(As originally published in FEI Canada F.A.R. member e-newsletter, January 2017)

Demystifying the Canadian middle-market deal environment

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By: Chris Hutchinson, senior manager, advisory in EY Canada’s Private Client Services practice; and Jason Marley, senior manager, advisory in EY Canada’s Private Client Services practice

Unprecedented technological advances, geopolitical uncertainty and a focus on innovation and competitive advantage have taken centre stage as middle-market companies look to reinvent their corporate strategy to align with the evolving landscape.

According to the 15th edition of EY’s Global Capital Confidence Barometer, Canadian executives have a strong belief in the local economy and deal market but have concerns about the global market as a whole. However, despite economic uncertainty around the world, the results of our survey indicate that Canadian businesses are actively looking for deals and predicting a strong M&A market in the year ahead.

Here are some developments we’re seeing unfold as we look ahead in 2017:

Potential for a buoyant M&A market

Executives remain positive about dealmaking and may be looking to boost deals in 2017. Our barometer reveals that 44% of Canadian companies expect the Canadian M&A market to improve in the next 12-months, compared to only 14% at the same point last year. In addition, almost 50% of our Canadian executives report actively pursuing deals in 2017, which marks the fourth period in a row that Canadian respondents are above the historical average for this question.

Geopolitical instability challenges corporate and M&A strategies

While it’s important to note that the barometer results were compiled prior to the US election, the tone of the US election campaign presented significant influence on US respondents with 57% listing political instability in their home country as their primary (18%) or secondary (39%) risk to their core business. The slowdown in global trade flows is a major concern for Canadian and US respondents underpinning the perceived weakness of the global economy. As we move forward in 2017, private businesses will be looking closely at growth of the Canadian economy, as well as growth outside the oil and gas sector. Developments in the US will continue to impact corporate strategy, with many looking at changes in the Federal interest rate, pipelines and NAFTA as having potential influence on dealmaking decisions.

More deals in the pipeline

Eighty per cent of our Canadian survey respondents indicate they’re currently looking at more than one acquisition – which means they have some of the deepest pipelines in the world. Combined with the finding that more than a quarter of Canadian respondents believe their pipeline will grow over the next 12 months and 52% expect to close at least one deal, it’s fair to say we expect to see increased and sustained levels of M&A transaction activity through 2017.

M&A market dynamics

Banks in both Canada and the US continue to be aggressive with their lending. In the middle-market, we see Canadian banks increasing their lending sophistication further down-market in an attempt to gain market share. Although interest rates in the US are rising, they’re still low, and remain historically low in Canada. This lending environment is enabling M&A to thrive in Canada.

With over $US 500 billion of dry powder raised by private equity around the world – with the largest component in North America – there’s a fundamental need for capital to be deployed. At the same time, public companies have a significant amount of cash and short-term investments on hand. This availability of capital is generating strong market dynamics that’s helping spur M&A activity.

Valuations continue to impact deal closing

With corporate cash holdings and private equity dry powder still at high levels, we expect the appetite for mid-market deals to remain robust. Sellers’ expectations have a tendency to rise with headlines of very high multiples in very large deals, even though those same multiples might not be applicable or comparable to their middle-market company. Balancing this, Canadian buyers are still acting with discretion and taking a prudent view when evaluating acquisitions, with 85% of Barometer respondents indicating they had walked away from an acquisition in the past 12 months. 52% of Canadian respondents believe we will see a decrease in the price/valuation of assets, which may help to bridge the valuation gap. Given the other market dynamics at play, this may be wishful thinking from a buyer’s perspective.

As we look ahead towards 2017, we’re seeing Canada’s low-growth economic environment compelling private business owners to look at both organic and inorganic strategies to sustain and grow their businesses. With a changing geopolitical landscape, uncertainty around oil price recovery and how valuations may be impacted by rising US interest rates and US trade policy changes, this is poised to be an interesting year for transaction activity. In a fast-changing, complex environment, middle-market companies with a mindset that disruption is more an opportunity than a threat will be best positioned to compete and thrive.