The Federal Reserve’s recent rounds of interest rate cuts and the anticipation of further rate cuts to come have sparked a renewed sense of optimism and enthusiasm in the long-moribund M&A market. Pitch activity, a precursor to future deals, is ticking up. Private equity, which has largely sat on the sidelines waiting for valuations to improve, is increasingly motivated to transact. Though considerable uncertainty lingers over future rate cuts amid mixed economic signals and the regulatory and trade priorities of the incoming U.S. Administration, for companies contemplating taking advantage of this window of opportunity in a resurgent M&A environment, the time to prepare is now so that companies are well positioned to act as macro conditions and industry and company specific dynamics warrant.
Animal Spirits
While the Fed’s three rounds of rate cuts in September, November and December 2024 totaling 100 basis points have had only a slight impact on actual borrowing rates, they have had a much more profound impact on M&A market sentiment. Whether you call it “animal spirits” or something else, there is a level of optimism among dealmakers that we haven’t seen in more than two years. Their return to the market is likely to drive strong M&A activity in 2025. We’re already seeing a significant increase in M&A pitch activity, which has historically preceded an uptick in deals within six months or so, though that process has elongated in recent years.
Dry Powder
The prospect of the cost of capital coming down is having a meaningful impact on valuations. That combined with the general level of optimism and outlook for the next 12 to 24 months is giving both buyers and sellers more conviction to proceed with transactions. The historically high volume of “dry powder” held by PE firms should only intensify that conviction. Undeployed private equity capital is estimated to have reached $2.24 trillion by midyear 2024 amid a drought of private equity monetizations. Sales of PE portfolio companies were slow over the past couple of years as owners waited for valuations to improve. For many, that waiting period has gone on about as long as it can as limited partners (LPs) insist on having capital returned before opting for investment in new PE funds, putting further pressure on PE firm economics. These structural and technical drivers look set to boost transaction activity even if the pace of rate cuts slows.
Winners and Losers
Capital intensive sectors, like technology, utilities and financial institutions, should be among the first to benefit from a lower cost of capital. Technology industry transactions, which have typically commanded premium valuations but struggled over the past two years to regain pervious valuations, should see a boost. Similarly, investors have been piling into regional banks on the expectation of outperformance and increased consolidation. The outlook for other sectors remains more mixed, with healthcare and consumer products continuing to face a variety of headwinds that are only partially ameliorated by lower rates. However, the easing of the “risk off” mindset that has prevailed over the past several years should benefit M&A activity level in most sectors.
The Wild Card
The impending change in Administrations in January adds a bit of a wild card to the mix. The Trump Administration’s expected lighter touch on regulation and tax policies is widely seen as positive for M&A activity. But the prospect of higher tariffs across the board and mass deportations of undocumented workers, if enacted, could add to inflationary pressures that inhibit the Fed’s ability to further lower rates and would have a direct impact on valuations in some trade- and labor-sensitive sectors.
A Tale of Two Cities
These conflicting currents and lingering uncertainty are likely to maintain and—in the short term at least—potentially exacerbate the bifurcation we’ve seen in the M&A market. Over the past two years, even as overall activity and valuations have receded, high-performing companies that are well positioned and growing have traded for high multiples and very strong valuations. Businesses with a murkier outlook and weaker performance have struggled. As interest rates come down, we will see overall valuations start to creep up and the closing rate for transactions increase. And while high-performing businesses will continue to command strong valuations, businesses that are underperforming or have a hard time projecting their performance amid an uncertain environment will continue to struggle to get deals done despite the benefits of lower borrowing costs.
Even as overall M&A activity picks up and valuations rebound, expect to see more restructurings and bankruptcies among less well-positioned companies. For private equity with weaker performing portfolio companies feeling the pressure to return capital to investors, some rational decision making will be needed. That likely means some capitulation on valuation and forced divestitures, as well as an increase in other types of liquidity events, such as minority recapitalizations, dividend recaps, secondary and continuation fund transactions.
Navigating Opportunity Amid Uncertainty
Despite the high degree of uncertainty, the renewed momentum in the M&A market sparked by lower rates seems to be accelerating. The concept of animal spirits is real and when market momentum starts to build, the landscape and opportunities can shift fairly quickly.
For companies looking to strategically or opportunistically take advantage of this dynamic market environment in the next 12 or 24 months, understand that the deal process takes time, so now is the time to get ready and be prepared. Enlist the right advisors and resources now to ensure that the business is positioned in the best possible light and ready for when you make the decision to go to market. Time kills all deals: if a company is not prepared to conduct a transaction when the opportunity arises, they will miss the chance to get that deal done.
With a growing appetite for M&A and a good supply of capital from both corporates and private equity with plentiful financing, particularly in the private credit markets, it’s generally a good idea to be on the early end of the cycle. You may not want to be the first to market in your sector or sub-segment, but if and when a comparable peer or benchmark transaction sets an attractive valuation, you want to be next in line. That window of opportunity may be short-lived so you need to be nimble, agile and prepared to take advantage of it while it exists.
