Will decelerating growth lead to accelerating M&A?
The number of U.S. small-cap M&A deals recently hit a 10-year high, with 503 announced for the trailing four quarters through June 30th, according to Bloomberg data.
That’s the highest number of deals in the asset class since before the Financial Crisis. For comparison, there were 334 deals five years ago in the trailing 12-month period ended 6/30/14, and only 269 deals 10 years ago in the trailing one-year period ended 6/30/09.
Number of Small-Cap M&A Deals At 10-Year High
Announced mergers and acquisitions over previous 12 months involving Russell 2000 companies
Source: Bloomberg
Based on our research and conversations with small-cap company executives, we think this trend could accelerate further.
In several of our portfolios, we are seeing a large number of acquisitions, and a few trends have emerged. Most acquisitions have been by strategic, rather than financial buyers, with a few exceptions. Moreover, while the largest number of deals in the industry have been in Financials, and comparatively few in Technology, within our own portfolios we have seen a different pattern, with a larger number outside of Financials and a solid amount within tech.
In the latter area, large-cap companies have been looking to extend their offerings into adjacent niche markets. Cray’s acquisition by Hewlett Packard Enterprises, for example, fit this mold. We have also seen companies acquire critical suppliers, such as Tesla’s acquisition of Maxwell Technologies.
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We have also seen ongoing activity from strategic foreign buyers, such as France’s Infineon Technologies acquiring Cypress Semiconductorand Germany’s Dassault Systems offer for Medidata Solutions.
At the same time, there have been a smaller number of financial buyers for our holdings, with Apollo Management’s buyout of food retailer Smart & Final a notable exception. Outside the U.S., we’ve had a number of holdings acquired by private equity buyers more recently, which may suggest that financial buyers are having trouble making the math work for U.S. acquisitions at current valuations. Strategic buyers, however, who may be in a better position to increase sales and/or reduce overlapping costs, can afford to pay higher multiples.
What happens from here? As small-cap specialists, we think the small-cap M&A trend could accelerate in a slowing economy. Regardless of market cap, CEO’s are under relentless pressure to grow profits. If they believe opportunities to grow them organically are limited, then inorganic paths such as acquisitions become more attractive. Along similar lines, the CEO of a small-cap company might look more favorably on a buy-out offer at a significant stock price premium if he or she sees limited opportunities for their own organic growth. Perhaps paradoxically, we think that a deceleration in economic growth could lead to an acceleration in M&A deals.
“As small-cap specialists, we think the small-cap M&A trend could accelerate in a slowing economy.” — Steve Lipper
Acquisitions may increase significantly among small-cap value stocks, both from small-cap and large-cap buyers. Currently, small-caps sell at the low end of their 20-year relative valuation to large-caps; similarly, small-cap value also sells at its lowest relative valuation to small-cap growth since the 2000 market peak. In this valuation environment, many small-cap companies will be attractive takeover targets.
We also think that many better-managed small-cap businesses will continue to be active as acquirers. Many of the management teams we meet run companies with strong balance sheets and are eager to find ways to grow. With interest rates so low, many acquisitions are likely to be accretive, which increases their attraction to a potential buyer.
As we discuss capital allocation priorities with senior executives, we are generally supportive of thoughtful acquisitions, as long as the acquired business seems within or adjacent to the company’s existing circle of competence and the price paid seems fair.
In the absence of the much feared, but we believe unlikely, recession, we think the number of small-cap M&A deals could continue to head higher.
Stay tuned…
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Mr. Lipper’s thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LP, and, of course, there can be no assurances with respect to future small-cap market performance.
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