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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

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 episode, Allan Marks, Global Project, Energy & Infrastructure Partner at Milbank, discusses how business cycles affect M&A valuation.

Milbank is a premier international law firm handling high-profile, complex cases and business transactions through 12 offices worldwide. Our offices work together on an integrated basis, giving us an extraordinary global presence and allowing us to serve a client base that includes the world's leading companies and financial institutions. Milbank is internationally recognized as a leader in major corporate/finance transactions (such as M&A, structured finance, banking, capital markets and project and transportation finance), litigation (including complex commercial, intellectual property, securities and white collar), financial restructuring, and trusts and estates.

Law Practice

Allan Marks

Allan Marks is a Global Project, Energy & Infrastructure Finance Partner at Milbank LLP, with over 30 years of experience. He specializes in M&A, private equity, infrastructure fund investments, project development, and financing. Allan advises institutional clients on complex transactions, including acquisition finance, capital markets, international business, and public-private partnerships. He is known for building collaborative teams, finding creative solutions, and reducing risks in projects critical to economic growth and sustainability. Allan also teaches at UC Berkeley and hosts the podcast "Law, Policy & Markets: Milbank Conversations."

Episode Transcript

What is a business cycle

Sure. I've been doing this long enough to have seen a few business cycles, which is always kind of scary to me. 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. Anyone in finance, working for a large corporation, a lawyer, or other advisor who has less than about 12 or 15 years of experience, has never really seen a prolonged contraction.

We had a very rapid and deep contraction, but it was short-lived during the onset of the COVID pandemic. However, we've seen a recovery from that, driven by massive amounts of government stimulus and, until recently, historically low interest rates.

This fueled a significant expansion that is still ongoing, despite the tightening of the credit cycle, which differs from the business cycle. The business cycle also affects valuations. 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, because we believe in growth during an expansion. This tends to drive up M&A valuations. 

In contrast, during a contraction, when there's less certainty about the future, potential headwinds on demand, a decrease in productivity, and a different employment market, asset values tend to decline, and there are fewer people bidding for them.

What is a credit cycle

That's a really good question. What I describe as the business cycle, or sometimes the economic cycle, refers to the economy expanding, holding steady, or shrinking. The credit cycle is distinct from that, though correlated.

Let me give an example of how one can influence the other. 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.

However, if things get too hot, as we saw last year in the global economy and in the United States, the Federal Reserve can make money more expensive. Although the Federal Reserve only controls short-term interest rates, their actions have a broader impact, including on the money supply. 

Making money more expensive, either by limiting the supply or raising short-term interest rates, can cool down an overheated economy. The goal is to avoid a contraction or recession. So far, it seems the Fed has been successful in slowing down the expansion without causing a recession. This could justify reductions in interest rates later this year.

The speed at which rates are cut or raised is crucial. It can contract the economy and affect valuations, as well as the appetite for new investments. So, the cost of capital, credit terms, and availability of credit constitute what I refer to as the credit cycle. One cycle can cause positive or negative effects in the other.

It's partly science, but also involves a lot of luck and art, as we're dealing with human behavior and psychology. Expectations can significantly influence what's happening today.

We can look at the credit cycle as essentially a lever into the broader business cycle. They are levers for each other. For instance, we've seen inflation countered by a change in the interest rate, which has been a significant driver.

Inflation has many components. Currently, we're observing a very strong labor market, evident in job openings, quits, layoffs, and labor force participation, which is higher. One of the major challenges in the companies I work with is a real shortage of skilled labor. 

I'll share a story to illustrate this. I was recently at a shipyard where a client is building offshore wind projects. We were looking at ships under construction for these facilities. They are specialized, expensive, large, and incorporate innovative technology.

Driving from New Orleans to the shipyard, you see the economic challenges impacting new investments. Retail stores are empty, with 'for lease' signs, and gas stations closed. This reflects the struggles of that part of southern Louisiana's economy. 

Conversely, industrial facilities along the way display 'help wanted' signs, unable to find enough skilled labor like welders, pipe fitters, and electricians. There's a scarcity of skilled labor in these areas.

This imbalance has a contracting effect on the economy, driving up costs and creating friction that impedes investment. Therefore, it's insufficient to only consider the big picture of the economy. We need to delve into what's happening in different sectors.

In M&A, financing, or corporate transactions, this means different types of investments in various sectors will behave differently, depending on their costs, inputs, and expected demand.

Cycle’s impact on energy sector

Let's stay with energy for a second and come back to that. It's a good example to see how these things differ.

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. 

These are very stable assets, and their long-term stable cash flow attracts not just debt, but also institutional money such as pension funds and insurance companies. They are interested in matching long-dated liabilities with long-dated revenues and fairly predictable income streams.

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. There are longer-term signals, such as shifts in technology and the move towards decarbonization. 

However, the volatility in these commodities can be quite high, meaning that values, especially tied to assets in these areas, may not be levered as much but will attract more expensive equity capital.

To mitigate this, scale is needed. Scale allows for the capital necessary to weather extreme volatility and make significant, long lead time investments that may be impacted by shifts in markets and regulatory policy. Investors in these areas typically have a bigger appetite for risk.

How business cycle impact M&A valuation

Yeah, it's interesting. Just look at the last four years. We had a real peak in M&A activity in 2021, as well as in finance activity generally. A lot of that was influenced by the pandemic shutdown and the uncertainty in 2020.

The public stock markets dropped significantly in March and then rebounded, but they don't really tell you much about allocations of capital and M&A activity, including corporate, strategic investment, and private equity. All of that went on hold in 2020, mainly due to uncertainty.

It wasn't a cost of capital question or about interest rates. It was the uncertainty of the duration and impact of the pandemic. Governments were trying to figure out what kind of stimulus to provide to various sectors. Some sectors, like airlines, received considerable help, especially in the United States and to a lesser extent in Europe.

In 2021, there was a realization that we would live through the pandemic. The government stimulus had a massive effect on the economy and investment. With very low interest rates in most markets, there was a green light to complete two years' worth of transactions in one year.

This resulted in almost three years of activity in 2021. However, in 2022, although rates remained low and valuations continued to rise, M&A activity was much lower than in 2021.

By 2023, there was an uptick in activity, but still not back to 2021 levels. The main reason seems to be the rising interest rates, leading to a higher cost of capital. In a rising cost of capital environment, discount rates on future cash flows change, reducing the value of these flows.

This affects asset valuation based on discounted cash flows, which is common in my sector of energy infrastructure. Valuations based on comparable sales, enterprise value to EBITDA, and price-earnings ratios also became more challenging. However, sellers hadn't fully adjusted their expectations to these changes in 2023.

This year, we're seeing a leveling of interest rates and potentially a drop, which could help reduce discount rates and increase future cash flows' value. What we need is confidence in those cash flows and asset values.

However, the United States is in an election year, which adds uncertainty. Geopolitics now influences many transactions, both cross-border and domestic. This impacts not just energy markets but also other sectors.

Supply chains, which were disrupted, are largely back together, but geopolitics can affect them as well. The situation between the United States and China remains uncertain.

Industries most affected by the cycles

Some of it's affected by geopolitics, like the US-China situation. The response to that also has an impact. For instance, businesses reliant on just-in-time supply chains are more exposed. They may consider onshoring some of their operations to mitigate this, but that could increase costs.

Businesses dependent on imports, not just from China but also from other regions, are affected by events like those in the Red Sea and the Suez Canal, which may alter manufacturing timelines. 

We often see in construction, as well as other sectors, that service providers or those agreeing to build or supply in the future are insisting on longer schedules. These schedules are designed to cushion potential supply chain disruptions or labor shortages. 

However, longer schedules tend to increase costs. If any of this is fueled by borrowed money, the interest expense also rises over time, along with exposure to volatility. This leads to more uncertainty, impacting asset values.

Sectors dependent on cross-border movements of capital, goods, or technology face these issues. In response, the United States, for example, has the Chips Act, a bipartisan law stimulating domestic semiconductor manufacturing investment. This is largely due to the geopolitics with China. 

It will lead to a better domestic supply chain of these technologies and closer production bases for technology as it innovates. This is crucial given the expansion of data and data centers, AI, and eventually quantum computing.

These are major attractors of capital and real investment. The onshoring might increase costs, but I believe it's more than offset by the security of supply, particularly if it leads to higher confidence levels.

There's a difference between being exposed to risk and perceiving risks, and this ties back to business cycles. One aspect is the inherent risk in your business, which can be internal or external.

The other aspect is how worried or aware you are of those risks, or what blind spots you might have. I often see people being either overconfident or missing some of the correlations inherent in the risk profiles for their business.

Lack of experience can also lead to overconfidence when it comes to M&A valuation. If you've never been through something bad, you either don't fear it, don't understand it, or overreact when it happens.

Part of it is that we've had such a prolonged period of growth and expansion, not just in the economy, but especially in the financial sector. There's been a shift in sources of capital from bank-dominated economies to private hands.

Private equity is now probably valued more than public equity. Private capital is also being directed to the debt side, with private credit now over a trillion dollars available for deployment. This is happening outside the fully regulated banking sector. When everybody's winning, we all look smart.

The real challenge, however, is if we end up with an economic contraction. The laws of business cycles have not been repealed, and eventually we will have one for whatever reasons. Then, when the tide comes back down, we'll see which boats remain afloat.

M&A valuation for first timers

Let me say one thing first. A lot of this is basic human psychology. We all have blind spots; that's normal. So, what do you do about that? One approach is to engage with other experts or business partners, and allow yourself to be challenged, either institutionally or personally. This is really important.

Regarding the question of whether people are overpaying in an M&A context or any kind of acquisition, by definition, the buyer overpays because they value what they're buying more than competing bidders and more than the seller. 

The seller, who has the best knowledge of the asset, prefers to part with it in exchange for cash or other assets, even after due diligence and despite working with advisors. This combination of asymmetric information and overpayment doesn't mean the transaction shouldn't have happened or that it can't be profitable.

However, it does mean there's a bit of extra to compensate for before getting into the aspects that truly create value.

Many companies are also shedding non-strategic assets, and we're likely to see more of this in the coming year. This isn't necessarily because they're better at it, although they should be, but because they're more confident about it.

When they assess the uncertainties, unknowns, risks, and their ability to withstand or control them, focusing on what you know best is probably a good idea.

For a corporate or strategic buyer, synergies are very important. The question becomes whether economies of scale can be used to cut costs, or grow market share in a way that is compliant with antitrust laws, creates a defensible level of market power, and potentially allows for higher margins.

Integration, particularly cultural integration, not just financial or production integration, becomes very important in these cases.

Most of these buyers plan on holding the assets or companies they're buying for a long time, allowing for integration and organic growth. If the cultures fit, these synergies can be real.

For other types of buyers, like some private equity firms, there may be a strategy to buy an asset or company and find ways to integrate it with other things in their platform to achieve those synergies.

They may also look to improve the business and then sell it. The key question then is what's the exit strategy? If the plan is just to buy today and sell for more tomorrow, assuming markets will go up without adding value, that's an overly optimistic bet.

The good old days are over. You could always find assets that were highly undervalued, but now everything is so competitive. This is partly because we have better access to information than ever before. There's greater transparency, not just due to disclosures and securities laws, but also because of how diligence is done. 

The ability to turn over vast amounts of information quickly and analyze it has improved, and AI is going to make this even easier. It enables the analysis of big data sets about companies with complex variables and processes.

Using the right algorithms intelligently might not always result in better decisions, but it allows for making more decisions more quickly that are at least as good.

You're right, with tools like LinkedIn and Glassdoor, you can figure out a lot about a company's people and culture. Synthesizing this information with AI also helps identify potential downsides. When investing in a company, it's crucial to be aware of liabilities, litigation risks, environmental risks, or IP gaps in patent portfolios. 

Being less blind to the downsides 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.

Importance of culture in M&A

Cultural blind spots, especially for companies trying to merge, can be a real challenge. We see it in different spaces, like private equity funds merging, law firms merging, and we've seen consolidation among accounting firms a few years ago. Some are still struggling with succession at the top and assimilating different ownership or partnership structures.

This is often underestimated because there's a lot of focus on finance, leading to oversight in other areas. For instance, in ESG diligence, there's significant focus on the environmental aspect and ideally on governance. Governance deserves more attention due to its potential blind spots and the need to make it more effective and fair.

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. 

When to pull of a deal

Okay, so here's a way to look at it just off the top of my head: risk aversion or taking on too much risk too eagerly. What determines that? Well, one factor might be your psychology, your personality, and this could be true of institutions or funds, not just individuals like CEOs and fund managers.

If you're in certain institutions where everyone's the same, this can reinforce behavior. For example, I remember working years ago for Enron, where there was a lot of groupthink and everyone approached risk in the same way.

Another factor is if you're spending someone else's money. You should be aware that you have a fiduciary duty to that person and be as careful with their money as with your own. However, in many corners of the economy, especially the financial sector, people often lose sight of this and may be more prone to take risks with someone else's money than their own.

This can be due to the incentive structure, where you're getting a share of the money you're holding but also have pressure to deploy it. You need to be prudent and responsible in making investments because you're sharing in the upside, but not necessarily in the downside, except as it affects your ability to raise further capital in the future.

The combination of asymmetric information in transactions and a lack of alignment of interests contributes to overconfidence in this context. I teach at Berkeley and have for over 15 years as an adjunct. I've noticed interesting dynamics in classes with MBA and law students.

Law students tend to be risk-averse and indecisive, seeing all sides of an issue, while MBA students are usually highly confident and make decisions quickly, though not always based on a solid quantitative foundation. Adding in graduate engineering or public policy students introduces entirely different problem-solving approaches.

The result is a discovery among all these students that a multidisciplinary team, where they each listen to each other, makes much better decisions than any one of them could have made individually.

Example of failed deals

One example that comes to mind is a toll road company that was very over-levered and had great exposure to risks that they initially didn’t realize were correlated in their financial plan.

During the recession in 2008-2009, toll revenues and traffic went down. The expected escalation of future toll revenues either didn't materialize or was delayed by four or five years. 

The company's liquidity wasn't sufficient to cover debt service, and the low-interest rates exposed them on some swaps that were meant to manage interest rates in a rising rate environment, but instead created significant additional liability alongside their senior secured debt.

What was missed in their original financial model was the correlation of these factors – that rates would stay down for a long time if there was a significant contraction in the economy. This is related to the business and credit cycles. 

They couldn't refinance because future cash flows were projected to be significantly lower than anticipated, and after the financial crisis, there was a higher risk premium. The asset went through bankruptcy but is now doing well with a great capital structure and new owners, ensuring they won't be exposed to those kinds of correlated risks again.

These deals are tough because so many factors can change the entire economic cycle. But you need to focus on what you can control and what you can't. You can predict changes in economic cycles or demand for your product, but there will also be things outside your control. 

So, how do you build resilience and downside protections? For example, in certain periods of the business cycle, it might be smarter to swap out high-yield debt for preferred equity, which doesn't require debt service. The economics may not be that different, but the resilience to downside could be significant.

Here's an example of a company that is highly regulated and prudent in its finances but nonetheless has been in bankruptcy twice. I worked on the bankruptcy for Pacific Gas and Electric, the largest investor-owned utility in California. They faced a much larger exposure to wildfire risks due to climate change, extreme heat, and lack of rain leading to dry vegetation.

One could discuss whether the utility needed to spend more money to fireproof its system. It's hard to do. You have to trim trees more and underground lines, which is very expensive for high voltage, long-distance transmission lines. Will regulators allow this when the cost has to be passed through to ratepayers, and power is supposed to be affordable?

They faced liabilities under California state law for billions of dollars of losses attributable to wildfires ignited by their equipment. Without the liquidity to pay for that, the question arose: who should bear the cost? Shareholders, current or future rate payers, state government, federal government, or insurance?

They managed to align creditors in the bankruptcy, various agencies of the California state government, the legislature, and the federal government to solve the problem. They created a pool of money to pay future liabilities to avoid bankrupting the company again and to make investments for a more resilient system.

This is an example of an external challenge that the system wasn't set up to handle, leading to a lesson learned in managing such crises.

Example of good deals

There were investors coming into JFK Airport's new Terminal 1, which is an almost 10 billion-dollar new international terminal. The initial financing for this was happening right before COVID. I saw something similar when representing investors in an airport in Latin America, in Chile, right before 9/11. After 9/11, international air traffic dramatically decreased. 

In the Chilean airport case, there was also a contraction in the world's GDP, which impacted demand for copper, a significant part of the Chilean economy. Air traffic through Santiago, Chile, is tied to copper prices in a longer-term macro way.

With COVID, an exogenous shock, we faced challenges with expansion plans for New York's major international airport. Smart investors, working collaboratively with the Port Authority of New York, state and city officials, airlines, other stakeholders, contractors, and unions, found ways to reshape the project. 

The terminal is now being rebuilt in phases. Financing came in for the first phase, and future phases of the terminal expansion will depend on the recovery and growth of air traffic.

They're doing this within the scope of the original federal permits, so there's no need for a new permit and review cycle. This shows the importance of aligning interests of different stakeholders to creatively restructure a deal.

Regarding the restructuring, it wasn't in the bankruptcy distressed sense, as the loans had not yet closed and actual construction hadn't started. They changed the deal's structure contractually and from an engineering standpoint before signing. 

This was different from the Santiago, Chile airport deal, where the adverse event, 9/11 and the subsequent drop in air traffic, happened after we had closed financing and built the new terminal. That's a significant difference.

Another example is a client of mine that was initially family-owned and then backed by some infrastructure funds. Those investors provided more liquidity, creating a structure where the original business, with its operating assets, could seed when the fund invested. 

The fund also provided liquidity for the future pipeline of expansion, mainly through acquisitions in the very fragmented North American rail market. They strategically acquired companies that, on their own, lacked the capacity for significant growth. 

As an integrated platform with strong management, economies of scale, the ability to train and relocate employees, bulk purchasing of equipment, and potentially proprietary technology, they built a platform at scale that justified the acquisitions.

This created real synergies and a premium. It's important not to underestimate the difficulty of this kind of integration. It is very challenging, and not every management team can handle it, but a good one can. As a result, the investments paid off for everyone involved.

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.

Additionally, there's the failure to conduct diligence on significant aspects. For example, I recall a company that experienced a major cyber attack after a deal was completed because cyber risks were not thoroughly examined. This was a few years ago; I believe such an oversight would likely not occur today.

M&A function maturity

It's like you have to go through some pains to get there. It is a muscle. If I had to think of anything else, it would be the way deal teams work. Some are very hierarchical, so you hope the person at the top is listening to others and making smart decisions. 

Others are more flat and consensus-driven, while some don’t make decisions much at all and are paralyzed. It’s not so much a cultural issue as it is a management governance issue, not in a formal legalistic way, but practically. 

  • Who's making decisions? 
  • Who's calling the shots? 
  • Who are they including in that process, both on their internal management team and their outside advisors?

What's impressed me the most in terms of seeing the right structure is when there's a high degree of internal argument and debate. Different points of view are heard, leading to consensus around the key objectives. 

  • What is our goal? 
  • What are our limits? 
  • What is our exit strategy? 
  • How does this investment further that goal? 
  • What are the next steps we're going to take right after? 

You don’t go into something thinking it’s going to be easy without a plan for integration or execution. The idea of being good at executing, not just good at doing the deal, is crucial. People who can do both are a much stronger combination.

Other early M&A considerations 

The team and the relationships are crucial. In a joint venture agreement, partnership agreement, or merger agreement, you can’t overlook the fact that if there’s friction or a lack of compatibility, it can’t be resolved just on paper.

The legal documents are important, and we work very hard on them. Remember, deals are collaborative. It’s not like litigation where sides are adversaries. People around a deal table are fundamentally working together to make a deal happen, because it’s beneficial for everyone involved in a fair and mutually agreeable way. 

At closing, everyone should feel that the deal is good for all parties, not that they lost. Finding a way to collaborate effectively is important. 

However, it’s also crucial not to force a deal at all costs if issues arise. If the parties can’t agree, have different views, or if diligence reveals problems, or if there's an ethical issue, these are all reasons to potentially pause the deal. It’s not just about making the deal happen, but about the collaboration around it.

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