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M&A market drivers

M&A activity in the metal recycling sector is expected to be robust through the remainder of 2021, driven by the economic outlook, industry dynamics, the aging demographic of scrap company owners and tax rate changes.

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August 2, 2021

Several factors affect the metal recycling mergers and acquisitions (M&A) market in any given year, with differing positive and negative results. While an infinite number of factors affect the M&A market, those having the most significant influence are, in no particular order,  economic outlook, state of the industry (e.g., industry leaders, customer and supplier leverage, scrap metal pricing), company/owner-specific issues (owner transition planning, financial performance) and taxes.

In 2021, most factors point to a robust M&A market through the second half of the year. I’ll examine these key drivers and the dynamics influencing an expected shift to a buyer’s market at the end of the year.

Economic outlook

A day does not go by without another announcement of some economic indicator. While assessments can be subjective, the overarching theme is that most global economies are recovering from the COVID-19 pandemic. While recovery might not seem altogether positive, growth is returning and it is generally believed that pent-up demand exists for many products and services around the world. While it might be growth back to where things were, it is growth all the same.

The general economic outlook is favorable, which makes it easier for buyers to purchase companies knowing there is time for consolidation and the ability to gain synergies before a market downturn. Across most sectors, corporate and private equity buyers have significant cash available, and the debt markets are standing ready to assist in acquisitions.

State of the industry

To gain perspective on the current state of the industry, one really needs to go back to the early 2000s, a time that most industry players would prefer to forget. Many U.S. steel mills went bankrupt, which led to significant industry consolidation. This steel industry consolidation increased the negotiating leverage of the steel mills with suppliers, which left the smaller metal recyclers with insufficient metal flow to attract buyers from the larger, newly created mills.

Fast forward to 2008, when two of the large U.S. minimills purchased two of the largest scrap companies in the country, creating further leverage to reduce scrap prices outside of the normal supply and demand equilibrium. In fact, the industry is still trying to find the correct supply and demand balance. Over the past several years, metal recyclers have expressed concern that these large, mill-owned recycling companies are depressing pricing. Further complicating the pricing environment is the opaque ferrous scrap market that trades metals during the first five days of every month, making it even more difficult for recycling companies to compete.

Additionally, throughout the past 10 years, the complexity of running a metal recycling operation has increased substantially. Regulations governing environmental processes and customer identification, other regulatory hurdles and tighter specifications on grades have made the owner/operator business model difficult to manage.

Steel industry consolidation and increased regulation have led more companies to pursue an exit.

Company-specific issues

Many owner/operator businesses still in operation today do not have transition plans for the next generation. Or perhaps, more importantly, the next generation is not interested in operating a metal recycling company. This leaves an owner with one decision, which is to sell. The question then becomes, when is the right time to sell?

Business owners need to sell when the time is right for them. Many are looking at the current market and seeing that their companies currently are operating very profitably. Often, most business owners do not want to sell when times are good but want to sell when times are bad. To the question of when the right time to sell is, the only real answer is that you cannot take all the chips off the table.

If the market is down, the proceeds of the sale will be invested into a depressed market that is likely to recover. A strong market provides for a good base to show a prospective buyer the potential of the company. But buyers are smart and recognize that the market will eventually come down again. As a result, they will look to an average earnings level when evaluating a business.

Today, the market is strong, showing buyers the possibility of growth, and many sellers are looking at this as a good time to exit.

Tax rate changes

One of the most powerful drivers of M&A is taxes. The accompanying chart shows M&A activity by quarter from Q1 2012 through Q1 2020. As you can see, one of the largest spikes in M&A activity was in the fourth quarter of 2012. Two separate things drove capital gains rates to increase as of Jan. 1, 2013. First, the Bush-era tax cuts were expiring, raising capital gains by 5 percent, and the Affordable Care Act increased capital gains by another 3.8 percent. A total expected capital gains rate change of 8.8 percent led to a tremendous amount of M&A activity in the last quarter of 2012.  

Middle Market M&A Activity by Number of Transactions and Transaction Value: (1)

chart
(1)  Middle market defined as transactions ranging from $25 million to $500 million
The current proposed changes to the capital gains tax would raise that rate from 20 percent to 39.6 percent on gains in excess of $1 million. This nearly 20 percent increase is having a significant impact on the M&A market.

There has been talk of making the capital gains tax rate change retroactive to April 2021. However, most businesses are pursuing transactions under the assumption that the effective date likely would be in October or November during the next session of Congress, and still others are expecting the change to be effective as of Jan. 1, 2022.

Deal activity is up significantly across all sectors, including metal recycling. M&A service providers are busier than ever. Investment bankers selectively are turning away potential clients, as many do not have the resources to complete transactions by year-end. Accounting firms that provide transaction services have had backlogs increased from four weeks to eight weeks. Real estate appraisers, equipment appraisers, environmental consultants and even surveyors are seeing substantial increases in activity.

An interesting change is taking place in the M&A market. The seller’s market that had been driven by a scarcity of quality deals is now shifting to a buyer’s market as a rush of companies look to transact ahead of tax changes.

A word of caution to potential sellers: Buyers will gain leverage in negotiations as tax rate changes become more certain and as the effective date approaches.

Robust activity expected

We expect M&A activity in the metal recycling market to be robust through the remainder of 2021. The current economic outlook, industry dynamics, the aging demographic of scrap company owners and tax rate changes are going to drive a busy second half of the year. Talk in the market of at least a dozen potential deals ranging in size from $5 million to $300 million-plus already provides insight into future activity. The final tally of completed transactions and the prices paid will tell the rest of the story.

Vince Pappalardo is a managing director and leads the Metals practice at Brown Gibbons Lang & Co., an independent investment bank serving the middle market. BGL publishes the "Metals Insider," a nationally recognized research publication that discusses critical industry trends and perspectives from leading executives. Contact Pappalardo at 312-286-9238 or vpappalardo@bglco.com.