The tepid global economy has greatly slowed the pace of US M&A activity, as deal flow dropped by 15% to 3,159 deals in the first half of 2012 from 3,729 in 2011[1]. Deal value also tumbled by 43% from the prior year[2].

While the US economy has exhibited signs of improvement, supplemented by an increase in consumer confidence, M&A continues to be affected by volatility in the credit and stock markets and uncertainty in the global economy, particularly in the Eurozone, exacerbated by slowing GDP growth in the emerging markets and minimal to nonexistent growth in the developed world.

Optimizing growth through organic growth

With M&A activity waning, boardrooms are focused on optimizing capital through organic growth and returning value to shareholders with M&A alternatives. According to Ernst & Young’s US Capital Confidence Barometer, 55% of companies cite growth as their primary focus, up from 42% six months ago[3].

The drop in deal activity and increased desire for growth has created a renewed focus on portfolio optimization, which could lead to corporate divestitures by management teams and boards in their bid to return value to shareholders and drive top and bottom line growth.

The Ernst & Young survey also reported that 34% of US companies were likely to sell assets in the forward-looking 12 months, a 70% increase from April 2011[4].

“In recent conversations with top corporate deal makers, there is a prevailing thought that incremental value will be created through strategic portfolio management,” said Rich Jeanneret, Americas Vice-Chair, Transaction Advisory Services for the Ernst & Young organization.

Divesting can be essential to growth

“Never before has it been more important for companies to evaluate which portfolio businesses are critical to implementing their corporate strategy over the next three to five years.”

Over the past decade, corporate strategy relied heavily on M&A for growth. However, Ernst & Young has found more executives are coming to realize that effective portfolio management and corresponding divestitures can be essential to growth.

Divesting with a focus on raising capital for investment in core businesses, emerging markets and extension of existing products and services builds value.

As executives increasingly understand the strategic benefits that proactive portfolio management can provide – particularly when corporate growth is difficult to achieve and efficient capital allocation is a priority – companies are executing well-timed divestitures, accompanied by stronger balance sheets and increased readiness for strategic acquisitions.

In the uncertain growth environment, expect to see the robust divestiture activity to continue through portfolio rationalization, star-bursting, tax-free spins and carve-outs.

“Companies that are focused on effective portfolio management will be well positioned for growth when clarity returns to the economy,” Jeanneret added.

Private equity revs its engines

While the overall private equity deal environment is stabilizing, activity levels remain well below expectations considering the amount of “dry powder” and availability of deal financing. In the first half of 2012, US deal volume was down 6% (buy side and sell side combined) and US PE deal value was flat[5]. Completed deals have taken longer to close and are being sold in very competitive processes, resulting in relatively high valuations.

Although fundraising remains challenging, there has been an increase in activity and funds continue to close. Approximately US$368.5 billion[6] in uncalled capital still remains available to PE funds, and credit markets have been receptive to new deal financing for the past six months.

Financing markets have stabilized

The financing markets have stabilized, with attractive terms available for buyout borrowings.

With nearly one-third of global companies considering an asset sale in the next year[7], PE firms have already started to demonstrate an eagerness to acquire carved-out businesses as platform or add-on deals.

PE firms are also focused on exits of more mature portfolio companies, positioning their portfolio companies for sale or IPO in an effort reduce the record numbers of investees residing in PE portfolios.

“As corporates streamline their balance sheets and sell off non-core businesses, carve-outs are a consequence and PE funds appear to be preferred buyers representing attractive near term buyout opportunities,” said Jeff Bunder, Global Private Equity Leader for the Ernst & Young organization.

“PE firms are poised to do deals – dry powder backed by an increasingly favorable borrowing environment is providing the impetus to complete acquisitions.”

In the next six months, PE activity is expected to continue at a moderate pace, likely consistent with prior years. This continuation will hinge on the stability of the global geopolitical situation, particularly as the next chapter of the Eurozone unfolds.

An even greater improvement in corporate confidence and re-emergence of corporate M&A activity may be required in order to see a significant surge in PE deal activity.

Despite improving deal conditions, vague economy clouds corporate M&A

Uncertainty surrounding the looming European debt crisis, slowing growth in emerging markets and the slow US economic recovery are dragging down confidence in the global economy. Although deal opportunities from six months ago still exist, corporates are reluctant to execute a deal without being able to predict economic trends.

While the near-term outlook inEurope is weighing heavily on corporate confidence overall, confidence in the US employment outlook is improving, and 90% of companies plan to maintain or increase their current workforce in the forward-looking 12 months, according to the Ernst & Young US Capital Confidence Barometer survey[8].

Cash and credit are also becoming easier to obtain with nearly $2.037 trillion in cash on corporate balance sheets and improving lending conditions for M&A[9]. Forty-eight percent of companies in the US expect to use debt as their primary source of deal funding, compared with 33% six months ago[10].

“Without clarity from Europe in the short term, companies are unsure of their ability to complete deals in the current economy,” said Steve Krouskos, Ernst & Young’s Global and Americas Markets Leader for Transaction Advisory Services.

“Slowing growth in China and Brazil are not easing confidence issues in the M&A arena, but companies are still looking to the emerging economies to reach new markets and seek growth through partnering and the right acquisition.”

Technology  still making headlines

Technology transactions continue to make headlines, with a handful of household-name deals, but on the whole tech companies are exhibiting some conservatism.

The number of deals in the first half of 2012 was down slightly by 3% to 663, compared with 686 deals in the first half of 2011[18]. Deal value was also down 42% to $32.2 billion[19].

“Cloud computing, ‘big data’ analytics, mobility and social media are the major trends still driving activity in the tech sector—and this trend will continue,” said Jeff Liu, US Technology Leader, Ernst & Young Capital Advisors.

“With more debt and equity deals in the last few months, traditional tech giants and newer, well-capitalized social media players are the primary buyers looking to add key businesses and expand into markets. Deals are happening faster, and there is a fair amount of PE interest in the sector.”