In the first half of 2018, there were 8,560 reported mergers and acquisitions (M&A) transactions globally valued at $1.9 trillion. Although this total comes to 1,069 fewer deals than during the same period in 2017, it represents an increase of 25.9 percent by value, according to Velocity Global LLC, a Denver, CO-based employment solutions company.
But the increase is relative as M&A value was down sharply in 2017 following a strong run from Q1 2016 to Q3 2016. Real recovery has yet to arrive. According to global advisory, brokerage, and solutions company Willis Towers Watson, the global M&A market underperformed for a fourth consecutive quarter in Q3 2018. The Willis Towers Watson’s Quarterly Deal Performance Monitor study found median adjusted performance of -3.0 percentage points for share price returns over the past four quarters.
What might bring M&A activity, value, and share price returns back up? The ACCJ Journal talked to five legal experts to find out what they see as having shaped the market in 2018 and potentially impacting activity in 2019.
A MATTER OF POLICY
Many changes in the United States and elsewhere have made M&A more attractive in 2018. These include shakeups brought on by Brexit and the United States-Mexico-Canada Agreement (USMCA), a trade deal that replaced 1994’s North American Free Trade Agreement (NAFTA).
But perhaps the biggest change is U.S. tax reform. The Tax Cuts and Jobs Act of 2017, which U.S. President Donald Trump signed on December 22, 2017, freed up money on the global landscape that can be used for such transactions.
“The recent U.S. tax reform has made outbound M&A—including in Japan—more attractive for U.S. companies,” J. William Dantzler, a partner at New York City-based White & Case LLP said. “Under the old tax law, many U.S. companies had large amounts of trapped foreign cash, which could not be accessed without paying U.S. tax on it. Most of that trapped cash is now released and available to be spent, including on M&A. What is more, the U.S. tax law will not create future trapped cash, and profits earned by a Japanese subsidiary of a U.S. company can be brought home to the United States free of U.S. taxation.”
The benefits also work in reverse. This reform has also made U.S. targets more attractive to non-U.S. buyers, such as Japanese companies, Dantzler explained. The new corporate income tax rate of 21 percent (down from 35 percent) represents a dramatic reduction in the cost of doing business in the United States.
For some companies, the tax reform has changed the approach to M&A. “An acquisition of the assets of a U.S. business—as opposed to stock of a U.S. company—is strongly incentivized by the tax law,” said Dantzler. “In that situation, the portion of the purchase price that is allocable to depreciable tangible assets can be immediately deducted for U.S. income tax purposes—a benefit that has never before been available under U.S. tax law. In many M&A transactions, this is effectively a subsidy of the purchase price.”
But all these benefits don’t come without a potential catch. One provision in the new U.S. tax law may counter both of the above trends. “There is a new limitation under which interest is tax deductible in the United States only up to 30 percent of earnings before taxes, interest, depreciation, and amortization (EBITDA),” explained Dantzler. “For highly leveraged private equity-type acquisitions, this limitation is significant. It is less significant for strategic acquisitions, such as a Japanese company buying a U.S. company for strategic reasons, as those acquisitions have historically not been as leveraged.”
Eric Sedlak, a partner at the Tokyo office of U.S.-based global law firm K&L Gates LLP and special adviser to the American Chamber of Commerce in Japan (ACCJ) Board of Governors, is not certain that all companies will use the benefits of tax reform for M&A. “There was hope that the increase in free cash among US corporates would lead them to go on acquisition sprees, but much of the money has been spent on stock buybacks.”
But, he added, the reduced federal corporate income tax rate and related adjustments will be key factors incentivizing selection of the United States as an investment destination.
“Our clients have successfully negotiated tailored incentive packages at the state and local level. Because every investor is different, those packages can have a significant impact on siting decisions,” he said. “Clearly, lowering the headline corporate income tax rate makes the United States a more attractive investment destination.”
Changes in Japan are also having an impact on the M&A landscape. Scott Sugino, a partner at the Tokyo office of Los Angeles-based global law firm O’Melveny & Myers LLP and vice-chair of the ACCJ Foreign Direct Investment Committee, cites efforts to shore up frameworks and improve investment value.
“Japan has tried to be a steady hand in protecting the global trading system through its leadership in pushing through TPP11,” he said, referring to the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, which replaced the Trans-Pacific Partnership (TPP) trade pact and has been signed by the original TPP countries minus the United States.
The administration of Japanese Prime Minister Shinzo Abe, he said, has shown “general support for improved corporate governance in Japan, and more emphasis on shareholder return is making corporate Japan a more attractive place for global capital. Many listed companies in Japan now have a large US institutional shareholder base.”
However, M&A in Japan by U.S. companies is still relatively rare, Sugino said. “Policy that encourages Japanese companies to divest non-core assets and continue to improve return on equity could lead to more inbound investment by U.S. companies.”
Sedlak sees a number of things Japan can do to boost its appeal for M&A. “Lower corporate and individual tax rates would tend to attract more inbound M&A activity to Japan. Other key factors include regulatory streamlining, labor market reform, and some steps to offset the aging and shrinking of the population.”
Which industries have been hot, and which might become so in the coming year?
Looking back at 2018, White & Case saw movement in fintech focused on cryptographic tokens, a unit of account in a digital accounting system. “We followed a couple of trends for Japan in M&A in 2018: IT companies moving to enter the crypto space, including through acquisitions and joint ventures, and financial services companies acquiring cryptocurrency exchanges,” said Nels Hansen, a local partner at the firm’s Tokyo office.
Sugino agrees: “Fintech is an incredibly active space. From blockchain to payments, there are many innovative startups that are challenging larger financial institutions. Large banks are increasingly working with fintech startups, and we may start to see more acquisitions of fintech companies by larger, more-established players.”
Meanwhile, Sedlak turned an eye to communications. “There has been a good bit of pushback both in the European Union and among U.S. consumers against further consolidation in telecoms and media.” Looking ahead, a key driver in this space, he said, will be how competition regulators respond.
Ryan Dwyer, a partner at the Tokyo office of K&L Gates, expects to see more investment in second-generation artificial intelligence (AI) companies in 2019, particularly among those who roll out practical AI applications for consumers and the business-to-business market.
Without going into specific industries, Sugino warned that—although the tax frameworks are favorable for M&A—other factors could hold back potential. “There is a lot of uncertainty ahead in 2019, with Brexit looming as well as trade and political tensions escalating between the United States and China,” he said. “We could see a pause in cross-border M&A as people wait to assess the state of the world and how these big events will play out.”
In addition to uncertainty around Brexit and global trade disputes, Sugino cited stricter scrutiny of Chinese investments and changing trade rules, such as the renegotiation of NAFTA. “This all creates uncertainty in the market, which could put a damper on cross-border M&A.”
Sedlak also pointed to China but has a positive outlook. “National security concerns have increased in importance—see especially the increased focus on Chinese investments by the Committee on Foreign Investment in the United States—but we do not expect this to hurt Japanese investment as Japan is a strategic ally with whom the U.S. values strong ties.”
As for Japanese companies investing in the United States, many rely on complex supply chains and have been relieved by the conclusion of the USCMA trade deal, he said. With new rules in place, uncertainty that had clouded their 2019 plans has been lifted.
And as a closing bit of advice, he added: “Executives considering an acquisition should ensure that they undertake a thorough diligence process. Cutting corners may save money but can lead to surprises during the post-merger integration process."
Custom Media publishes The ACCJ Journal for the American Chamber of Commerce in Japan.
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