Originally published in Middle Market Growth
By Joanne Baginski and James Drybanski
The U.S. economic expansion recently marked its 10th anniversary, but an analysis of merger and acquisition deal activity from the past three years suggests that an economic slowdown could be on the horizon.
Look no further than transaction size and the number of deals closing for evidence that buyers are becoming more wary about the outlook for target companies.
Even amid the deals slowdown, however, there are bright spots. Health care, real estate and information technology appear to have greater strength than other sectors.
This analysis draws on data from S&P Capital IQ from 2015 to the end of the first quarter of 2018, comprising 8,046 deals valued at $4.3 trillion. It shows annual M&A activity is significantly below the $1.82 trillion worth of deals that closed in 2007, before the last recession began, and has been cooling for the past three years.
In 2015, 3,355 deals valued at $2.06 trillion closed. The following year there were, 2,516 deals valued at $1.38 trillion—a 25 percent drop. Last year, there was another 22 percent drop to 1,978 deals valued at $866 billion.
Already in 2018, things have slowed even further. In the first quarter of this year, $44.9 billion worth of deals closed.
It’s not just the volume and value of deals that are declining. The average size of deals is also dropping. In 2015, the average size was $619 million. For the first three months of 2018, the average deal size was just $229 million. Declining M&A activity is typically viewed as a leading indicator of a shift in the business cycle from expansion to recession.
Rising stock market valuations could partly explain declining M&A activity. As of May 17, the price-to-earnings ratio of the S&P 500 was 24.8x, up from a post-recession low of 14.8x in 2012. Those high valuations have made buyers increasingly cautious, as evidenced by the rising number of earn-out agreements that are now written into the contracts of a growing number of deals.
Earn-out agreements are a more significant feature in deals today than they were in 2007, before the last recession. Back in 2007, such clauses were included in 21.8 percent of deals, withholding 0.63 percent of total deal value. During the first quarter of this year, contingency clauses were included in 28.4 percent of deals, withholding 1.3 percent of value. This could indicate the deal pricing has passed its peak and that valuations can be expected to fall.
The notion that a recession may be looming is in keeping with broad economic forecasts. Among economists surveyed by The Wall Street Journal, 8 percent predict the expansion will end next year, 59 percent say it will end by 2020 and 22 percent see a recession starting in 2021.
Whether or not a recession is coming, three sectors are accounting for a rising share of overall M&A activity—information technology, health care and real estate. Where overall revenue multiples declined by 15 percent from 2015 to 2017, valuations have risen in these three sectors.
Information Technology: IT deals over the past three years were worth $752 billion, or 17.4 percent of total deal value. The industry is experiencing disruption, driven by the shift to cloud computing, rising demand for cybersecurity, and the increasing use of big data and analytics as well as artificial intelligence. That disruption is producing target companies with significant growth prospects, prompting buyers to pay growing multiples of revenues, rising from 3.6x in 2015 to 5.3x in 2017.
Health care: The health care industry is undergoing a massive wave of consolidation, driven by a shift in the business model where health care providers are rewarded for outcomes rather than the volume of patients they serve. That has helped produce $576 billion worth of deals, representing 13.3 percent of total transaction value. Revenue multiples increased from 4.8x in 2015 to 5.4x in 2017. Additionally, health care deals are getting significantly larger; the average deal size rose 50 percent to $1.4 billion between 2015 and 2017.
Real Estate: Real estate also accounts for a growing proportion of overall M&A activity, representing 12 percent of transaction value in 2017. The size of those real estate deals has risen as that market undergoes the disruption that comes from the global shift away from old-fashioned retailing to online sales from firms like Amazon that is driving demand for warehouses and logistics centers.
In keeping with an M&A market that is cooling, overall the average revenue multiple paid was down 15 percent over the three-year period to 6.24x. Revenue multiples paid were highest in the real estate sector, at 17.87x, and were the lowest in the telecommunications sector, at just 2.85x.
While the decline in the volume and value of M&A deals overall is a leading indicator of an economic slowdown, the data, coupled with macro trends, suggest that the health care, real estate and IT sectors may weather any potential recession better than the broader economy.
Joanne Baginski leads the transaction advisory services practice at EKS&H. James Drybanski is a consulting senior manager on the team.