PE Shying Away From IT Buyouts; Healthcare Set To Grow Past Challenges via PitchBook

B2B at a glance

Valuations remain primary concern

Although the U.S. business products and services (B2B) sector continues to see healthy deal activity, the sector as a whole  is going through a transitional period. Buyers continue to pay frothy multiples to close deals, yet from a performance perspective, many companies may not warrant those heightened multiples. “There continues to be a slowdown on the size of growth, in terms of speed and margin compression. There is some inflation in health care, benefits and labor costs and probably some increasing in pricing, but there is definitely a slowdown on the top line,” says Milton Marcotte, practice leader of transaction advisory services at McGladrey.

Adding to this, bottom-line cushions expected by B2B companies from subdued energy prices appeared to be offset by some of the same costs mentioned above, along with forex volatility in certain currencies abroad. While the transitional period could lead to a slowdown in B2B deal flow, the middle market B2B market should outperform other industries, “simply due to there being more quality companies available for sale in that market,” notes Michael Fanelli, partner with transaction advisory services at McGladrey.

As energy prices have moved lower than many expected, the sector has not seen the boost in anticipated profit, due to a lower theoretical input cost. “The amount of the decrease in energy prices is not enough to dramatically impact certain companies, depending on the industry,” states Mark Gaines, partner with the business and professional services practice at McGladrey. Fanelli says that B2B products companies, which have fuel as a primary expense, will likely benefit the most from the current oil price level, yet even those businesses have not seen the predicted results in his view. “The drop in fuel is not the same as the drop in oil, so it is not enough to move the needle as much. It is also offset by other expenses, such as wages and benefits.”

PE Shying Away From IT Buyouts

Another headwind continuing to be a greater-than-anticipated issue for multinational B2B companies is ongoing currency volatility abroad. Despite the recent paring back in the dollar, the U.S. is still an outperforming economy, and a Fed decision to move rates higher will likely attract foreign capital into the country, propping up the domestic currency. With events unfolding, such as the recent devaluation in the Chinese yuan, U.S. companies are being forced to put hedges in place to protect their bottom lines—an added expense, but a very necessary one. “I expect the U.S. growth rate will outperform all of its major trade partners, the inflation rate will remain stable and the U.S. employment rate will continue to improve, all of which will attract capital to the country,” says McGladrey chief economist Joe Brusuelas. “If you’re a company and you’ve got exposure to the global economy, you need to think about effective hedges as a form of insurance that you hope you never have to use, and the premium that one pays is well worth it.”

A pending U.S interest rate rise has been an exhausting topic of discussion in both public and private markets, but it isn’t likely to be the sole catalyst that will derail M&A activity, especially given that rates have been at historically depressed levels for quite some time. “Banks have been very aggressive and I see that continuing,” states Marcotte, referring to the lending environment. “Rates may creep up a bit, but I do not see a major impact from that.” Normalization around interest rates would obviously cause debt to become more expensive, yet a 25 basis points hike, as many expect the Fed will start with, shouldn’t derail buyers zeroing in on attractive deals. From the private equity (PE) side, fundraising efforts have also been very strong over the past couple of years, and firms are constantly looking for targets to use their accumulated dry powder. Aggressive lending and PE firms hunting for quality deals should offset the potential negative impacts of an initial rate hike. Yet even with that, the cost of debt alone shouldn’t be a near-term issue for buy-side M&A players. As mentioned, the capital to make deals in the B2B space is certainly available, so a potential slowdown in the market will not be due to an inability to finance deals. Instead, the overhanging concerns moving forward will remain valuations, the quality of companies looking to come to market and pinches in global economic growth.

M&A deal flow

Slowdown on the horizon

Driven by a continued appetite to find synergistic acquisition targets, B2B M&A activity in Q2 remained relatively strong. While counts were down, compared to the unexpected uptick seen in Q1, aggregate capital invested was up a rather impressive 49 percent quarter on quarter (QoQ). Indeed, various nations abroad have seen economic growth slow, yet the U.S. is coming off a second quarter that saw gross domestic product grow by approximately 3.7 percent, and thus, the continued relative strength of U.S. B2B M&A doesn’t come as a major surprise.

The significant jump in Q2 total invested capital was certainly a positive note, but this number may be a bit inflated, due to a couple reasons. “Average deal size is larger, so a few big deals have overstated that number,” states Fanelli, referencing the $377.5 million figure (90-plus percent QoQ) recorded for the period. Also, heightened valuations are still very much present in the market, notes Harshad Khurjekar, director with transaction advisory services at McGladrey. “Even with deal counts down (10 percent QoQ), the valuations are still much higher, which is why capital invested has gone up.”

As deal multiples have remained elevated for a significant period, B2B M&A could see a slowdown, as we progress over the next couple of quarters and move through 2016. “We are in a low-growth mode, so we will see cost increases and tepid growth,” says Marcotte. “Valuations will not go up as high, and I think valuations and M&A activity may actually soften, as well.” Investment banks appear to share the same sentiment, as they look to push client businesses to market in order to take advantage of the current multiple environment. “Investment bankers say that now is the time to try to sell,” explains Marcotte. This notion also extends to PE firms looking to offload previous investments. “Controllers are working at getting their portfolio companies ready for sale. Along the same lines of talking to investment banks, they are projecting that the market is going to get soft, so they need to spend the next couple of months getting ready,” Gaines adds. As always, there is the potential for the expected trend to deviate, at least in the very near term, according to Khurjekar. “I think activity will be similar to what we’ve seen in the first half,” Khurjekar says in reference to the second half of 2015. “It could soften a little bit, but I expect it will be the same for the most part.”

PE Shying Away From IT Buyouts

Despite the hunger of PE to find quality portfolio companies and strategics’ continued hunger to grow via acquisitions, valuations will continue to cause rifts. Khurjekar notes certain
companies having inflated revenue expectations, in turn, causing buyers to either pause transactions altogether, or significantly delaying the entire sale process. He also points to purchase disputes halting deals stemming from negative impacts, including currency exposure for multinationals and increasing labor costs affecting bottom lines. These concerns will remain in the deal environment for the foreseeable future.

PE Shying Away From IT Buyouts