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March 5, 2024

M&A valuation isn’t just about looking at the numbers. There are a lot of different factors that affect and contribute to the volatility of the M&A market. In this article, Allan Marks, Global Project, Energy & Infrastructure Partner at Milbank, discusses how business cycles affect M&A valuation.

“Being less blind to the downsides (of the deal) helps not just in having confidence in what you're buying, but in having appropriate confidence, so your valuation has a greater chance of being accurate.” - Allan Marks

What is business cycle

Business cycles are generally thought of as boom and bust, expansion versus recession, or contraction in the economy. This usually involves looking at a macro picture: GDP, aggregate demand, productivity, and employment, which constitute the real economy.

How does the business cycle impact M&A valuation

• Economic expansions and contractions - When times are good and the economy is expanding with increasing demand, there's more competition for assets. There's more confidence that future values will be at least as good as they are today. This tends to drive up M&A valuations. 

• Changes in cost of capital - In an expansion phase of the business cycle, lenders and equity investors feel more confident. They loosen their purse strings, leading to more money flowing into the economy. 

In such a situation, money is easy to come by. Lending terms may be lighter, and refinancing is usually easier, often facilitated by low interest rates. This means the cost of capital is low. In M&A, if a target has a low cost of capital, this will increase valuations as well.

• Risk assessment - In an economic downturn, people perceive risks very differently. Companies might be more cautious and factor in higher risks, which could lower valuations.

• Sector-Specific Impacts: Different sectors react differently to the business cycle. For highly regulated sectors like power, the cycles are not meant to significantly impact them.

Demand may fluctuate somewhat for inelastic items like power, water, etc., regardless of what's happening. Regulators aim to make these sectors inflation-resistant and also resistant to recessions. 

Other parts of the energy sector, particularly fossil fuels like coal, oil, and gas, are not covered by long-term contracts. They are very exposed to changes in demand and supply, which can dramatically change prices in the short term.

Common mistake during M&A valuation

One mistake would be using only one valuation methodology. Another is insufficient diligence, and third is related to overconfidence, missing important findings in diligence.

This can happen either by overemphasizing less critical issues, or focusing on high magnitude but low probability risks while overlooking higher probability risks because they seem less severe.

Importance of culture in M&A

Cultural blind spots, especially for companies trying to merge, can be a real challenge. This is often underestimated because there's a lot of focus on finance, leading to oversight in other areas.

It's crucial to acknowledge these non-financial risks that companies and investors should be aware of, regardless of how they are labeled. Culture is one of those significant factors, and it’s not just about if the CEOs are getting along. Looking under the hood is essential.

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