The strength of the equity markets masks the largest valuation gap between the highest- and lowest-valued companies observed in a decade. This gap continues to widen, driven by differences in innovativeness, growth, balance sheet strength, earnings stability, and exposure to protectionism risk. In particular, the potential impact of protectionism requires firms to be acutely focused on maintaining strong corporate fundamentals, optimizing the supply chain, and prioritizing strategic initiatives.
Investor receptivity to M&A remains positive, despite concerns over the prolonged duration of the current cycle. In fact, we observe that while M&A announcements are well-received through business cycles, highly levered deals announced in the last year of an expansion under-performed in the long run. We also find that since size and scale are increasingly relevant for competitive positioning, there is an ongoing need for firms to capitalize on strategic opportunities to improve market share and competitive strength in their industries.
Financial sponsor firepower has reached new highs, and now includes larger and more diverse pools of capital. This trend is enabling sponsors to be more competitive and pursue larger targets, while employing more aggressive leverage levels. Although lower rates are often a symptom of lower long-run growth expectations, we do not estimate this to materially dampen the LBO outlook given the associated decrease in financing costs.
Capital deployment will remain a key theme in 2020 given high corporate liquidity, low interest rates, and continued activist pressures. Firms should lower investment hurdle rates commensurate with recent declines in cost of capital driven by lower rates and greater leverage. Moreover, in today’s low-rate environment, firms with a sustainable dividend policy command a robust valuation premium relative to peers. Firms should adopt a dividend policy that ensures dividend sustainability through the cycle. Share repurchases will remain an attractive way to return capital to shareholders given their flexibility.
Recent focus on shareholder distributions and M&A has led many firms to migrate down the credit spectrum. This trend may expose some firms to credit and valuation pressures in the event of an economic slowdown, a vulnerability that is amplified by protectionism-related concerns. Firms will need to proactively manage these risks by publicly articulating a capital structure plan—to provide commitment and clarity—and recalibrating their funding strategies.
Firms face a delicate balancing act between building balance sheet strength and managing activist pressures. In particular, activists continue to target firms with robust liquidity positions. Additionally, activists are increasingly focusing on larger companies, urging them to consider all strategic options to maximize shareholder value, including buyouts. These trends require firms to evaluate all capital allocation alternatives and ownership structures.
Focus on environmental, social, and governance (ESG) issues has risen sharply in financial markets in recent years. The menu of ESG-aligned financing options is rapidly expanding as is the influence of ESG factors on credit ratings. As the reliability and acceptance of ESG metrics expands, they will increasingly become a priority in corporate decision making.
Governance is also increasingly relevant for the IPO market. In addition, investors are paying particular attention to a firm’s financial fundamentals and path to profitability. While the overall macro environment is supportive of IPO activity, we encourage firms to be proactive in accessing the IPO market in 2020 given the evolving geopolitical landscape.