While still managing to avoid a downgrade in April, South Africa has found itself at a crossroads of uncertainty since Moody’s Investors Service’s bleak budget reaction that sparked junk status fears for the country.
The speculation about the credit downgrade has been amplified by the fact that South Africa is in the middle of an election year – a factor that has also been blamed for a decrease in foreign investors’ confidence in the South African market.
An analysis of mergers and acquisitions (M&A) activity pre-and-post downgrades in Brazil and Greece suggest that although foreign investment will not end, investors do adapt their investment portfolios to align to the parameters of their investment mandates.
Government bonds and treasury securities become largely un-investable instruments post a sovereign downgrade. However, statistics suggest that while capital outflows are a reality, some funds do remain behind in these countries, and new funds do flow in. These investments will naturally seek viable and alternative high-return investment opportunities – options often presented by M&A. One theory that emerges from this analysis is that mature economies have more stable but lower growth rates. While developed economies also represent a seemingly lower risk, they do not offer sufficiently high returns.
In order to achieve the required overall return on investment in a risk-on environment following a credit downgrade, fund managers will inevitably still require some form of investment in emerging markets.
In order to understand the impact a credit downgrade has on M&A activity in a country, we compared M&A activity as reported by Zephyr, a Bureau van Dyk company that offers a database of deal information.
We compared M&A activity before and after a credit downgrade in Brazil, which has a similar economy to South Africa due to slow growth and political instability in both countries, as well as in Greece. The raw data suggests that a catastrophic capital flight is unlikely because the sums invested may be lower and the investment profiles between the countries are different. But opportunity abounds and returns remain strong as there exists a direct correlation between risk and reward.
According to Trading Economics, Moody’s was the first to downgrade Brazil in September of 2014 for political and economic reasons. Fitch Ratings followed suit with a downgrade in April 2015. In July 2015, S&P downgraded the country too.
The Bureau van Dyk / Zephyr data looked only at transactions where the targets were Brazilian companies and considered deals that were both completed and announced each year. The transactions analysed include mergers, acquisitions, institutional buy-outs as well as venture capital and private equity.
It is evident from the data that the volume of transactions was relatively flat after the first downgrade by Moody’s in 2014. The volume of transactions decreased by approximately one-third after the remaining agencies downgraded the country in 2015.
While the total value of transactions reported also decreased, it is evident that the average transaction value in 2017 was similar to 2015. For example, the average value per transaction in 2015 was R973 million and R929 million in 2017. On a cursory view, transaction values held up well after the Moody’s downgrade.
Analysing the data for Greece, which was downgraded in 2010, the following graph illustrates the effect on both volume and values reported by Bureau van Dyk over a similar period to Brazil.
The data illustrates a clear downward trend in M&A deal values over the period of the financial crisis in 2008, 2009 and well into 2010. While there was an initial slump in volumes and a slight decrease in value immediately after the downgrade in 2010, it is only 2017 that has subsequently underperformed the deal values as they were similar to levels seen in 2010. Again, the average deal size in the period following a downgrade is shown to have increased.
The data analysed makes no currency or inflation-related adjustments. And the data, being Euro-denominated, indicates that the M&A sector remained resilient even after credit downgrade events.
Although Moody’s did not downgrade South Africa to junk, the data from Greece and Brazil does indicate that deal flow will not evaporate should this happen. Volumes may initially drop but average deal values can be expected to increase.
While we continue to work to avoid it and acknowledge the punitive impact thereof, the statistical reality is that a downgrade is not likely to be as detrimental for the M&A sector as otherwise perceived.
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