The recent volatility in US equity markets, compounded by heightened geopolitical tensions, is likely to have a big impact on whether companies decide to pursue an initial public offering (IPO), acquisition or divestiture.
The current brew of inflation, rising interest rates, supply chain disruptions and investor uncertainty can “move the goalposts” for companies that had been planning to pursue deals this year. Key to this is that volatility is about increased variability: in deals, one party’s risk is the counterparty’s opportunity.
Here’s how to think about today’s volatility.
M&A dealmakers need to calibrate variables
Broader market volatility affects acquisitions and divestitures, with the impact varying depending on the industry and the status of the process. Some industries — for example, those that use semiconductors — have been more negatively impacted by supply chain disruption or other volatility drivers. Since uncertainty creates risk in an M&A process (in both overall pricing and lending), completing acquisitions and divestitures in such industries can be especially challenging in the current market.
But those same challenges present opportunities for investment. They also can give owners of scarce resources greater clarity as to their own capital investment or potential exit paths.
M&A deals that are currently being pushed through to completion are working changes around long-term expectations and growth assumptions into their process – including using purchase agreement mechanisms that capture the increased volatility in forecast outcomes, such as with an earn-out.
If the process has not formally started, some sellers may want to delay in the hope that there will be greater clarity and less market volatility in the future. Others may want to accelerate the process based on the impact to their business. The key is a balanced view of the range of potential impacts on a business’ trajectory.
Companies considering acquisitions should factor in potential supply chain and resource risks in their valuation models, along with the market demand and pricing implications that can help improve profitability with higher volatility. Those considering a divestiture should assess how much the business is currently impacted by key variables, and the levers to manage those impacts, from sourcing to workforce to energy prices. Clarity as to how to better mitigate these challenges provides a clear and consistent message for potential bidders.
IPO market is quiet — for now
The keys to a well-functioning IPO environment include foundational elements such as solid economic indicators (GDP growth, a stable interest rate environment, low unemployment) and strong equity markets. Low volatility — as measured by the Chicago Board Options Exchange’s Volatility Index, which reflects broader global market considerations — is also a critical element. When volatility is high, the number of IPOs usually decreases because it’s difficult to settle on a widely agreed-upon IPO valuation. That’s why, with the exception of a few notable deals, the IPO market has largely been quiet in 2022.
The factors working positively for the IPO market today are GDP growth and low unemployment. But they are offset by a level of inflation the US hasn’t seen in 40 years, challenging the concept of a stable interest rate environment.
Given that the recent IPO market has been dominated by technology and pharmaceutical and life sciences companies, some are forecasting that today’s volatility will likely continue to keep other issuers out of the market. But it’s valuation, not volatility, that’s restraining the market.
For the first time in years, some issuers are balking at using comparable stock valuations to estimate the value of their business. The Russell 2000 is down 23% so far this year, and as that tide went out, so did 115 of 119 tech IPOs from 2021 — which are currently trading below their IPO price, according to PwC research. Investors have been left to “average down” on the bulk of recent IPOs they’ve invested in. It’s clear that it will take some time for issuers to adjust to the fact that they may have to accept lower valuations.
Private equity is hunting for deals
After a record 2021 for both deals and fundraising, private equity (PE) firms are likely to continue to be busy in 2022. Private market valuations for prospective PE portfolio companies have yet to decline significantly, but they are likely to follow the public market’s valuation reset. This could lead very active PE firms to provide M&A exits that may prove easier than the public markets — or even to an increase in take-private deals. Leveraged buyout (LBO) deals will likely continue despite higher interest rates, with more capital potentially coming from a record amount of dry powder. PE firms likely won’t wait for the market to hit bottom; they traditionally are willing to invest as long as the valuation is in line with their projections, and supported by a clear value creation path.
Takeaways to consider
During the current market volatility, executives should consider three things:
- M&A dealmakers, whether looking to acquire or divest, should assess the impact of greater variability on business units and factor that into their valuation models.
- Executives considering IPOs should keep the current market situation in perspective. Traditional IPOs have outperformed the S&P 500 for eight of the past 10 years, and the investment community will likely continue to support high-quality issuers with proven management teams, growing markets and existing profitability.
- Executives considering PE deals should understand that while PE firms won’t necessarily wait for the bottom, they will be looking to take advantage of market corrections to strike more favorable deals.
(Courtesy PwC. By David Ethridge US IPO Services Leader, PwC US Derek Thomson Capital Markets Research Leader, PwC US)