Is another wave of M&A activity coming, and what does that mean for pension funds' private equity investments?
High interest rates stalled much of the Canadian mergers & acquisitions (M&A) market. Following a massive buying spree by private equity investors in the age of zero interest rate policy (ZIRP), the rapid increases in interest rates we saw across the US and Canada from 2022 onwards caused a significant shift in that market. At the high end of the market, assets that were purchased with cheap borrowing costs were now being sold on a market with higher cost of capital. Deals stalled and the supply of businesses appeared to have dried up.
Now, however, there are signs of hope. In Canada interest rates have fallen by 0.75 per cent and the US is expected to begin its interest rate cutting cycle this week. Amidst greater optimism John Cho, KPMG Canada’s national leader of Deal Advisory, explained where he sees green shoots on the Canadian M&A market, what impediments still remain, and how pension funds and institutions looking to buy businesses can win on this market.
“It’s been a slow M&A market, especially at the large deal size level for 18-24 months, but now as rates are starting to come down are seeing more M&A activity especially in the mid-market,” Cho says. “Large deal size assets were already owned by private equity and have a bit more difficulty getting to a trade where the bid equals the ask because the owner bought that asset in a lower interest rate environment…But in the mid-market the business is often owned by a founder or a founding family, so there’s a different dynamic where they’re not trying to match an entry valuation.”
While the mid-market has been a steady driver of activity through much of the past 18-24 months, Cho believes that the simple fact of lowering costs of leverage should bring even more of these large size deals to market. There is a huge amount of capital waiting to be deployed in this space, he notes, estimates of around $3.9 trillion. However there haven’t been as many quality businesses coming to market yet.
Some of that dearth in supply, Cho notes, is due to the buying spree private equity firms went on when rates were near zero. Because capital was cheap and growth seemed likely, many companies were bought at a premium. Before they flip the business in a tighter market, the new owners need to get profitability up to meet or ideally exceed the valuation they paid for the business at. That takes time. Nevertheless, as rates drop further and the market digests new valuations, Cho is confident that more businesses will come to market.
So in that market, Cho is looking at how buyers and sellers can be more successful. From a buyer’s standpoint, information is key. It’s always hard to know exactly how a business operates, so using technology and data frameworks can help a buyer find out more before they close a deal. Generative AI has already proven to be an effective tool in both establishing that data framework for buyers and in creating a more attractive value proposition for sellers.
Cho explains that many selling businesses will explore how generative AI can improve their overall productivity and margin. However, he notes that it’s important for any buyer to parse through the use of AI as a buzzword to get a better price and the real application of AI. When AI gets mentioned, he suggests that potential buyers ask for hard evidence of the integration of AI in this business. That should include the investments being made, the application of the technology, and the change management processes underway to ensure that this technology is already driving a real increase in valuation.
As pension funds, institutions, and large asset managers look at the M&A market today, with the opportunities and pitfalls Cho laid out present in the space, he believes that success can come when these players use their scale to their advantage.
“They can win by leveraging their scale and all the information in the organization. Chances are someone’s already looked at a similar business or sector. So scale matters because information advantage matters in sourcing and in deal execution and in value creation of an existing investment,” Cho says. “Then the execution of that is equally critical, and that's where that talent side we speak to matters. We get asked all the time if we know any good CFOs? Never lose sight of talent.”
