How will capital gains tax increases in 2022 impact M&A this year?

Business acquisitions accelerate in response to President Biden’s plan to double the long-term capital gains tax rate for those at the top, from 20% to 40%. When you include the 3.8% net investment income tax (NIIT) and some state income taxes, you could be looking at a 48% all-in capital gains tax rate by January 1, 2022. In this report, we discuss the biggest drivers of accelerated business sale activity, as well as analyze the outlook for eight industry sectors.

Tax increases in 2022

If you’re selling your privately held company, a key consideration may be closing the transaction before January 1, 2022 when new tax increases are likely to take effect. President Biden recently announced his plan to double the long-term capital gains tax rate for those at the top, from 20% to 40%. When you include the 3.8% net investment income tax (NIIT) and some state income taxes, you could be looking at a 48% all-in capital gains tax rate by January 1, 2022.

If you own a business and you’re considering selling, you need to plan for these tax increases. The top marginal income tax bracket would also rise under President Biden’s plan to 39.6% from 37%. The change would apply to 2022 income above $452,700 for individuals and $509,300 for a married couple.

According to the Tax Policy Center’s analysis of Internal Revenue Service data, taxpayers who filed Schedule D accounted for 62% of capital gains nationwide. For any of those selling a business, they are highly likely to exceed adjusted gross income of more than $1 million in the year of the sale. There would also no longer be a distinction between short-term and long-term capital gains, all charged at the higher rate.

The plan also contains other changes targeting the wealthiest Americans, including ending the 1031 like-kind tax break that lets real estate investors defer capital gains taxes, bulking up IRS scrutiny and enforcement on high earners, big corporations and large estates and closing the "carried interest" tax loophole. Passing the bill through Congress in its current form may be more challenging, however, with Republicans and some Democrats opposing the idea.

What else is on the horizon this year for M&A?

The pipeline is solid for new businesses coming to market. At ClearRidge, we have several new advisory engagements in the last couple of months, targeting a closing before year-end. Analysts expect 2021 to be a banner year for M&A activity, with low interest rates and capital stacking up to be deployed. In the section below, we consider the M&A outlook for the remainder of 2021 for several key industries in our region.

Aerospace and Defense

Commercial aerospace suffered under the pandemic with analysts projecting a slower recovery and commercial aerospace companies using this time to position for long term growth and recovery, focusing on liquidity, fleet rationalization, and supply chain stability. The Defense subsector had a more muted COVID-19 decline with many areas still in deal activity focus, including IT modernization, cyber, unmanned assets, and space. While the new administration’s budgets may flatten for defense spending, they will remain stable with ongoing necessity and remaining geopolitical tensions.

M&A opportunities in aerospace will focus on adding value to core competencies, cost-competitiveness, and emerging technologies. We anticipate an increase in the number of aerospace transactions closing in 2021, even if total value of all aerospace deals does not surpass pre-COVID levels.

Chemicals

Chemical sector M&A activity will likely focus on consolidation, technology, and specialty chemicals. Commodity chemicals have faced lower demand and supply chain disruption, while specialty chemicals focused on pharma, hygiene, agriculture, and nutrition have thrived.

Capital availability among larger strategic acquirers is plentiful and cost of financing transactions remains low, enabling strong valuations among niche privately held chemical companies.

As chemical companies transition from cost management and operational efficiency efforts, we see targeted strategic initiatives, particularly in niche sectors, with technology advancement, research and new product development that allow for long-term growth in an evolving chemicals environment.

Healthcare

Analysts anticipate an uptick in healthcare deals as organizations shift attention back to long-term initiatives. The pandemic highlighted inefficiencies in hospitals and healthcare systems that could be addresses through M&A activity. Healthcare companies may look to diversify across markets and revenue sources, in addition to pursuing scale or intellectual capital.

Amazon Care, the telehealth services available to Amazon employees in Washington State, has announced its intention to expand availability to all employees and other companies by summer this year. As Amazon enters the larger healthcare marketplace, we anticipate long-term disruption and consequently targeted acquisition activity.

President Biden’s Secretary of Health and Human Services, Xavier Becerra, was confirmed by the Senate and stated his intention to combat rising healthcare costs, seeking more power to fight healthcare consolidation where practical monopolies exist in many healthcare markets. This is one to watch for healthcare M&A.

Industrials and Manufacturing

Deal volume increased in Q1 over the previous quarter. Companies continue to streamline, focusing on core business lines and looking to divest non-core businesses. As the macroeconomy improves, analysts see an increased focus on industrials M&A. Exports, as well as manufacturing production, both faced temporary declines in Q1 due to severe winter weather, supply chain disruption, and some continuing covid-19 restrictions.

On a positive note for the sector, investment in US manufacturing research, development and job training is part of the Biden Administration’s infrastructure proposals and it remains to be seen how this will impact the manufacturing sector.

Niche manufacturers are back in focus for acquisitions in the remainder of 2021, as acquirers seek those companies outperforming through the recovery.

Construction and Engineering

President Biden introduced his “Build Back Better” infrastructure investment plan to fund roadway, bridge, and manufacturing projects. Congressional debate and approval remain on this proposal aimed to rebuild and reshape the nation’s infrastructure and economy.

Construction costs are soaring, with lumber prices up over 180% in the last year, while significant price fluctuations and shortages in other construction materials, including steel, copper, pipe/PVC also create project delays and cost escalation. Coupled with rising material costs, there is an ongoing construction labor shortage, contributing to higher bid prices, scheduling challenges and risks for project deadlines.

New home sales dropped during the first quarter likely due to material shortages, cost increases, and rising interest rates. Demand for residential construction continues as the number of homes sold pre-construction rose 20% over last year.

Energy: oil and gas

Oil and gas deal activity is slowly increasing again, with mergers and consolidation to gain scale. Upstream companies are looking for consolidation to return stronger, with greater appeal for dissatisfied shareholders. In April, we saw private equity sponsors re-entering the energy industry, with Pioneer Natural Resources’ acquisition of DoublePoint Energy, one of the largest oil industry acquisitions so far this year. Since 2017, equity issuance, IPOs, venture capital, and private equity investments had dropped to low levels, with much of the industry’s growth funded by debt. With a more challenging debt environment for oil and gas, the recovery in deal activity had been slower than previously anticipated, even in a rising crude price environment. After more than 100 upstream and oilfield services bankruptcies in 2020, the industry was able to discharge significant excess debt, with assets selling at attractive prices and we anticipate increases in deal activity in the remainder of 2021.

Analysts forecast additional investment in energy systems of the future as companies transform for the long term. In research published by DNV GL, from a survey of 1,000 oil and gas executives, two-thirds say they are actively moving toward a less carbon-intensive mix in 2021, a 44% increase over 2018. As environmental and social awareness investing grows and renewable energy expands, the oil and gas industry is expected to face greater scrutiny from investors. Divesting higher-carbon assets and acquiring lower-carbon oil and gas, may play a role in how oil and gas companies consider acquisitions and capital deployment in the future.

According to a new Rystad Energy analysis, natural gas production in the United States is set to grow to a new record of 93.3 billion cubic feet per day (Bcfd) in 2022 and will continue to rise thereafter, exceeding 100 Bcfd in 2024.

Transportation and Logistics

As consumer spending and industrial growth increase, logistics will need to keep pace to meet demand. February reports on transportation, warehouse, and inventory costs showed their highest levels in two years. Automation and increased efficiency will be critical capabilities for supply chains.

The transition to electric fleets is another trend in the transportation industry. The International Energy Agency predicts that the world’s demand for gasoline will remain below the 2019 peak (26.6 million barrels per day) through 2026 and potentially may have peaked altogether. Lyft, Amazon, UPS, FedEx and others have already made pledges with timelines to convert their fleets.

Through 2020, smaller trucking fleets were hit hard by the pandemic. Fleets of fewer than 20 trucks comprise 97% of the US freight industry according to the American Trucking Associations. Many closed their doors, unable to weather the overnight decrease in demand during the 2nd quarter of 2020. As the broader economy recovers, consolidation is likely to continue as companies seek to maintain or improve margins.

Agriculture

In recent years, the agricultural industry has experienced hurricane related damage, flooding, supply chain mismatches, shortages or oversupply during the pandemic, and freezing weather across the Midwest in February. However, agribusiness still has reasons for optimism. The industry also received record stimulus and subsidies in 2020, which in some instances provided capital to invest. The pandemic highlighted demand for automated processes and technologies such as automated sorting, remote monitoring, and robotics. These trends are expected to accelerate through 2021.

Exports for food and crops are forecast to strengthen in 2021, as are commodity prices. Exports to China, particularly soybean exports, are on the rise and US farmers are planting 7 million more acres in 2021 to meet the growing demand.

Farm Equipment is seeing a trend in agricultural machinery dealership consolidation. Larger dealerships have better scalability and can better service a consolidating customer base. Equipment Manufacturers also structure programs to benefit larger dealerships, pressuring smaller dealers to consider growing, merging, or selling.

Summary

The M&A market is primed right now. Low interest rates remain. Cash abounds to invest in acquisitions. The tide is turning to drive a surge in activity.

Plan Today

In order to execute a business sale in 2021, work needs to start today, with diligent planning and preparation critical to maximize the sale price of a company. Our team at ClearRidge stands ready to clear all pre-emptive due diligence, research, identify and screen prospective buyers, create all confidential marketing materials, data analysis and memoranda, confidentially market the business, lead negotiations on price and terms, and manage the buyer's diligence teams.

Sources: This report has been compiled from reports and research including federal data, independent analysis, Reuters, Janes Capital Partners, US Chamber of Commerce, Oilprice.com, Kaufman Hall, DC Advisory, Kiplinger, PCE-Companies, Mergermarket, PricewaterhouseCoopers, and SDR Ventures.

For further information on the ClearRidge team, industry expertise and transactions history, please visit www.clearridgecapital.com/recent-transactions/.