As we enter 2023, we are seeing a peculiar phenomenon in the macroeconomy: prices are on the rise, but growth is on the decline. The aftermath of the COVID-19 pandemic has left the economy in a fragile state, with a lot of uncertainty looming over the heads of investors and consumers. The tightening of monetary policy by federal reserves coupled with the loosening of fiscal policy by governments is driving the economy towards stagflation, which has resulted in a significant drop in consumer and business confidence levels.
However, this recessionary macroeconomic outlook has opened up a new avenue for private equity firms and major corporations to capitalise on in the forms of mergers and acquisitions, as valuations are at cyclical lows and uninvested capital is at an all-time high.
The next wave of M&A is upon us.
A brief introduction to mergers and acquisitions
The term “acquisition” describes when one company takes over another and establishes itself as its new owner via either a friendly takeover or a hostile takeover. The term “merger” describes when two companies join together to form a new company. In the former, the two companies remain separately owned and operated. However, this is not the case for the latter. Companies complete mergers and acquisitions (M&As) to further growth through the adoption of new product lines, intellectual property or customer bases, and to increase cost efficiencies – for example by combining production facilities to reduce overhead costs, increasing production and reaping the benefits of economies of scale.
Generally speaking, in the lead-up to an M&A transaction, the acquiring company’s share price will drop, as they are promising an outflow of cash (or shares), while the target company’s share value will rise, as the offer must be attractive enough to convince the current shareholders.
Source: Wall Street Journal
The next M&A wave
Despite murky market conditions caused by global recession fears, rising interest rates and geopolitical tensions, we are potentially in a sweet spot for M&A for the year ahead, as M&A deals undertaken during downturns are usually the most successful. Valuation resets and reduced competition for deals is likely to cause a boost in M&A activity in 2023. Valuations in the context of M&A refer to the process of putting a dollar amount on a business by accounting for several factors such as its business history, future market position, and the level of risk associated with the business. Valuations tend to decline during cyclical lows because potential buyers tend to be more cautious and risk-averse. Furthering this, the record amount of uninvested capital ready to be deployed by private equity (PE) funds, as well as the comeback of cross-border M&A, will likely help drive more M&A activity over the near future.
Where will the investment be focused?
While valuations have declined in the broader market, the next M&A wave promises to be focused on two key sectors: tech and energy. In these areas, we have seen large valuation declines and structurally supportive thematics, allowing long-term investors to take advantage of the equity market’s short-term volatility gyrations. Energy remains the focus for the investment of private capital, as the opportunities provided by the energy transition continue to be highly rewarding for private investors. The energy sector is well-suited for private capital, with strong, long-dated cash flows that require higher upfront investment which can be funded with higher debt loads. These types of businesses are often misplaced on the equity markets, where shareholders are less willing to provide additional capital for investment, but would prefer greater returns. In private hands, however, there is more capital to support this energy transition. Both large private equity firms and sovereign wealth funds are vying for greater investment in the space to deploy their trillions of dollars in dry powder. A recent example of PE interest is Brookfield and EIG’s bid for Origin Energy, Australia’s largest listed electric utility. The buyers see Origin as the vehicle in which to deploy over $20 billion of additional capital, as its platform and market position can provide greater returns than standalone projects. Further examples of M&A in this sector include the large energy company AGL, and Australia’s laggard status in the energy transition has resulted in an excess of investment opportunity remaining (and potentially far stronger returns) than in overseas markets.
Amidst the aggressive cycle of rate hikes globally, we are observing depressed valuations for tech companies. Tech stocks are high-growth stocks, with higher risk and a correspondingly higher cost of capital. This means a lower value is placed on future expected cash flows, contributing to lower valuations for tech firms. Additionally, due to recessionary fears, there is lower spending in the near term on tech. As a result of this, valuations are low. This makes M&A in this sector more attractive to long-term investors who see through the near term and are not concerned by short-term pressure (such as PE and sovereign wealth funds). In Australia, there have been various bids by private equity for tech companies, such as for Tyro payments by Potentia and for Nitro Software by Potentia and KKR. This signifies a lot of opportunistic interest and speaks to the outlook for M&A in the technology sector in the foreseeable future.
What are the benefits of heightened investment?
Generally, increases in investment can be positive for the economy, in many ways. The more efficiently capital can be allocated to productive uses, the more value we can create and produce, and the more competitive we can be as a country on a global scale. This can all lead to increases in economic growth, the creation of new jobs, innovation, and societal progress. Additionally, as markets develop and firms become more profitable, those businesses (are supposed to) pay more in taxes; therefore governments (and the societies they represent) can benefit from increased tax revenue. This can lead to increased availability of funding for critical public services such as education, healthcare, and social services, as well as flow-on effects such as further job creation stemming from the increased government expenditure.
More specifically, as there is such enormous potential for investment in the technology and energy sectors, there are many reasons to be optimistic about the continually accelerating development of cleaner and more sustainable energy. As the level of investment in clean energy improves and the industry continues to develop, we will be able to further reduce our dependence on dirty fuels.
“A clean energy future” – This image was created with the assistance of DALL·E 2, an AI system by OpenAI.
Increases in investment will, as discussed above, lead to innovation and the development of new and improved ideas and technologies; this can lead directly to the creation of new jobs in the tech and renewable energy sectors. Note that whilst the dinosaur proponents of the fossil fuel industry often like to use the preservation of jobs in coal mining as a fallacious argument intended to divide public opinion on dirty fuels, in reality, re-skilling and up-skilling the labour force to be prepared for the industries of the future is key to Australia’s success; in the energy industry, while old jobs must go, new ones will continue to appear.
Unfortunately, due to immense lobbying pressure, the Australian government has continually performed incredibly poorly with regard to climate action. For example, in 2021-22 Australian government subsidies to the fossil fuel industry were an eye-watering 11.6 billion dollars (yes, from the taxes you’ve paid, that’s over $22,000 per minute going to the fossil fuel industry). On such an unfair playing field, it is undoubtedly far more difficult than it should be for the smaller, developing renewable energy industry to compete. With proper support and unbiased government policy, the clean energy industry would be far further progressed, and far more efficient (and therefore much cheaper) than it currently is. That being said, when generated at large scales, renewable energy is in fact already cheaper than fossil fuel energy – and, according to the International Renewable Energy Agency, this has been the case since at least 2021!
In conclusion, the current macroeconomic conditions with rising prices and declining growth present a unique opportunity for private equity firms and major corporations to capitalise on M&A deals, as valuations are at cyclical lows and uninvested capital is at an all-time high. The tech and energy sectors are expected to be the focus of investment, as they offer long-term investors opportunities to take advantage of short-term volatility gyrations. M&A activity is likely to boost economic growth, create new jobs, and lead to innovation, making firms more competitive on a global scale. Importantly, as we become less reliant on fossil fuels, there will be significant reductions in pollution and emissions of greenhouse gasses, hence leading to a decrease in the rapid deterioration of our climate; thereby, these opportunities for investment will, even if indirectly, give us a chance to preserve some of the beautiful life that still exists on our planet. However, careful consideration and evaluation of potential risks and challenges are crucial in undertaking M&A deals to ensure their success.
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I’m a Bachelor of Commerce student in my penultimate year majoring in Economics and Finance, with a concurrent Diploma in Computing. My main interests are Microeconomics, Behavioural Economics, Environmental Economics and Real Estate Finance. As an editor at Cainz, I strive to produce high-quality, purposeful articles on a range of topics.
I am a final year STEM student passionate about the intersection between data and Economics/Finance.
Thomas is a final year Finance and Accounting student in the Bachelor of Commerce at the University of Melbourne. His interests include Financial Markets, Technology, Environmental Economics, Start-ups, and Real Estate.
I am a second year BCom student majoring in Finance and Economics with a passion for financial markets and writing.