Talk of the US-China trade war has permeated much of the discussion surrounding the recent decline in deal making activity – but is this the only factor, or indeed even the main factor, behind the downturn in activity?
The last few months have been somewhat of a roller-coaster for equity and bond markets, which have been fluctuating more than in the past. Geopolitical risk has negatively impacted sentiment and consequently, global M&A volumes and activity has also been affected.
Excluding Japan, Q1-Q3 activity in Asia-Pacific slowed to levels last seen in Q3 2013. According to Mergermarket, M&A for the region was down by 26% and outbound M&A declined by almost 30%. Asia-Pacific ex-Japan now accounts for just 15% of the global market share in terms of activity, down from 20% in the same period last year. Equally, global M&A volumes have also been on the decline, with volumes for 2019 down 21% from Q3 2018, which like in Asia, represents the lowest quarterly total since Q3 2013.
The story in China is much the same. In fact, Chinese outbound investment peaked about three years ago, at US$220 billion in 2016. Activity declined in 2017 and we saw it fall off again in 2018. For the first six months of this year, the market took another beating, as figures from PJ Solomon show, the number of outbound Chinese M&A transactions, especially to western nations, declined 31% in the first half, marking the tenth consecutive quarter of decline.
Natixis research also shows that in the first half of 2019, not only did China outbound M&A decline in terms of volume, but the average size of M&A deals has shrunk too. Decelerating growth, lower domestic returns and cheaper funding conditions are supporting Chinese corporates to seek M&A opportunities abroad, in addition to acquiring superior technology, products or skills – however, the deteriorating international environment and tightened Western restrictions have created a slowdown. The number of both announced and completed cross-border M&A deals remained flat, but the value of deals edged lower, signaling that small-sized deals are increasingly popular.
For 2019, in an optimistic scenario, we expect to see US$50-60 billion of volume in China outbound investment. So, while the volume and size of deals has declined, deals are still going ahead and will continue to do so. That being said, there has been a shift in the focus for the deals that are taking place, for a number of reasons.
Firstly, the ability to satisfy China’s consumer appetite, underpinned by middle class income expansion. Previously, this appetite was met by consumer goods. Today however, there is a shift towards essential services that have the ability to make people’s lives better – such as healthcare and education services.
Secondly, you have the national agenda. Ten to 15 years ago, during the early stages of outbound M&A, the focus was acquiring natural resources. Today, it’s more focused on the food value chain and the infrastructure value chain – which is also linked to the Belt & Road Initiative.
Finally, and perhaps the most important point: China is incredibly aware of the need to compete on a higher level. The GDP of a county is a function of government spending, consumer spending, productivity and investments. In that sense, investments in high productivity assets, are going to deliver higher return. Thus, there is an impetus to develop assets at the higher end of industrial production technology – such as artificial intelligence/robotics – whether they are developed organically or through acquisitions. China is in a sweet spot in this sense, because it can afford to make acquisitions, while it develops its domestic technology ecosystem through domestic vertical integration.
Combined with macroeconomic factors, potential Chinese and Asian acquirers need to employ caution.
In the mid-innings of economic expansion cycle, costs have been cut and businesses have been streamlined. When this activity plateaus, large mergers become prevalent. Deals of a greater magnitude are needed to capture market share and squeeze additional earnings.
Today, we are in what is classically known as a “late cycle” environment, meaning that growth is decelerating and we’re seeing increased levels of volatility – reflected in the behaviour of equity, bond, FX and even emerging markets. This has been particularly evident in the years following the global financial crisis, because rates have been low due to central bank actions and volatility has been moderate. We’ve also seen valuations and asset prices go up in the same time frame, and so the environment, where there is a confluence of these factors, becomes one in which it is riskier to do bigger M&A deals. Combined with this, the trade war has brought with it an elevated risk of recession.
If you’re doing a deal of any significant size, at a board level, it is now more important than ever to ask yourself the questions: ‘is this good for my company’, and ‘why’? Deals should be based on solid industrial logic. It should not be the case that you’re doing an M&A deal because your competitor has just done one – which we do see happen, because companies don’t want to get left behind. It speaks to reason that if you’re going to do a deal in an environment that’s riskier than it was, to survive the situation that’s coming, you really have to be able drive the synergies.
Those synergies should be identified upfront. You should have a plan to integrate the asset into your company, and this should involve a broad swathe of departments: management, communications, human resources, marketing and media. You also need to ensure proper liquidity and balance sheet strength are maintained. Compared to just four years ago, it is more important now to have a better understanding of the downside case, to protect yourself.
It’s not that the deals should not and will not happen, but rather the deals that are going to be successful and survive in this kind of environment are the ones where prudent thinking has been incorporated.
Raghu Narain is the head of investment banking APAC at Natixis