As part of our inaugural M&A Report, which publishes Tuesday, March 10th, we got a hold of Rich Jeanneret and Jeffrey Greene at EY to discuss what they’re seeing in the current M&A landscape and what they expect to see in 2015. Keep an eye out for thePitchBook Newsletter tomorrow morning to download your free copy of the report. Jeanneret is Americas Vice Chair, Transaction Advisory Services at EY. Greene is EY’s Global Transactions Advisory Services Leader, Life Sciences.
Q: Why was 2014 such a big year for M&A when the current market fundamentals have been in place for a few years?
RJ: 2014 was a good year for M&A. It’s been a bit overhyped because of the number of large deals that got done. But underlying that is the fact that the number of transactions that got done last year was only up about 5% over the prior year. The value of those transactions was up around 40%, so the story was that 2014 was the year of the big deal. There were several headline-grabbing, multi-billion-dollar transactions, probably the most $10+ billion transactions in a number of years. But the reality of it is, the number of transactions getting done was only up modestly. I think that’s a result of one factor, and that’s growing confidence. There are a lot of things that can contribute to that, like cash and credit, and those elements of deal-making have been strong now for a couple of years. Corporate cash has been strong and private equity coffers have been full. Credit has been strong, and it got even stronger last year, but there’s been a series of macroeconomic and geopolitical building blocks that have occurred over the last 24 months that have contributed to a resurging level of confidence in the C-suite. That, and growth has gotten harder. The pressure on creating shareholder value, which might be a little more acute now because of the role of activists – I think has triggered the uptick in larger scale deals.
The U.S. economy is at its strongest level since the Great Recession. There’s a smooth transition at the Fed. There’s relative political peace in Washington on issues that matter toward deal-making. What was perceived to be “taper tantrum” last summer came off with relative ease. The world seems to shake off large-scale geopolitical issues relatively well. The equity markets have hung in there, and I think that’s given C-suite executives more confidence to make deals.
JG: That’s largely true in the life sciences sector. A component of last year’s record was favorable tax strategies that were available, but even if you adjust for that, 2014 was a really good year. We see continued robustness in 2015, with that one caveat.
Looking ahead to 2015, have the underlying factors that led to the M&A boom last year changed significantly?
RJ: I think we have momentum going into 2015. While 2014 was the year of the big deal, what it didn’t say was the middle market (<$1B) stayed on the sidelines. Deal volumes for transactions under $1 billion were down roughly 10% or so, and even at higher levels throughout the year. We thought that the middle market would start to recover around the fourth quarter, based on the sentiment we’ve seen through our Capital Confidence Barometer and what C-suite executives were saying. The middle market had been watching the action but wouldn’t stay on the sidelines for very long. We still think they’re going to come out to play and they’re not going to get left behind in the M&A boom.
The markets have generally rewarded smart M&A. If you watch the trades happening on the public markets, share prices for both the buying and the selling companies are going up. That’s happening at a much higher level today than it has in previous years. I think that gives the middle market some confidence in doing deals in 2015, which bodes well for momentum and maybe even an uptick this year, as well. The private equity industry has raised an enormous amount of capital in the last two years, and I think 2015 will be a very interesting and complex year because of the swing in commodity prices like oil having a complex impact on many different industries. PE firms are very good data collectors for that kind of analysis. I think they’ll spring to action faster than most. They’ll have an idea about how changes in commodity prices will impact different industries.
The markets have been a little more volatile because of the price of oil lately. We think the lower cost of oil, and perhaps its adverse impact on GDP, will be more than offset by an increase in consumer spending. It should be a good year for GDP in the U.S., and that means a high level of confidence for executives and investors.
Do you see increases in M&A counts or value? Or both?
RJ: I think we’ll see more volume this year, particularly in the middle market. That might drive down a little bit the value per transaction, but I still think you’ll see big deals. It will just be a mix issue, but it doesn’t change the overall story. We actually started to see middle-market deal volumes start to flatten out in the fourth quarter. They sort of stopped their decline.
How about activity at the upper end of the market? Do you think that’s largely played out, or do you think there’s still some runway left for mega-deals?
RJ: There’s still a level of large deal activity that will get done this year. It might be a little less than last year, which was a breakout year. A lot of people got first-mover advantage, and the equity markets have moved up again, so it’s possible that larger scale deals won’t be as frequent, but they haven’t petered out by any means. We had such a restrained level of deal activity since 2007, so there’s plenty of pent-up demand for deal-making, as long as it’s smart deal-making. Companies are smarter than ever before on doing deals, how they’re underwriting them and doing the business analysis and diligence on them. It should be a decent year again for large-scale deals. It’s hard to see activity getting dramatically larger than what it did last year, but I think it will stay reasonably strong.
JG: We saw some very large deals in life sciences last year. Some of the biggest transactions were effectively bolt-ons, which can run upwards of $15 billion in the sector. We also expect to see a fair number of those in 2015. And there’s still potential for more very large deals as the lines continue to blur among Big Pharma, Big Biotech and Specialty Pharma.
One reason we may see more large deals in the life sciences sector is because, despite having some mammoth companies with large market capitalizations, it’s still fairly fragmented compared to other industries. There’s still potential for consolidation among big pharma and specialty pharma companies. That segment has actually become more fragmented over the few years, so that could drive deals.
Speaking of pharma, are there any other sub-sectors in the healthcare industry that could see that kind of increase in M&A activity this year?
JG: There’s sort of a cascading effect from deals that have been done over the last year or two. Consumer health, for instance, is a very hot segment. A number of life sciences companies want to increase their exposure there, but also consumer product companies want to get more into consumer health. So there may be more competition for the assets that might come to market in that segment.
I think private equity would like to play there but it’s hard for them to compete against the strategics. One place where private equity is probably going to have more success is around medical technology and devices. That’s also a very fragmented industry with lots of opportunity to consolidate as a result of recent regulatory changes and R&D results, so I think you’ll see more deals there. In addition there were several rumors about established products deals – off-patent drug portfolios. There were some assets in the market but no big deals ended up getting done by private equity, in part because whole companies aren’t being shopped. It’s mostly products without a lot of infrastructure to run those businesses. So until the big pharma companies can figure out how to do that in a way that makes it palatable and feasible for private equity, it’s going to be a challenge to get those deals done. But there’s definitely the potential to see that over the next twelve months.
One of the things we’ve noticed is that strategics trumped private equity quite a bit in 2014, thanks largely to synergy opportunities for strategics. Do you see a similar dynamic going into 2015?
RJ: Jeff’s comment about pharma’s interest in consumer is one of the reasons that PE has a harder time playing there. When you’re looking at a business that a strategic wants where there’s natural synergy, they are going to have the advantage. But there is plenty of transaction volume out there for both. My sense is that there will be a continued interest in PE in Corporate America and an interest from Corporate America to have PE involved.
Complex carve-outs are a good example. This whole wave of divestitures that began about four years ago continues to occur. What’s attractive to private equity and attractive to corporates as potential sellers of assets is a private equity-type buyer of those assets, for a variety of different reasons. Typically, when Corporate America decides to get rid of something, it’s shedding something that’s no longer core to it. When Corporate America gets rid of these businesses, it allows those businesses to reset their priorities with a management team singularly focused on that business and not distracted, confused or impeded by broader corporate policy or capital allocation constraints. It no longer has to hit certain financial operating metrics for a publicly traded corporation or for a publicly traded corporate that has a different set of business metrics, like focusing on dividends. With the private equity buyer providing the capital, they can enter new markets or get funding for new products, for example. PE will clearly compete with assets like they always have, but I think private equity is filling a very important role in this divestiture wave.
What about the strategic-PE battle playing out in pharma?
JG: There’s more fertile ground for PE in medical devices, tools and diagnostics. Eventually some aspects of consumer health, and then if these established products assets come back to market, PE will have a role to play. The priciest assets are more in the biopharma space, which hasn’t been where classic private equity has ever really played because of the high R&D component. The risk and volatility involved haven’t really been conducive to the private equity structure that involves some amount of leverage.
Do you expect the overall divestiture wave to continue into 2015, particularly PE-led carve-outs?
RJ: There’s been a lot of success for the private equity-led carve-outs for both the seller and the buyer. I think that will continue.
I think there’s plenty of runway left for this wave of divestitures. It all depends on how you want to think about it. There’s still a lot of activity that can be characterized as “de-merger” activity from 2004 to 2008. There are plenty of non-core businesses that have been affected by technological revolutions in so many industries in the U.S. in the last five years. It’s made certain businesses, no matter what industry sector they’re in, not as core as they used to be. The changing landscape around energy prices is going to create a potential wave of transactions, as well.
And lastly, I think the activist wave will continue to give fuel and fire to divestiture activity for a couple of reasons. One, the activists are there with a significant amount of dry powder and they’re causing transactions to occur, but secondly, the activist wave has caused Corporate America to be much more strategic around portfolio optimization than ever before. Corporates are undertaking proactive reviews of their businesses in order to be prepared, and that in itself is forcing a level of activity that we haven’t seen in the past.
The reality is the divestiture wave has created shareholder value. There’s been success in the last two years around these deals that have been done that manifests itself through in either greater share prices, or the assets that were spun off actually end up trading at much higher levels than the day they were spun, or in some cases breaking apart the sum of the pieces to create a great whole – those are all good outcomes for shareholders. The track record of divestiture activity over the last two years has been good and I see no reason for that to not continue. There’s still a lot sitting on the balance sheet of Corporate America.
JG: That’s true in the life sciences sector, as well. There are still a lot of non-core businesses left among the largest and the next tier players. There’s been a theme over the last few years of increasing strategic focus. So we expect to see more divestitures, and I think private equity can play a material role there.
Shareholder activism has affected all industries, as Rich has said. Just recently, the activist spotlight has started to shine on the life sciences sector pretty brightly. You’re familiar with the very big saga that played out over six or seven months in 2014. A couple of other prominent companies came under activist criticism, and we expect that to increase going forward, which should drive divestitures and increase focus on improving operational performance and governance as well as other issues unique to the sector.
All of what Rich mentioned is true, even more intensely in the life sciences sector.