Uncertainty will continue to cause most dealmakers to shy away from large transactions in 2014. But the middle market will host plenty of M&A activity, driven by a strong deal financing environment and companies with an abundance of cash on hand. Deals will flow from sectors that are undergoing rapid change, especially the energy and health care sectors, says Robert Profusek, global head of M&A at law firm Jones Day. Profusek has worked on the Continental-United Airlines merger, Procter & Gamble Co.'s (NYSE: PG) sale of the Pringles business, the merger of International Steel Group and Mittal Steel, and many other deals.
Can you describe the current climate for middle-market M&A?
The number of mega deals has been relatively small this year. Depending on what side of the bed you got out on, you might say: "That's terrible, and let's figure out why," or you might say: "That's normal." Most M&A is on the lower end of the middle market. M&A is just one part of business investment, and there is no question that business investment in general has been down since the financial crisis. So, that's part of it.
The bigger factor is the lack of animal instincts in corporate boardrooms across the board today. There is a cautious attitude.
The other thing happening on a macro basis, at least for public companies, is that most of their shareholders do not want them to be doing significant M&A activity right now. The pressure from shareholders is to increase your dividends and buy back your stock, that is, return capital to shareholders. To some degree, shareholders care less about the future and more and more about tomorrow. I think that has been exacerbated by two things: One is that people are having a hard time making money on the fixed income parts of their portfolios, and the other part is that companies are very underleveraged and balance sheets are just stuffed with cash.
Despite this, if you are a chief executive officer, you can go into the boardroom and say, "Well, I would like to do this and here is why it makes sense, but it is not so big that it will cause investor pushback." This produces an active middle market, but not really bold, step-out transactions.
What types of deals will get done in 2014?
M&A follows the important things in the global economy. Where things are changing on a rapid basis - that is where you will see transaction activity. There will be lots of cross-border transactions. European companies will probably buy something in America to get a little less exposed to Europe. Everybody is running to China, but doing deals there can be harder to do than to think about doing. In terms of industries, it will be the industries that are going through the most change: health care in all of its aspects, and energy and energy infrastructure.
Will the lower middle market continue to attract buyers?
Until we get animal instincts in the boardroom, yes. It is not like we are fearful, as we were a few years ago, especially in the immediate aftermath of the financial crisis. There is just not a real sense of confidence in the future, in large part because every time you look at what is going on in Washington, it looks like a horror show. We can't figure out a budget, tax laws, Obamacare, or much of anything else. In an uncertain environment it is hard to make huge bets. If you are the CEO of a company, are you going to make a huge bet or a lot of smaller bets? Probably the latter.
When will middle-market deal flow pick up?
In the first six months of 2013, we were down about 10 percent, and that is spooky when you are in the deal business. There is tons of money, an accommodative regulatory environment and fabulous financial environment, so I think we are going to continue to see a lot of activity. However, unless Washington gets its act together, I do not think people will be confident enough to make really big deals.
Will there be any changes in the financing climate for middle-market deals?
The deal finance markets have never been better. One of the reasons is that banks really love transactional finance because the fees are higher than normal lending.
When it becomes clear that the rates are going to start to go up significantly, I think that will have a perverse short-term stimulative effect. When people figure out rates will go up, those who have been thinking about making a deal will think it is the right time to make a move.