2016 Corporate Finance Priorities

The global landscape in 2016 remains uncertain with increased divergence in economic prospects around the world. Improving economic fundamentals in the U.S. have provided a catalyst for the first increase in interest rates by the Federal Reserve in nearly a decade, signaling confidence in the continued strength and sustainability of a U.S. recovery.

In contrast, the European Central Bank has extended its quantitative easing program and Japan has slipped into another technical recession. China has acknowledged additional downward revisions in its GDP growth targets, confirming fears of a slowdown in the world’s largest growth engine. This reversion in Chinese demand is exacerbating pressures on global commodity markets. All firms will need to plan for the adverse impact of heightened commodity price volatility on corporate revenue growth. These macroeconomic divergences will require companies to rethink how they invest, expand, and continue to create value for their shareholders.

In response to investor demand for top-line growth and evolving activist agendas, companies have turned to M&A and restructuring alternatives more than ever before. Strong U.S. fundamentals, low financing costs, and favorable investor responses to M&A have encouraged growth-challenged firms to strive for larger and more transformative deals in 2015, leading to the highest level of M&A activity in history.

If equity valuations are sustained and market volatility remains in check, the M&A momentum will likely continue in 2016. However, companies will need to exercise discipline in light of high equity valuations and a recent decline in equity investor response to M&A announcements. Moreover, since a third of all companies globally are not earning their cost of capital, corporate executives will need to proactively consider restructuring alternatives in 2016.

Corporates will also need to reevaluate their capital allocation and distribution policies in 2016. Over the past several years, shareholder distributions have represented an important component of shareholder returns. However, as market valuations have risen, the undervaluation signal associated with buybacks has become more muted. Investors are also closely scrutinizing repurchase-driven engineered EPS growth. In 2016, deploying capital organically or through M&A could be a more effective path to value enhancement for those firms with the requisite balance sheet strength.

While investment-grade firms should remain relatively insulated from potential market turbulence given the record amount of liquidity on their balance sheets, these firms are likely to face shareholder pressures to deploy excess capital. Noninvestment-grade corporates, however, could face difficult tradeoffs between investment and the need for capital preservation if credit markets tighten. We are currently observing the widest spread differential between sectors in the top and bottom quartiles of the high-yield universe. Companies in commodity exposed sectors such as energy and mining are likely to require more drastic measures to defend their balance sheets. A closer evaluation of the tradeoff between asset sales, dividend cuts, capital expenditure reductions, and equity issuances – which have varying equity market responses relative to the amount of incremental liquidity generated – will be warranted.

In the emerging markets, particularly in Asia, the strong feedback loop between the corporate and financial sectors – reflected in the simultaneous rising of bank and corporate credit spreads – will necessitate that corporates opportunistically diversify their funding sources and pursue customized structured solution alternatives. A potential increase in risk premia affecting both the cost of debt and equity for bank-reliant corporates will pose an added challenge for these EM firms as they seek investment opportunities that earn a return commensurate with their cost of capital.