M&A transaction activity increased throughout 2021 and continues in 2022. Many private company owners are now working to close a transaction before year-end 2022 and avoid the uncertainty of a new economic, inflationary and tax environment in 2023.

There are three key reasons business owners are considering a business sale in 2022 rather than waiting until next year.

1) Tax changes in 2023

The Biden Administration’s FY 2023 Budget and Treasury Greenbook, released March 28, 2022, proposes significant tax changes that would impact business owners selling a company. The proposed changes include:

• Increasing the top tax rate for individuals to 39.6%
• Imposing a minimum tax on wealthy individuals
• Taxing some capital gain at ordinary income tax rates
• Expanding triggering events for capital gains recognition
• Limiting like-kind exchanges

The most critical tax consequence for an owner delaying the sale of their company:

Biden’s current proposal would subject long-term capital gains (which are generally subject to a lower tax rate than ordinary income tax rate) to a higher tax rate for taxpayers with over 1 million of taxable income. For example, a business owner who sells their company in 2023 and has taxable income over $1 million, long-term gains over $1 million would be subject to a much higher ordinary income tax rate (39.6%) than the maximum capital gains rate (20%) under the current law.

2) Inflation and interest rate risk

U.S. consumer price increases again in March, underscoring increasing inflationary pressures as supply chain disruptions and shortages linger across the economy.  The Bureau of Labor Statistics’ (BLS) Consumer Price Index (CPI) rose 8.5% in March compared to the same month last year. That marked the fastest rise since December 1981. This followed a 7.9% annual increase in February.  Even excluding volatile food and energy prices, core CPI jumped 6.5% in March over last year, accelerating from a 6.4% increase in February and representing the fastest increase since August 1982.

In this inflationary environment, interest rates will continue to rise. The cost of capital to acquire a company will increase. Debt service will increase and this puts downward pressure on business valuations, as an acquirer needs to contribute additional equity or alternative financing to cash flow the same purchase price.

3) Inverted yield curve and recession warnings

A yield curve inversion happens when short-term Treasury rates pay a higher interest rate than long-term Treasuries. Demand increases for long-term treasuries when investors have concerns about the short-term environment. This just happened again at the end of March.

Economic cycles transition from growth to recession and back to growth and inverted yield curves are an element of these cycles, preceding every recession since 1956.  Since then, equities have peaked six times since after the start of an inversion, and the economy has fallen into recession within seven to 24 months.  Inverted yield curves do not cause a recession, but they are a leading indicator that many businesspeople watch. From a longer term perspective, Peter Lynch made an observation in 1994 about US corporate growth:

“Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs. Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years.”

Long term, US public corporations grow, but there is always short-term volatility in valuations. The challenge for a private company business owner is that valuations take a lot longer to recover from a recession than public corporations. Privately held companies are valued on their immediate historic financial performance while public companies are valued based on future expectations. If an owner of a privately held company wants to maximize sale price and terms, they either sell in a growth cycle, before a recession, or wait until a couple of years after the US economy has exited the recession.

What else is on the horizon for M&A?

Business owners may be contemplating selling in any given year but are often motivated by a trigger event to take action and sell, responding to a prospective buyer or engaging an M&A firm to guide them through the process.  As discussed in the research below, higher valuations are luring many business owners to sell.  The pipeline continues to be strong for new businesses coming to market. Analysts expect 2022 to be another strong year for M&A activity, with capital stacking up to be deployed.

In the section below, we consider the M&A outlook for several key industries in our region.

Aerospace and Defense

President Biden signed the National Defense Authorization Act in December, authorizing $740 billion for the Department of Defense (DOD).  The increased defense budget is benefiting military service providers, manufacturers and construction companies, defense-related aerospace companies, and defense contractors.  Spending related to the current geopolitical tensions and emerging technologies will continue to drive defense M&A activity this year.

Commercial air travel is returning to near pre-pandemic levels and will continue to improve as vaccination levels rise.  Commercial aerospace manufacturers are raising their production forecasts possibly indicating M&A activity returning to pre-pandemic levels.  Currently, the capacity in the supply chain exceeds demand, so consolidation could also be a deal opportunity for suppliers with capital on hand.

 Chemicals

As previously forecast, Chemicals M&A activity finished the year strong, with the deal value in the third quarter alone exceeding that of the first half of 2021.  Chemicals companies are seeing operating margins increase and are more willing to use capital for growth.

Optimistic about the post-pandemic market, buyers are focusing on chemicals with high valuations and plentiful capital to deploy.  Chemicals companies are taking advantage of a seller’s market, leading to a solid pipeline of divestures for 2022.

The chemicals industry is under the spotlight with environmental, social and governance (ESG) which may also lead to product and division review, with consequential divestures, capital investments in cleaner and carbon neutral opportunities, while also providing some attractive acquisition opportunities of non-core or non-ESG assets.

Healthcare

Long Term Care and Physician Medical Groups were the subsector leaders with deal volumes up 56% in 2021 over the same period in 2020.  High capital availability, regulatory pressure, and a search for value continue to fuel the appetite for deals.

The return of healthcare megadeals in 2022 led to the sharp increase in deal value of 227% compared to the same period in 2020.  2019 and 2020 each had one megadeal, while 2021 had seven megadeals, the most remarkable among them Humana’s acquisition of the remaining 60% of Kindred at Home, and two deals involving the Walgreens Boots Alliance.

An emphasis on healthcare technology remains in focus for acquisition targets as the industry has an interest in mining large datasets, while also needing to counter security breaches.

 Energy

With a recovery in energy prices, deal activity over the last twelve months returned to pre-pandemic levels and analysts expect an active 2022.  Upstream accounted for most of the deal activity growth.

Oil and gas activity is being constrained by more moderate capital deployment with higher prices, as well as a scarcity in employees. There are many projects held up because they cannot find the field crews to perform the work. The result is a slower increase in activity, but many consider this current growth more manageable.

Environmental, social, and governance (ESG) will play a role for energy M&A deals.  Companies trying to reach net-zero goals will use acquisitions for low carbon production capabilities.  Stronger energy prices provide capital for these investments.    While ESG will be a focus, the majority of global energy still relies on oil, natural gas and coal.  Deals involving traditional assets will continue in 2022, especially as economies strengthen out of the pandemic.

Oilfield Services could find deal activity consolidating smaller companies to improve efficiencies, cash flows and reduce costs, as well as opportunities toward expansion in digital, carbon capture, or other green technologies.

Engineering and Construction

Strong deal activity is forecast in 2022 with the passage of the Infrastructure Investment and Jobs Act, with high levels of capital ready to be deployed in engineering and construction. There will also be a focus on “green” construction.

Acquisitions that can increase a company’s environmental, social, and governance (ESG) capabilities such as sustainability, self-sufficient buildings, or carbon capture and storage technologies, give a company competitive advantage for winning projects.

Although analysts are optimistic about deal activity in 2022, Engineering and Construction still faces the headwinds of costly raw materials and labor shortages.  Any acquisitions that can improve sourcing and supply chain disruption or increase efficiencies and margins will help increase industry resilience and preserve deal valuations.

Even with the high prices of materials and labor shortages, housing starts increased 11.8%, the highest level since March 2021.

Industrial Manufacturing

Deal activity finished strong for industrial manufacturing with deal value up 50% over 2020 and deal volume remains stable.  Activity is expected to remain strong throughout 2022 driven by a continued need to streamline portfolios and invest in growth areas, with many company owners looking to exit before potential policy changes with the upcoming midterm elections.

COVID-19 highlighted the need for digitization and industrial manufacturing companies will continue to use M&A activity to obtain and increase digital capabilities, particularly those that can help mitigate supply chain risk.

Other trends experienced include deals to increase scale or product portfolios, or expansion into new markets.

Transportation and Logistics

M&A activity was robust in 2021 for transportation and logistics as many companies fought to gain control over their supply chains.  Supply chain solutions will continue to be a trend this year and consolidation among transportation companies continue.

Technologies to enhance supply chain visibility, decrease operational costs, and improve inventory sourcing for e-commerce growth will be sought after to help companies continue to combat supply chain challenges.

In addition to e-commerce order sourcing, companies are focusing on last-mile delivery and improving the customer experience.  They are seeking control up and down the supply chain and will need M&A opportunities to reach their goals.

 

Disclaimer: Securities related services (capital sourcing and securities transactions) are offered through an unaffiliated entity, M&A Securities Group, Inc., member FINRA/SiPC. Managing Directors of ClearRidge are registered investment banking agents with M&A Securities.