Inflationary Backdrop Puts Wrench in M&A
How do you value a company against an inflationary backdrop when the only operational data has been during a deflationary environment?
That is the question that many private equity firms have been struggling with as they hunt for deals to put their dry powder to use.
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“It’s very hard to project where a business is going to be three to five years from now,” one private equity expert said confidentially. This person explained that businesses have a financial history in how they operate in a deflationary environment. But now, suddenly, there’s inflation and no one really knows what it means for the business over a longer horizon.
Another private equity investor said that the lack of clarity has made projecting the operational profile difficult. Without clarity on certain metrics, even if they are estimates, financial sponsors are hard pressed to get a calculation on what their return profile would be on potential investments. Moreover, the changes in the U.S. interest rates have added to the level of difficulty in getting deals underwritten, a factor considered to be a “temporary dislocation” as investments in different sectors cycle in and out of favor.
That dislocation has resulted in private equity firms allocating fewer investment dollars to retail, with much of it due to the uncertainty surrounding consumer spending.
“We had a big slowdown as all of you know because interest rates rose so sharply and that really affected everything from dealmaking to exits to fundraising,” Hugh MacArthur, chairman of Bain & Co.’s global private equity practice, said last week during a company webinar providing an update on the current mergers and acquisitions cycle.
“It’s not necessarily the level of interest rates, but it’s actually the rate of change in interest rates and how that really set the industry reeling,” MacArthur said. He noted that dealmaking slowed because of the “almost unprecedented 500 basis point increase in central bank rates over an 18-month period.” He explained that it’s “hard to get a deal done when you’re trying to project your debt costs over a five-year period and every two months you have to put new numbers out there. That has really caused a great deal of uncertainty in the market.”
Also challenging for private equity has been exits by financial sponsors selling to another sponsor. “Exits actually emerged as the most challenged during [2021 to 2023], and they continue to be a challenge,” he said. MacArthur explained that a sponsor who paid a 12 times multiple a few years back using 5 percent debt will have a hard time selling because financial sponsors now can only afford to pay nine or nine-and-a-half times for the asset with 10 percent debt. That 500 basis point change in credit costs changes the model and there’s no way to make the math work to get to 12 times using 10 percent debt, he explained.
He also said the competition for high-quality assets is “still very, very high” given the amount of dry powder that’s available to be put to use. How much dry powder? According to MacArhur, about $4 trillion is available across all private asset classes, with “over $1.2 trillion for buyouts alone.”
“We’re pretty bullish on dealmaking for the 2024-2025 time period. Obviously, we can’t predict black swan events, but this amount of capital is going to support pricing and also going to support creative ways to get many more deals done,” MacArthur said.
With interest rates likely to remain higher companies will have to figure out what they need to get margin expansion. That could mean cutting costs, or finding some other way to get operating leverage. “We need to get back to figuring out how does margin expansion really contribute to value creation,” he said “Because if we don’t, [then] overall returns are probably headed for a much less attractive picture in the next five to 10 years versus the past 10.”
Among strategics, the one deal in fashion still awaiting closure is Tapestry Inc.’s $8.5 billion transaction to acquire Capri Holdings Inc., announced last August. E-commerce firm Coupang Inc. in January closed on its purchase of the troubled London-based Farfetch, but that was part of a pre-packaged, or planned, administration process. And earlier this month, the intellectual property assets of the defunct Zulily brand was acquired by Beyond Inc., which is the owner of the Bed Bath & Beyond and Overstock.com brands. Zulily wasn’t in bankruptcy, but its assets were sold under and ABC agreement, or assignment for the benefit of creditors. The ABC is essentially a liquidation out of bankruptcy court where proceeds are earmarked for creditors.
Elsewhere in home, Ashley Home Inc. this month acquired Resident, a digital retailer and wholesaler of mattresses and bedding accessories.
What will be interesting is what happens to Gildan Activewear, now that the company has decided to put itself up for sale. There rumblings are that private equity firm Sycamore Partners could make an offer, but for how how much remains unclear. Gildan is believed to have already received a nonbinding, unsolicited offer at $42 a share. Gildan has been battling activist investors since December when it dumped co-founder and former CEO Glenn Chamandy, a move that has failed to sit well with the activists, who want to reconstitute the board and have him reinstated.
More recently, Lever Style Ltd. executive chairman Stanley Szeto said earlier this month that mergers and acquisitions (M&A) activity could be one avenue for growing the Chinese apparel manufacturer. Lever is a supplier for brands such as Ted Baker, Columbia, Spanx and Ministry of Supply.
But the bigger players in the M&A category could be in logistics, which thus far this year has seen the merger of Forward Air-Omni Logistics, the Ryder System Inc. deal for Cardinal Logistics and the AIT Worldwide Logistics deal for Global Transport Solutions Group. Also in logistics earlier this year was the Shift-Yodel delivery transaction, the tech deal that saw Blue Yonder acquiring transportation planning software Flexis, and the ADL Final Mile firm’s acquisition of fellow last-mile delivery company Sonic Transportation & Logistics.
