Perspectives – Marc Cooper – July 2024

M&A Outlook: Strategic Deals Soar, Private Equity Stalls

by CEO Marc S. Cooper

The merger and acquisition (M&A) world was a tale of two cities at the halfway mark in 2024. A smart rebound in strategic corporate deals has been offset by an estimated $3.2 trillion backlog of unsold portfolio assets on the books of private equity funds, which is holding back a full-fledged recovery.

A closer examination of the underlying factors behind this divergence offers clues about what to expect in the second half and beyond.

First the good news. As inflation eases in the US, Federal Reserve Chair Jerome Powell and his colleagues are clearly inching toward cutting interest rates later in the year.

With rates set to head lower after an eye-watering 525-basis-point rise in interest rates in 2022 and 2023, CEOs at many corporations have resumed their pursuit of strategic deals aimed at bolstering growth, expanding market share, and acquiring new technologies and capabilities.

Energy, technology and finance companies are seizing the current opening to finance acquisitions at a more predictable cost of capital, enabling them to make bold moves with greater confidence. Many companies are far less interest rate-sensitive than they were a year ago.

Capital One Financial Corporation and Discover Financial Services ($35.3 billion), ConocoPhillips and Marathon Oil ($22.5 billion), and Home Depot and SRS Distribution ($18.25) — all these deals reflect a return of the proverbial animal spirits, as companies leverage their balance sheets to drive long-term value creation.

Unfortunately, that deal-making energy hasn’t yet fully returned to the private equity world. The deals financed during the ultra-low interest rate environment in the 15 years after the Great Financial Crisis are creating a standoff. Many of these transactions, struck under the assumption of sustained low borrowing costs, now appear less attractive as interest rates have risen.

Private equity funds are reluctant to sell assets at lower valuations, which might result in financial hits and writedowns, as well as more modest returns. On the other hand, holding onto these assets longer than anticipated ties up capital and resources that could be deployed elsewhere.

This price discovery conundrum caused buyers and sellers to have differing fair market value expectations and has led to a significant slowdown in PE-driven M&A activity, contributing to the broader market’s sluggishness.

The reluctance to do deals at reduced prices has also been exacerbated by the need to demonstrate strong returns to their investors. Private equity funds are under pressure to justify their investment strategies and maintain their reputations for delivering high returns.

Make no mistake: There’s plenty of money out there, plenty of capital, both in equity and in debt. Private equity funds are overflowing in dry powder capital, some $2.5 trillion at last count, according to S&P Global.

In some cases, private equity funds are simply waiting to sell, betting that improving earnings will reach a point at which an absolute sale value allows them to reach their objectives even at lower multiples.

More broadly, though, I sense a bigger challenge. What’s missing is the willingness to sell portfolio companies at prevailing valuation levels as price discovery has yet to be realized. Instead, market participants are nibbling around the edges, redistributing some capital gains to investors via dividend recapitalizations, or minority stake sales — but stopping short of an outright asset sale.

So when will the dam break? In my view, it will take a handful of significant asset sales by major private equity funds to signal a new realism about valuation to the broader market.

In the meantime, the current environment calls for a nuanced approach from market participants. Companies and private equity funds alike need to balance immediate opportunities with long-term strategic goals.

For corporations, this means continuing to pursue strategic acquisitions while being mindful of the changing economic landscape. For private equity, it may involve re-evaluating portfolio strategies and making some tough calls that may crimp returns short-term.

I’m confident that the M&A market will continue to work through these structural challenges, and a full-fledged recovery is in the offing. The M&A reset after two years of muted deal volume is certainly taking longer than the historical average. Rest assured, though, the market is well on track to return to prosperous times.