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Why private equity is driving A&D deal activity in 2024
In this episode of the Advanced Manufacturing and Mobility Business Minute podcast, speakers Raman Ram, Mike Cadenazzi and Mike Iacono examine the turbulence shaping the aerospace and defense sector.
While airlines are placing more orders, supply chain issues and safety concerns are impeding production rates. Pilot shortages have become an issue, particularly for regional carriers. In terms of deal activity, private equity has championed creative financing solutions and has emerged as a net buyer despite complex market fundamentals.
Regulatory scrutiny remains a significant concern, necessitating proactive planning and engagement with antitrust counsels. Furthermore, sellers are increasingly evaluating prospective buyers for their ability to close deals without regulatory hiccups.
Industry leaders anticipate more orders, new solutions to supply chain issues, updates on sustainability challenges and technologies, and more transaction announcements in 2024. As businesses focus on strategic portfolio rationalization, private equity is expected to play an increasingly important role in driving transaction volume and deal value.
The podcast also includes perspective from EY Americas A&D Leader Raman Ram and EY Americas A&D Managing Director Mike Cadenazzi, as well as EY Americas Strategy and Transactions Partner Mike Iacono, on where larger deals are getting done in the A&D sector.
Key takeaways:
North American airlines were profitable last year and it's expected that the rest of the world's airlines will also be in the black this year.
Despite underwhelming market fundamentals, private equity is leveraging sector resiliency and capital availability to continue with strong buying.
While pilot shortage is a looming issue, fleet availability is seen as a more immediate concern.
Strategic buyers continue to shape their portfolios, even as they remain cautious about buying.
For your convenience, full text transcript of this podcast is also available.
Mike Cadenazzi
Thanks everybody for joining us today for the next in our EY Aerospace and Defense Podcast series, discussing the relevant topics in the world of commercial aerospace and defense. I'm joined as before with my colleague Raman Ram, America's head for aerospace and defense here at EY. Thank you for joining me, Raman.
Raman Ram
Thank you for having me Mike.
Cadenazzi
In addition, today, we brought to us another leader in the commercial Aerospace and Defense and also government technology space. Our colleague Mike Iacono, who is a leader within the EY strategy and transaction practice. And he leads our efforts on A&D mergers and acquisitions. Mike, love to have you introduce yourself and thank you for joining.
Mike Iacono
Yeah, great to be here today with both of you. As you said, I'm a partner in our Strategy and Transactions practice. And for the last 18 years, my team and I have worked with buyers and sellers in the Aerospace & Defense and Government Services sector as they execute on transactions.
Cadenazzi
Terrific stuff, Mike. Thanks so much for joining us. Look forward to talking about that. We're going to start today talking with Raman on the commercial aerospace front. Since we last talked in the fall, a lot has happened in the commercial aerospace sector, obviously. Unfortunately, we've seen a spate of accidents and incidents here in the US that have shaken the market and forced the government and industry to look carefully at their role overseeing the trajectory of the American aerospace sector.
And this is all happening while commercial aerospace demand is growing and securing pressure from a concurrently more demanding defense sector where it impacts at the lower tiers. So, Raman, let's talk a little bit about what's happening in commercial aerospace.
Ram
Yeah, Mike, as you rightly said, you used the right words. It's unfortunate. It's during a time when the industry is growing. So words like door plugs, tires falling off, panels falling off, in-slight engine shutdowns, pilots falling asleep, things like that, unfortunately, are all a confluence of things that are happening. But that notwithstanding, the intrinsic demand has come back.
Even though the growth rate has slowed down, it's still higher than what it used to be historically. But the travel spike has come down. Still, we're growing and eventually we'll get back to the 3 to 4% air traffic growth rate. Cargo traffic, as expected, has come back due to the mean reversion. So the growth rate has not been what it used to be. In fact, it's declined considerably with all the reductions in e-commerce-led demand, as well as the vaccine transportation supplies and things like that. Personal protective devices, things like that. But net net, the intrinsic demand is pretty strong and it's exceeded 2019 levels. Airline profitability, which is actually required for the aerospace sector, airline profitability, U.S. carriers, North American carriers will be in the black, were already in the black last year, and we expect the rest of the world to be in the black in aggregate this year as well. So that's all good. But right now, capacity is the issue and airlines now are coming back strong. As I mentioned earlier during the prior forecast, the traffic recovery is helping them to improve revenues and revenue recovery is helping them with the financial recovery.
And now airlines are coming back to place orders. But unfortunately, the industry is not ready. We've got supply chain problems. We've got these safety issues dampening production rates. So that's essentially the issue right now. So the near-term, there is a little bit of a mismatch between demand and capacity. So then that's what the industry is trying to solve.
Cadenazzi
One question, Last year you testified in front of the Senate about talent issues in commercial aerospace and in particular topics around pilot shortages. We discussed the pilot shortages in our last podcast. What is the status of that now? Is this still an issue or has it gotten better?
Ram
We've always felt that there's pilot shortage issues. Is it an issue? Is it not? With the changes that we made, some would call it a slow moving freight train, things waiting to happen and we're watching it, but not acting on it. And then over the past year or two, we've seen that really manifest in shortages, regional carriers, particularly. They are more constrained and they have to make some adjustments in their routes, particularly for pilots, not even flight officers, but pilot shortages happening and impacting them on regional side.
It's a confluence of things. The pandemic happened, demand went down, a lot of retrenchments happened on the pilot side and people left the sector. But we’ve had some improvements happen as well. Major carriers, at least in the U.S., signed new contracts with the pilot union, and the pilots have ratified these new lucrative contracts and major carriers also started taking actions (inaudible) improve and build the pipeline of pilots.
But then we have capacity issues. Pilot shortage is one thing, but then it's dependent on fleet growth. One Dallas-based carrier, for example, hired about 1100 and 1200 pilots in 2022. There are about 2000 pilots in 2023. But this year I think they're going to put the brakes on pilot hiring. It's about 350 or so.
Same thing happening with other major carriers. If you look at the Chicago based carrier or a Denver based carrier, they're all temporarily slowing down the pilot hiring. And the reason for that is we don't have the fleet ready for capacity expansion. Essentially, the pilot shortage is not on the critical path. It's actually other things on a critical path.
So longer term, I would say, but retirements happening and the demand increasing, we could have an issue. But in the near-term, availability of aircraft is actually the primary issue. So that's actually pushed the pilot shortage back right now. So that's not really the primary thing.
Cadenazzi
So a little manageable. That's a good thing. Certainly a lot happening on the commercial side. Let's pivot then to talk about transactions. We're going to skip defense today and focus on Mike Iacono's portfolio in his world. So, Mike, you and your team have had a relatively quiet start to 2023, as I recall. And then as is usually the case, the tide turned and it's been exceedingly busy this last 6 to 9 months with the end of 2023 and a rapid start to 2024.
Talk to us about what you're seeing in the market and how demands changing and what that's doing for M&A within the aerospace and defense sector.
Iacono
Sure, your summary is correct in terms of the way 2023 started and finished and what we expect going forward. There's been some macro uncertainty in 2023 and a lot of the interest rate dynamics certainly slowed activity broadly across the sectors. This sector was not immune to that in the first half of 2023, as you mentioned, but it's really come back strongly in the second half of 2023.
And early indications in 2024 are good and we're already starting to see that uptick in activity. Despite interest rates and fears of the recession, this industry, as typical as we've seen in other cycles, really does show resiliency. And there is some signaling that the rates will start to ease and potentially come down. So obviously, the cost of capital is a big consideration in M&A and how businesses value deals and look at return on investment.
So any easing on interest rates is going to be key to ramping up the deal volume throughout 2024. But that being said, people still see growth opportunities out there. We've got high expectations for the rest of 2024. There's a lot of optimism and we're already seeing buyer demand. I mean, there's been buyer demand pretty steadily even in 2023 when things were slow. It was just harder to get deals done.
Valuations have started to ease, I would say, I've seen slightly not a lot, but just a bit where that alignment and valuation gap between buyers and sellers is starting to get smaller. That obviously helps for deals to get done. From a buyer perspective, PE has been a net buyer throughout this last 18 to 24 month period. We're seeing higher selectivity from corporates, but PE using some creative finance solutions has been able to get deals done. But we are seeing processes take longer because there isn't as much competition for every deal.
So buyers are stretching out processes a bit more. Due diligence is lengthening out from what we may have seen in the COVID period. And like I said on PE, they're getting deals done. They're finding ways to finance transactions, moving away from traditional bank lending, and we're seeing a lot more private credit in the market and even transactions where PE is willing to over-equitize, write a bigger equity check than they normally would upfront on a deal to get some of these deals over the line.
So they're using greater methods to get deals done. Capital is available as a result of that and PE has been raising a lot of money and they need to put money to work. So for PE as a buyer, fundamentals are still okay for them. They're not great where they might have been over a year ago. But going back to one of my earlier points, resiliency of this sector, particularly in defense, is attractive and enduring for them to be able to make some of these bets.
And we've seen a lot of new platforms getting created by PE continuing that trend over the last couple of years. And we're actually starting to see the flip side too where there were platforms created during COVID. And now those assets are getting ready to come to market. If you think broadly about just the three sectors, we're here talking about government services, that market has been fairly steady.
Businesses in that area generally have steady, consistent cash flow, very low capital intensive businesses. So those are very attractive from a PE buyer perspective. A lot of roll up opportunities in the government services arena just because of the very fragmented market that still exists out there. And there's not really a lot of pure play services in the middle.
You have either really small companies or some really big ones that have been created and that middle market is ripe for somebody to enter. And so we'll see some more roll up opportunities there. On the defense side, a broader boost from the global threat environment that we're in is going to continue to help for deal flow in that area.
There's definitely some growth factors that are worthwhile considering there. And on commercial aerospace, there are tight labor markets, supply chain issues. We could certainly see some vertical integration opportunities around the supply chain there. The only other thing I'll mention here, the deals that are getting done, we typically have seen deals in this sector be under $500 million.
That's where the vast majority of the deals have been getting done. But we have had some pretty good sized deals in this sector, over half a billion or even in excess of a billion in areas like government services, cybersecurity, space and satellites and aftermarket and actuation on the commercial side. So large deals getting done. But as it's been in the past, the vast majority of the deals in our sector are in the middle market arena.
Cadenazzi
So Mike, what other big trends do you see driving transaction volume through the rest of this year? What are the big drivers from your standpoint of new activity?
Iacono
Yeah, as I mentioned a minute ago on defense, the global threat environment and the conflicts that are out there around the world are driving demand for more products, more types of innovative technologies. So I think that's going to drive investment and organic investment that may need to be made. On the commercial aerospace, the procurement cycle is very long and then on government, the procurement cycle is lengthening out and we're seeing more protests and so organic growth has been pressured on the government services side and companies looking for growth, they may need to tap into some inorganic activity. And then on commercial, as passenger levels and all those other forward-looking indicators stay strong, there will be more deal activity there. I think we're going to see strategics or corporate buyers continue to be selective.
We're expecting more portfolio shaping out of the strategics. So I would say strategics more of a net seller in my view in 2024, still being a little bit, not cautious, but more selective on buy side activity, whereas I think PE will continue to be a net buyer, even though we'll see some platforms coming out on the market from a sell-side standpoint, I think reinvesting some of those returns, we'll continue to see PE as a net buyer here.
Cadenazzi
One big follow up question, M&A in general, are you still concerned about regulatory scrutiny? This is a big deal certainly when the Biden administration came into play. We saw the impact of additional scrutiny, not a positive on a couple of big deals. Have we moved beyond that? Are those pressures easing?
Iacono
I wouldn't say they're easing, no. So we get asked this all the time about how we see the regulatory landscape playing out. Yes. To your question, regulatory scrutiny is still a big deal. We're seeing those pressures requiring companies to plan differently, plan earlier. We actually put a thought leadership piece out on this last summer on our website, if people are able to check it out, discussing the impact of the regulatory environment on transactions in our sector. We probably need to update that and say things have changed a little bit, but there's still overall a lot of focus on this and how companies can approach things differently to hopefully have a higher chance of getting deals closed when there's expected antitrust scrutiny on a transaction.
For instance, we've seen companies change their approach. The biggest change has been just being more proactive, engaging with antitrust counsel earlier on, conducting a more thorough risk assessment earlier in the deal process, not waiting longer in the due diligence process, getting out in front of that, focusing on the contract portfolio, key customers, any overlap of critical suppliers, things like that.
I'd also say like from a seller's perspective, they're not just sitting back and letting the buyers deal with this. They're definitely more attuned to which of interested parties in their process are more likely to be able to close the deal quicker? Which of the buyers maybe have a lower risk of running into regulatory issues with getting a deal done? So they will obviously want to strike a deal with the best economics, but a lot of other things are coming into play as well, including potentially what's the certainty to close? That's always on a seller's mind as well.
Cadenazzi
Fascinating rundown. Thank you for talking about so much that's happening in the A&D sector. One things are pivoting a little bit to looking ahead is we're in the long runup to Farnborough and our biannual cycle of Farnborough in the Paris Air Show. Our EY team will be attending. We're also a sponsor at Farnborough. So we're very excited to go ahead and come back again with strong presence from across our global team. We’ll have folks from Europe, The Americas and Asia is in attendance as well.
So we're excited about that. On the defense side, we tend to get a little bit more participation in Farnborough. A lot of the UK based companies temper their participation in the Paris Airshow and then they double down each year when it's at Farnborough. And I think it'll be interesting this year with all the ongoing conflicts, some of the geopolitical tensions to see if there's a shift in the balance of systems. Will we see more autonomy and more weapons? There was a certain amount of that at Paris last year, which I was surprised at, and I'd expect more going forward. But again, focusing on the commercial air side and the transaction side. Raman, what are you looking ahead to see at Farnborough this year?
Ram
Yeah, a few things, Mike. I'm excited. I'm looking forward to it in July this year. Obviously, we're optimistic for orders given how traffic has come back and given the current near-term capacity constraints. So we're going to be looking forward to seeing more orders happening. We're also going to look for more announcements on resolution, the supply chain issues, sustainability challenges, more technology updates and advanced aerial mobility and that kind of stuff.
We're also looking forward to seeing more transactions announced as well. I think Mike talked quite a bit about it. We're seeing a lot of the A&D companies focus more on portfolio rationalization, coherence, pruning, things like that. Mike talked about more divestitures as well. So we're seeing a lot of strong demand from strategic buyers to do all of this.
And second, Mike talked about private equity. We're seeing more private equity participation. We have seen over the past few years, we expect to see the same trend continue. And as you all know, roughly about 50% of the transactional volume in A&D and maybe 40% of the deal value is driven by private equity. So we expect them to play a bigger role as well.
And lastly, our conversations with private equity also indicates that they're more interested in doing bolt-on transactions and focused more on smaller buy and hold type acquisitions, which hasn't happened in ten years. It would be considered as placing a risky bet, but now we're seeing more emphasis on that. So we're expecting to see all of this at Farnborough this year.
Cadenazzi
And Raman, you'll be running a panel at Farnborough this year as well, correct?
Ram
That's right, Mike, EY and I will be involved along with a couple of marquee industry, aviation and aerospace experts on a panel. And the topic is going to be the business case for commercial aerospace. So I feel like this is an interesting topic and it's going to analyze the confluence of the Paris climate accord, the sustainability and the net zero aspirations and the implications for the commercial aerospace industry.
So that's going to be a 45-minute session or so. But look forward to seeing you all there. I have an interesting dialog on this.
Cadenazzi
Great. Pivoting to Mike Iacono. What are you focused on for the rest of the year of 2024, starting out strong? How do you see it unfolding going forward?
Iacono
Yeah, I think building off what Ramon said, agree with all the points he made about what we expect to see. And as I said earlier, I think very optimistic for 2024 and what it's going to mean for M&A activity. We've already started to see that enthusiasm play out. There's an appetite to do deals. We'll see some good, I think, portfolio rationalization, as Raman mentioned.
And I think the focus for buyers is going to be just on high-quality targets and we're going to start to see valuations come down. There's also going to be sort of a widening of valuations where assets that are really high quality are going to start to demand that premium and other businesses not perceived as high quality would start to come out lower in terms of valuation expectations.
So we're going to see some widening of the valuations that overall start to help bring valuations back into line and get that valuation gap a little bit tighter between buyers and sellers. But overall, I think 2024 is going to be a great year. We're in a great cycle for the industry broadly and so I look forward to the rest of the year and what it means for M&A activity.
Cadenazzi
Also, I have to mention, it’s been two years since the last Farnborough. I truly hope the air conditioning is better because it was so, so hot in 2022. I think everyone would appreciate an attempt to deal with the elevated temperatures on the tarmac there. So both to Raman and to Mike Iaconono, thanks for joining me today, I appreciate you both for sharing your expertise and insights on what’s happening in the world of commercial aerospace and mergers and acquisitions and thanks to everyone for listening and we’ll see you next time. Thanks!
