Despite a decline in M&A activity for the first time in years (Value: -15%, Volume: -9%), it can be assumed - ceteris paribus - that the M&A market in Germany will continue to develop robustly in 2020 and will remain at roughly the same level as last year. The downward trend of the past year can be explained primarily by the international slowdown in economic growth as well as the continuously high level of economic uncertainty. Unaffected by this, the number of transactions in the TMT, medical technology, pharmaceutical, and consumer goods industries is expected to remain high.
In this context, it is important to always keep the current macroeconomic conditions in mind: Sovereign debt levels have reached historic dimensions, which are about three times higher than the worldwide GDP. In addition, the growing bubble in the bond markets is accompanied by negative interest rates and an inverted yield curve. This development is leading to a steady increase of so-called "zombie companies", i.e. companies that have to take on additional debt to cover their current financial liabilities. Moreover, distortions on the international financial markets, various trade wars caused by increasing protectionism and high levels of national debt of certain individual countries, especially Italy – currently the EU's biggest problem child – are increasing the risk of the next major economic crisis. However, no expert can predict when the next crisis will strike and what the exact impact will be. If the frequently predicted major crises will hit the markets, it would at least be the crisis with probably the longest public warning period ever. A potentially severe crisis like back in 2008 or even more severe – as feared by some renowned experts – would of course have a massive impact on the global M&A markets.
We expect that strategic investors will continue to pursue transactions, which will sustainably improve their competitiveness in an increasingly digital and rapidly changing world. Especially, large global companies will continue to review their portfolios and dispose non-core assets as well as unprofitable business units by way of spin-offs or carve-outs in order to be better prepared for the very probable crisis. The funds and resources made available through these transactions will be subsequently used for investments in innovation, digitalization and disruptive technologies. The disposed assets continue to attract private equity investors in hope for superior returns on a stand-alone basis. The ongoing sale of Thyssen Krupp's elevator business worth around EUR12 - 15 billion is a current example for such a transaction. Private equity investors are currently also putting a greater focus on portfolio companies affected by the industrial recession and are taking strategic and operational steps to make these companies more crisis-resistant. Provided there is no immediate exogenous pressure to sell these companies, it can be assumed that they will not be put up for sale for the time being.
In addition, the number of distressed M&A transactions will continue to rise sharply after an already significant increase in 2019. In the past fiscal year, particularly larger insolvencies increased at a significant rate (+42%). Prominent examples include Thomas Cook, Gerry Weber, Eisenmann, Kettler and Germania. Many companies in the automotive, mechanical engineering and chemical industries have already been in a crisis for many months, pointing towards further consolidation as a result. Furthermore, there will likely be an increase in crisis-related transactions in retail, e-commerce and financial services over the next 12 to 18 months. Not every company in distress will find a new owner. In the worst case, these companies may even have to be liquidated in the event of an insolvency.
Companies that cannot keep up with the technological change and that offer products or services that are increasingly interchangeable or easy to substitute are becoming less interesting for investors. This ultimately leads to declining valuations and a continuously shrinking number of potential investors. In extreme cases, some companies from these industries will not be able to find interested investors at all. As a result, pressure to act is currently rising on owners of companies in the affected sectors in order to liquidate their assets tied up in their companies.
So far, the general valuation environment has not changed noticeably despite the economic uncertainty and remains at a very high level. According to Mergermarket, the average EBITDA multiples in Germany in 2019 were 10.2x, again slightly above the previous year's level (9.8x). However, the analysis of individual industries and their sub-sectors reveals a much more differentiated picture. Valuations in the automotive, oil/gas, telecommunications services and mechanical engineering sectors are under strong pressure and have fallen significantly in the past three years. Suppliers in these sectors are also forced to revise their business plans with negative effects on their valuations. By contrast, companies with strong growth prospects, low cyclicality and solid and expandable profitability continue to enjoy high demand. EBITDA multiples of 7- 9x or even higher remain achievable. For IT, software and technology companies in particular, EBITDA multiples of 10x and more will continue to be the rule rather than the exception in the future, with the quality of the respective business models ultimately being the decisive factor. Driven by the current interest rate environment and investors with significant amounts of dry powder that face a limited supply of high-yielding, solid and well-positioned assets, valuation levels are expected to remain high at least for the coming months. Overall, however, we assume that the highest valuation level has been reached and that valuations could tend to fall. This means that there is still an attractive window of opportunity to initiate the exit process for entrepreneurs who want to arrange their succession in the next 2-3 years as well as for PE investors who plan the disposal of well-running portfolio companies.
Increased caution by banks financing leveraged buy-out transactions, which was already observable in 2019, will negatively influence the M&A market in the near future. Banks are becoming noticeably more diligent and examine their financing commitments more carefully. This trend will particularly affect companies in cyclical industries and those with high export shares. This has already led to more conservative financing structures as well as stricter capital requirements and lower debt multiples. Lower valuation multiples will be the result if private equity investors are not willing to adjust their equity return targets accordingly. While equity ratios of 25 to 35% were still possible a few years ago, today 45-50% have become common in most cases.
The M&A market in 2020 will probably show a stable sideways movement measured by the number of completed transactions, while the share of crisis-related transactions will increase significantly. While the financing environment will have a negative impact on the valuations by private equity investors, there is still an attractive exit window for business models that are resistant to economic cycles. However, the general economic uncertainty remains very high and exogenous shocks could trigger the next major recession at any time.
Article by Marco Strogusch, Partner, IMAP M&A Consultans AG
Sources: mergermarket, Handelsblatt, Finance-Magazin
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