acquisitions with Europe-based targets have been announced since late March, up from only two in the preceding 90 days.

Ongoing Recovery in Europe

While the dynamics described above apply to the full extent for sponsors and corporates based in the U.S., additional considerations are relevant in Europe.

Europe’s M&A recovery has been strong in certain sectors but slower to develop in other segments, with acquired targets typically demonstrating resilience during the pandemic.

Targets with cyclical characteristics and/or continued drag from COVID in Q1 2021, given deeper and more widespread lockdowns in Europe (relative to the U.S.), are delaying sell-side processes until the second half of the year. In addition, some buyers and lenders are naturally taking a more skeptical view of COVID addbacks than sellers, increasing the importance of delivering solid post-COVID performance for a meaningful period.

As demonstrated by the above points and the gradual loosening of COVID restrictions in Europe, late 2021 and beyond are setting up for a strong M&A rebound across sectors.

• Pitch activity has picked up in 2021, which should translate to numerous process launches later in the year and deal agreements by the end of the year.
• Many transactions could slip into early 2022 due to lenders and sponsor buyers wanting to see a significant stretch of normalized results for targets in sectors affected by COVID.
• An upturn for M&A in 2022 seems more likely for site-based consumer businesses that reopened only recently.

Asian Outbound M&A Slower to Rebound

Japan and China are among the largest single-country contributors to global M&A activity, with cross-border transactions involving entities based in these nations of particular interest. However, since the early stages of COVID, potential buyers from Japan and China have typically struggled to engage in competitive M&A processes in the U.S. and Europe.

In China, we anticipate stronger cross-border activity in the second half of 2021 than in the first half, as vaccination distribution proceeds and business travel continue to recover.

• China’s outbound M&A deal value increased 53% year-over-year in January-May 2021 but was 61% below the average level of 2018-2019. While we expect regulatory sensitivity to remain heightened for outbound M&A involving technology and infrastructure assets in the U.S. and Europe, Chinese buyers are increasingly focused on cross-border M&A in the healthcare sector, which is experiencing high investor interest in China.
• China’s inbound M&A transaction value was up 89% year-over-year in January-May 2021 and topped the 2018-2019 pace by 127%. The deal value for inbound deals exceeded outbound value to date in 2021, with this dynamic likely to continue over the rest of the year as China’s market opens further to foreign investors.

Late 2021 Considerations

Although the pieces are in place for an excellent second half in the M&A market, several issues could cap the upside to overall results late in the year.

• Resource constraints during any final push to exit holdings before year-end in advance of potential tax policy changes, as execution bandwidth is already limited for financial sponsors and other M&A market participants.
• Valuation discipline among buyers, with sellers often seeking premium multiples based on recent comparable LBO transactions, elevated valuations for public market comparables, and rising growth projections.
• Less aggressive approaches by credit committees and debt funds that reach their expanded 2021 lending targets well before year-end amid continued strength in the leveraged finance markets.
• The impact of increased inflation or other macroeconomic factors on interest rates, as any uptick in debt pricing could dampen leverage multiples and deal valuations, although M&A financing should remain widely available in the middle market as well as upmarket in view of how direct lenders passed the stress tests of 2020 amid COVID disruptions.
• Return of lockdowns or restrictions driven by new COVID variants, particularly in Europe.

We encourage you to contact Baird’s Global M&A team to discuss your M&A plans for the remainder of this year and beyond.