Expectations of another bumper year for US M&A failed to materialize in the first half of 2017, as total deal volume fell below 2016 levels.
In the first six months of 2017, there were 2,413 deals, an 8 percent drop from the 2,631 recorded in H1 2016. Value was up, albeit by a small margin, edging 0.5 percent ahead of the US$585.4 billion in H1 2016 to US$588.5 billion in the first six months of 2017. Inbound activity fared a little better, buoyed by activity in the consumer sector, with a deal value of US$209.7 billion for the first half of 2017, up 26 percent on the same period in 2016.
Meanwhile, US dealmakers remain confident acquirers overseas, conducting 592 deals worth US$202.5 billion in the first half of the year, overtaking all half-year value totals on record despite volume dropping 6 percent year-on-year.
Dealmakers temper their expectations
There was an expectation that momentum from the last quarter of 2016 (when close to US$500 billion worth of deals were announced) would carry into 2017. The expectation was built around continued stock market growth and the business-friendly agenda of incoming President Donald Trump, who had laid out plans to cut personal and corporate tax rates, reduce the taxation of overseas cash piles repatriated to the US, invest US$1 trillion in infrastructure and roll back regulation.
Trump's agenda has been thought to be beneficial for business, but there are now substantial questions about whether he can implement it, and you have to price that in.
John Reiss, Partner, White & Case
However, doubts about Trump's ability to move his agenda through the Capitol have emerged after an unsuccessful attempt to push through healthcare reform and the botched execution of an immigration order. These factors have weighed on initial optimism.
"M&A activity does feel a bit lackluster when compared to previous years," says John Reiss, Global Head of M&A at White & Case. "Trump's agenda has been thought to be hugely beneficial for business, but there are now substantial questions about whether he can implement it, and you have to price that in."
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Consumer spending spree
Scale is defined differently now. Scale is not defined by stores and leases. It’s defined by clicks and ad revenues.
Michael Deyong, Partner, White & Case
Dealmakers will be encouraged by a return to strong activity in the consumer sector, which delivered US$132.9 billion worth of transactions and was the most active sector by deal value in H1. This is a marked improvement for the industry, which was only the sixth-largest sector by deal value last year and has already delivered a higher value in the first half of 2017 than it did in the whole of 2016. Growth in consumer M&A can bode well for wider M&A activity, as consumer M&A is a good barometer of disposable income, employment levels and economic growth.
The deal activity in consumer will also have a positive effect on technology M&A, as consumer companies increasingly rely on digital and online platforms to sell and market their products. Amazon's US$13.5 billion purchase of grocer Whole Foods is a prime example of how deal activity in one sector spills over into another.
"Consumer habits have affected the way companies approach their acquisitions, and convergence between industries does drive activity in different sectors in new ways," says White & Case partner Michael Deyong. "Scale is defined differently now. Scale is not defined by stores and leases. It's defined by clicks and ad revenues."
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China puts on the brakes
China showed almost insatiable appetite for foreign companies in 2015 and 2016, with deal value more than doubling 2015's record levels to US$207.4 billion. But restrictions in China now require the foreign exchange regulator to screen and approve any deal worth more than US$2 billion, which could hinder outbound activity.
There are some concerns that the US is perhaps not as friendly to China as it used to be, and if you put that together with the limitations in China on capital outflows, then it does put inbound M&A from China under pressure.
John Reiss, Partner, White & Case
In 2016, China was the third-biggest inbound M&A investor into the US, with US$62.6 billion worth of deals. Only Canada and Germany closed deals worth more. In the first half of 2017, however, China ranked only ninth, with US$6.1 billion worth of deals.
Trump's "America First" rhetoric may prove a further barrier for Chinese firms looking to do deals in the US. The decision by US authorities to block Fujian Grand Chip Investment Fund's US$550 million acquisition of technology group Aixtron last year due to national security concerns also indicates the increased scrutiny surrounding Chinese investors pursuing even non-US transactions with an affiliated US business involved.
"There are some concerns that the US is perhaps not as friendly to China as it used to be, and if you put that together with the limitations in China on capital outflows, then it does put inbound M&A from China under pressure," Reiss says. "That is a concern, because China has been one of the most important stories in the M&A market in recent years."
Strong fundamentals persist
Despite these headwinds, deal figures for the first half of 2017 remain high by historical standards. Deal volume and value in H1 2017 was higher than in any H1 period from 2011 to 2013. There may be some signs that the market is slowing after record levels of activity from 2014 through 2016, but the outlook for M&A is still positive on balance.
M&A remains a strategic imperative for corporates that need to grow, private equity has money to invest and the financing market is supportive. If you look at the fundamentals, they are favorable.
John Reiss, Partner, White & Case
The US economy is expected to continue growing steadily, with the World Bank forecasting growth of 2.1 percent in 2017 and 2.2 percent in 2018. This is higher than forecasts for the Eurozone and compares favorably to faster-growing but riskier emerging markets. Debt markets are open and with interest rates at 1 percent (significantly lower than 5.8 percent average over the last 50 years), financing is accessible and cheap.
Given these solid economic fundamentals, it isn't a great surprise that the seven of the ten largest M&A deals in the world in H1 2017 involved either a US bidder or a US target. The US remains an attractive jurisdiction for overseas buyers, with five of the ten largest US M&A deals in the first six months of the year involving a bidder from overseas.
"Even when you put aside the benefits of the pro-business Trump agenda, the US is in good shape and continues to give buyers confidence. M&A remains a strategic imperative for corporates that need to grow, private equity has money to invest and the financing market is supportive. If you look at the fundamentals, they are favorable," Reiss says.
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CYBERSECURITY AND THE C-SUITE
The c-suite is responding more proactively to cyber risks during the M&A process, but implementing effective due diligence practices remains a challenge
The business community is grappling with the evolving threat of cybercrime. Research firm Ponemon Institute puts the average cost of a breach at US$7 million for US companies, while Juniper Research predicts that the global cost of cybercrime will reach US$2 trillion by 2019. In a recent Mergermarket survey, 68 percent of respondents said initiating due diligence early is of utmost importance in mitigating cybersecurity risks.
Despite increasing awareness across all sectors, many c-suite executives are still unsure how to respond to the threat of cybercrime and how to build cybersecurity into their wider business and M&A strategy.
"The c-suite understands that cybersecurity is a material issue that could affect their business," says White & Case partner Steven Chabinsky. "What is still lacking is an understanding of how senior leadership gets into the risk management process. The c-suite is still too focused on this being an information technology issue and not a whole of business issue."
Deal diligence disrupted
M&A is one area in particular where the c-suite needs to be more proactive on cyber risk. Chabinsky believes that while companies have been good at reviewing compliance, there is work to be done when it comes to carrying out effective due diligence. "A lot of the c-suite is relying on representations and warranties as their primary defense against subsequent privacy or cybersecurity events," says Chabinsky. "The issue there is that those reps and warranties really may not be sufficient, as they may not capture the full extent of the harm to a business from a pure dollar perspective."
Kevin Petrasic, partner at White & Case, says that in addition to a thorough review of all representations, warranties and caps, technology due diligence should also review the integration of a target's technology infrastructure, how the target shares data with third parties and the risk of exposure to a cyberattack through the target. "It is simply good practice for companies to monitor cyber vulnerabilities in the context of an acquisition, and understand exactly where the risks are and what price concessions may be appropriate if it turns out that an acquirer is taking on risk," Petrasic says.
The challenge facing acquirers is how to gain this insight in an acquisition process when time and resources are scarce. Petrasic adds, "I don't think there's necessarily a magic bullet. I think it's about being informed, and understanding what the potential risks are by understanding the structure, industry and particular circumstances of the target."
Trump's proposed tax reforms have the potential to significantly change the way US firms conduct M&A at home and abroad, although they may be a mixed bag for dealmakers
Dealmakers have been cautiously optimistic about President Trump's and the House GOP's proposed tax reform plans. Underpinned by a strategy to cut rates, remove special-interest deductions, move to a territorial rather than worldwide system and provide a one-time reduced rate on earnings repatriated from abroad, the proposed reforms hold the potential to provide a significant boost to US M&A activity.
But White & Case partner Andrew Kreisberg cautions against over-enthusiasm, as uncertainty around the implementation of the reforms needs to be priced into M&A forecasts. "We really have very little indication as to which of these reforms, if any, will happen," Kreisberg says.
Kreisberg also points out that even if the full package of reform is implemented, the changes will not necessarily benefit all investors. One proposal in the House GOP plan, for example, is to eliminate the deductibility of net interest expense, which Kreisberg says would have "a very prominent and obvious effect on M&A," as the removal of such deductions would make any deal using leverage instantly more expensive. "This would be a significant disadvantage to private equity (PE) funds who more commonly borrow significant amounts to engage in buyouts, versus strategic buyers," Kreisberg says.
Another proposal to allow for the immediate expensing of investments in both tangible and intangible assets (not including, however, financial assets or land) rather than depreciating such assets over time, could, however, be a positive for M&A. It could also impact the form that such transactions take. "This would strongly favor asset purchases rather than stock purchases, because stock would be treated as a financial asset that would not give rise to this immediate deduction," Kreisberg says.
The Trump administration and the House GOP have also proposed moving to a territorial system of taxation, which, when combined with reduced corporate rates in the US, should remove the incentive for inversions. "If we go to a territorial system, then foreign earnings should not be subject to tax in any event, so there would not be the motivation to shift those operations abroad," Kreisberg says.
THE CFIUS CLAMPDOWN
Inbound M&A from China is down this year, as CFIUS continues to scrutinize incoming deals on national security grounds
The Committee on Foreign Investment in the United States (CFIUS), a US government body that reviews the impact of inbound deals on US national security, has ramped up its scrutiny of Chinese deals. In 2016, inbound transactions from Chinese companies hit a record high of US$62.6 billion, a more than five-fold increase on 2015 totals. In H1 2017, however, inbound M&A from China is down sharply, with only US$6.1 billion worth of deals announced.
Heightened concern around US national security has given regulators reason to rigorously scrutinize inbound investments from China, according to White & Case partner Farhad Jalinous.
"There is undoubtedly a heightened level of apprehension about how transactions coming from the more sensitive parts of the world will progress," Jalinous says. The concern has also created caution among some buyers, who are unsure about the eventual outcome of their transactions. "Twenty years ago, few outside of Washington and traditional national security-related M&A circles knew what CFIUS was, but now it is covered in the mainstream media all the time," says Jalinous.
Jalinous adds that although the laws and regulations applying to how CFIUS assesses transactions have not changed so far this year (even though proposals for change are expected to be coming soon), there is a sense that CFIUS clearance can now come into play across a wider range of transactions, which has had implications for Chinese deals. "There has to be a very careful consideration of the facts of a deal, including the identity of the buyers, their backgrounds and sources of financing, the target company and its business, and the risk profile of the transaction from a US national security perspective ," Jalinous says. "It is not enough to just look at how a target company's activities relate directly to national security, but also indirectly. From the government's perspective, there is a universe of factors, which can have a significant impact on US national security—and sometimes even the target companies involved are not aware of their sensitivity from a national security perspective."
Although inbound buyers are exercising caution, the number of CFIUS filings remains very high, Jalinous points out. "Based on the number of filings so far this year, I would not be surprised if we end the year with over 250 filings, which is a remarkable number."