For the first time in the 10 years that we have been tracking industry mergers and acquisitions (M&A) activity, there were no new transactions announced in April that came to our attention.
While we know that companies are continuing to have discussions, and state they are continuing to pursue M&A transactions, clearly there has been a pause as companies brace for what they expect to be a challenging second quarter (Q2). The consensus view, or conventional wisdom, in the fluid handling industry is that Q2 will be the most challenging quarter of the year as the full impact of the COVID-19 shutdown is felt in the United States and Europe as well as the disruption of the oil and gas market worldwide. That, of course, remains to be seen with some economists forecasting that Q3 will be the most challenging quarter in the U.S. for capital goods orders. Regardless of the view of the next two quarters, it is widely expected that we will see an upturn in economic activity in Q4 2020 and through 2021.
The key questions that will determine the level M&A activity and valuations in the industry going forward will be:
- Do buyers have the same strategic imperatives that were driving the strong demand for acquisitions?
- To what extent has the current situation impacted buyers’ and sellers’ risk tolerance and outlook for future growth?
- To what extent will companies seek to realign their strategic focus to reduce risk and enhance exposure to higher growth opportunities?
At this point, based on what industry CEOs are saying in their Q1 earnings calls and from our conversations, it would seem there is a mix of sentiment. Some companies who have been active M&A participants say they are planning to continue to be active, while others have hit the pause button for the near term. We can expect that until there is a more clear path toward economic recovery, M&A activity from strategic buyers will be significantly impacted. However, in the longer term, we are likely to see not only bolt-on acquisition activity but also some significant strategic realignments.
Capital is still flowing into private equity funds and private equity is continuing to do deals. According to a recent survey by Eaton Partners a majority—64 percent—of institutional investors are making no change to their private market allocations. As we said last month, our expectation is that private owners will have a heightened sensitivity to the risk of ongoing ownership. Consequently, there will be potential supply in response to demand—the question will be valuation.
Interest rates are likely to remain low for the foreseeable future, depending on what happens with inflation going forward, and it is likely that we will see economic growth, at least in the U.S. market, in 2021 and 2022. However, that growth may only get demand back to 2019 levels. If those projections are correct, it would seem the demand for capital goods to expand capacity may be muted over the next couple of years. If that turns out to be the case, the M&A focus will likely be on companies that have a competitive advantage in helping owner/operators to enhance their operating efficiencies.
Speculation is that competition for quality bolt-on acquisitions and low interest rates will combine to support valuations at a relatively high level in the lower middle market. However, valuations for some businesses may be tempered by a cautious outlook regarding their ability to consistently produce growth in the long term.