The Indian markets have been on a high, with both the Nifty and the Sensex reaching records in November 2017 and a slew of initial public offerings (IPOs) in the market. Higher valuations are reflected in the increasing price-to-earnings (P-E) ratios, with monthly average P-E climbing from approximately 21 in January to more than 24 in November, as compared to approximately 18.5 in 2014. This gives rise to the question: what has been the impact of such high valuations on deals? (See chart 1.)
Market valuations would typically impact deal-making in two ways : price discovery, as prevailing market prices form a reference point for deals, and volumes, with the number of deals getting concentrated in “hot” sectors in which investors perceive significant potential, and decreasing in general if markets are overheated. In the latter case, investors may expect only limited upsides to their investment returns, or deals may fail due to valuation differences.
We examined index movements and deal data on private equity (PE) and mergers and acquisitions (M&A) that happened over 2015-17, to see if market data can support this hypothesis, considering aggregate investment data on key sectors during this period.
We considered PE investments in three broad buckets, namely information technology (IT) and IT-enabled services (ITeS), banking, financial services and insurance (BFSI), and other segments. IT/ITeS and BFSI segments appear to be driving growth across the period. In other segments, we observe that PE investments grew in 2016, when public markets were muted and valuations were relatively range-bound. In 2017, with valuations on the boil, there has been moderation in deals, with annualized growth working out to negative 4% over 2016 (see chart 2).
Aggregate value of M&A deals nearly doubled in 2016 and then reduced by approximately 28% in 2017 on annualized basis. While there was significant deal activity in the BFSI and telecom segments in 2017, M&A deals in other segments declined significantly this year (see chart 3).
P-E ratio of the BSE Bankex is at 29.76 compared to an average of 16.63 for 2014-15. In this sector, rising valuations do not seem to be impacting investor sentiments. The telecom sector too has been witnessing significant consolidation activity over the last 15 months. In other sectors, while there are a variety of factors that influence deal making, including GDP growth, industry sentiment and global market trends, it is arguable that higher prevailing valuations have played their part in depressing deal activity this year (a lot of PE activity has supported consolidation in the consumer internet space and are to that extent outside the ambit of this study).
The above quick analysis of market data broadly supports the hypothesis that in M&A deals involving a limited number of parties and with greater information available for price discovery, valuations can play a significant role as both investor and investee would be ruled by economic principles. In the stock markets, on the other hand, factors such as market sentiment, liquidity and limited options for deployment of investible surplus do appear to play a role, apart from corporate earnings.