The Cycle of Increased M&A Activity

The Cycle of Increased M&A Activity
by Scott Van Winkle

With just about any aspect of business, there is a cycle.Nutritional supplements have experienced a few cycles of late; functional foodsappear to be in a strong up cycle; and mergers and acquisitions (M&A) acrossthe nutrition industry are also in a cycle of increasing activity. There willalmost always be several drivers of any cycle, and M&A is no exception. Inthe case of M&A, there are both demand and supply drivers.

On the demand side (demand for businesses to acquire), wepoint to three primary drivers: high levels of private equity capital, anincreasingly consolidated industry with a few leaders eager to furtherconsolidation, and a growing market for healthy products that is attractingadditional investment interest. On the supply side, the consolidating market isaggregating market power and forcing the need for further consolidation assmaller participants lack scale to compete. This is partially offset by a lackof meaningfully sized businesses, and thus attractive M&A candidates, acrosssectors due to prior consolidation. The fact that prior consolidation hascreated a market with several large players, but few middle market ($50 millionto $250 million is our definition for this industry) players, has resulted in ashift toward M&A at the expense of initial public offerings (IPOs). While a few large players control an increasing percentage ofthe market, the industry is still highly fragmented.

In the case of nutritional supplements particularly, but notexclusively, we believe the business environment almost assures furtherconsolidation. Product margins are being squeezed as companies get better termson ingredients and leverage scale in almost every other aspect of operations.Between their lower costs and their desire to fight for shelf space, the leaderscan offer reduced prices that cannot always be matched by the smaller players,forcing further market share shifts and a widening profitability gap between theleaders and the niche players. This is the natural life cycle of an industry,and consolidation is the natural result. However, new entrants should continueto feed the market, created by innovative entrepreneurs, who seek to profit fromthe latest trends in nutrition (which come around often, through both changingmedical science and consumer tastes), and who may find few significant barriersto entry. This maturation of the industry is probably the most significantdriver of consolidation.

The rising levels of private equity capital cannot, however,be overlooked as a significant driver of M&A. The idea of cyclicalityapplies here as well. During the late 1990s, capital aggressively flowed intoprivate equity funds in search of the next hot Internet company. As the stockmarket cooled over subsequent years, the inventory of uninvested capitalcontinued to rise. The result was a demand/supply imbalance. Given theattractive characteristics of the Healthy Living® market, private equityinvestments and buyouts in the nutrition and healthy food categories haveincreased, as private equity investors have directed attention on this space.Additionally, the average deal size has crept downward, indicating the decliningsupply of meaningfully sized businesses available for investment. Even beyond the Healthy Living industry, private equityinvestments and buyouts have risen steadily over the last couple of years,driven by high levels of committed, but uninvested, capital, as well as from acombination of low interest rates (allowing less-expensive use of debt-leverageto complete a deal) and lower valuations of target businesses due to the stockmarket correction. This trend should continue as all of the primary driversremain in place.

Scott Van Winkle covers the Healthy Living® Sector for Adams Harkness. These comments are not arecommendation to buy or sell specific securities.