The policy responses from central banks and governments to deal with the economic impacts from the COVID-19 pandemic were unprecedented. Low interest rates and quantitative easing were prescribed by central banks the world over. These policy settings kept New Zealand’s unemployment rate at historic lows during the pandemic but coupled with other global challenges, have led to levels of inflation not seen in decades. Unsurprisingly, central banks are tightening monetary conditions to slow spending and reduce inflationary pressure. As a result, the economic storm clouds are forming.
The Reserve Bank of New Zealand (RBNZ) painted a less than rosy picture in its Monetary Policy Statement in November 2022. The key takeaway was that “the New Zealand economy – like many economies around the world – is expected to enter recession in 2023” and that outcome seemed unavoidable in the RBNZ’s opinion. Whether this statement was genuine, or alternatively a self-serving warning designed to curb inflation remains to be seen. That said, a recession in 2023 remains a real possibility.
While the forecasts from economists are grim, that does not always spell disaster for M&A activity. To truly understand market sentiment, we canvassed several of New Zealand’s leading investment banks and private equity firms to gain their insights on what they see happening in the M&A space in the year ahead.
The investment banks included Cameron Partners, Jarden, Murray & Co, PWC and UBS, and the private equity firms included Direct Capital, NZ Equity Partners, Pencarrow and Waterman Capital.
The consensus view was that the macroeconomic environment undoubtedly poses some challenges, but it is not all doom and gloom. Even the darkest storm clouds have silver linings and, as with any macroeconomic downturn, there will be plenty of opportunities.
In terms of the level of M&A activity, the sentiment across the investment banks was fairly consistent. After a record couple of years in 2021 and 2022, those we spoke to believe we can expect “a reversion to more normal levels”, “M&A activity will continue to slow down”, “the second half of 2023 may prove more challenging” and “the number of completed deals in our view is likely to decline”. This will largely be driven by macro-economic factors, but investors may also be more hesitant with a general election looming.
Private equity firms are expecting tougher times for portfolio companies, with higher interest costs, high wage and operating cost inflation, and a shortage of workers, combining with a shrinkage in consumer expenditure, resulting in substantial margin compression. Some private equity firms noted that we could expect some portfolio companies may need to raise equity to strengthen their balance sheets. While the private equity firms expect the tougher economic environment will present opportunities for M&A, and in particular sector consolidation, deals are expected to take longer to complete with more due diligence to understand the sustainability of the earnings base, and more bi-lateral/ balanced transactions.
Many of the private equity funds and investment banks also pointed to the “wall of private cash” which is still there and looking for a home. That includes local and offshore private equity funds sitting on dry powder, and also a growing number of debt and credit funds seeking opportunities. We expect that we will continue to see the growing prominence of credit funds (both local and offshore) as an alternative to traditional bank lenders.
It was also interesting to note that noncyclical industries with macro-economic tail winds are less likely to be impacted by market conditions and will continue to see investment at reasonable valuations. That includes the healthcare, transport, and education sectors, together with long term infrastructure assets. There was less enthusiasm around the more cyclical sectors, with construction and consumer discretionary spending in particular noted as challenging.
One key challenge for M&A activity will be rising interest costs. The RBNZ has pointed out that the predicted recession will “differ from contractions experienced in New Zealand in recent decades when poor economic outlooks, often related to international conditions such as those during the global financial crisis, were cushioned by lower interest rates”.
All the investment banks and private equity firms we spoke to agreed that there would be less debt available which will impact leveraged buyouts (particularly, large leveraged buyouts) and the debt that is available will come at a higher cost. The market has already seen larger deals struggle to get to the finish line in the last six months of 2022, with the scale of debt needed to be raised proving to be difficult to obtain. That is expected to continue in 2023.
Generally speaking, private equity funds noted that we can expect more conservative funding structures (i.e. lower leverage with a greater equity component in funding packages). Helpfully, New Zealand private equity funds are not typically as highly leveraged (or large) as offshore deals so a decrease in the availability of debt will not have as large an impact on private equity M&A activity in New Zealand, as compared to other jurisdictions. Further, alternative financing structures – such as the use of non-bank lenders/credit funds, and vendor financing – are expected to become more common.
A further challenge for M&A activity is that valuation bid-ask spreads have widened. Difficulty in agreeing valuations will be driven by uncertainty regarding post-Covid normalised earnings. It will be difficult for management to accurately forecast future performance given the tight labour market, upward wage pressure, foreign exchange volatility and inflationary pressures on input prices. These valuation gaps are not insurmountable with many advisers agreeing that we can expect to see more earn-outs and other deferred consideration mechanisms to bridge valuation gaps. However, as these challenges are worked through, we can expect deal timeframes to slow.
The result of the above is likely to be a reduction in multiples and business valuations as buyers recalibrate the price they are able to pay in order to meet their desired return on the investment, and investors may need to reduce their expectations around levels.
There will be opportunities ahead for those with access to cash. Equity market valuations have been hit hard and it is expected that private market valuations will also adjust. This creates opportunities to buy at valuations that have not been seen for a while, with a number of businesses seen as low hanging fruit after the challenges of the pandemic. The expectation is for it to be a buyer’s market with less vendor-friendly deal terms. Further, while there has not been a great deal of distressed M&A during 2022, the expectation is that this will emerge during 2023.
The investment banks see both private equity buyers and trade buyers being active. As discussed above, private equity firms have a significant amount of dry powder so there is capital to deploy in a more attractive valuation environment (particularly for those who have not traditionally been big users of acquisition leverage). However, we can also expect a return of trade buyers as competitive bidders for assets as rising interest costs and the reduced availability of debt impacts returns for financial investors. Further, corporate balance sheets were generally seen as being in good shape and, with tougher economic conditions, we can expect to see synergistic acquisitions and industry consolidation so corporates can realise scale benefits in a higher cost environment. However, for those corporates with less-healthy balance sheets, we may see strategic reviews with a focus on key business units and a divestment of non-core assets – this again drives M&A activity.
With equity market valuations hit hard, the investment banks foresee an increased appetite for takeover activity. Some public companies are trading at very attractive valuations which will see them as targets of private capital. While many didn’t see New Zealand adopting some of the more aggressive M&A tactics that have been adopted in Australia, the general sentiment was that takeover activity would increase as would the use of more aggressive bidding tactics.
Investment bankers note that we can expect continued interest in New Zealand from offshore jurisdictions. Decreasing valuations and a weakened New Zealand dollar together with the fact that New Zealand is also seen as somewhat of a safe haven for capital in an increasingly unstable geo-political environment will make New Zealand assets attractive to offshore buyers. Offshore infrastructure funds are expected to continue to show a strong interest in New Zealand assets with infrastructure broadly seen as a key sector of interest alongside healthcare, education, and renewable energy. The expectation is that this inbound M&A will originate in several jurisdictions with a mix of Australian, Japanese, US and European investors. An interesting observation was the return of Japanese investors to the market – something we at MinterEllisonRuddWatts have recently seen, in acting for Dai-ichi Life on its acquisition of life insurer Partners Life.
The investment banks and private equity firms were generally less optimistic about IPOs with the majority expecting a challenging IPO environment in New Zealand in 2023. However, a number noted that the second half of 2023 could see the IPO window opening, particularly if the markets become comfortable that the interest rate cycle has turned, and the US equity markets have a sustained period of positive returns.
So, what’s on the horizon for New Zealand?
The economic environment in 2023 is looking challenging and M&A activity is expected to decrease compared
to 2021 and 2022. A decrease in the availability of debt, and a widening in bid-ask spreads, are both expected to pose challenges for completing deals. However, decreased valuations, coupled with buyers with access to
large pools of capital, will see resilience in M&A activity, which is expected to be supported by continued levels of offshore interest in non-cyclical assets. While a recession looks likely in 2023, the impact on M&A will not be as severe, although the equity capital markets community will need to wait a little longer for the IPO party to commence.
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