Why Private Equity Will Be Looking At Aerospace And Defense
By Dennis Santare and Daniel Leblanc
 // . //  Insights // Why Private Equity Will Be Looking At Aerospace And Defense

Following COVID-19’s disruption of the aviation market, many aerospace and defense (A&D) companies in 2021 are looking for capital investment or thinking about divesting. On the demand side, private equity investors are sitting with idle capital seeking out opportunities. Because of this convergence of interest, we expect to see an increase in mergers and acquisitions (M&A) in the sector this year.

In commercial aerospace, the emphasis will be on shoring up the supply chain through consolidation of lower-tier suppliers and acquisitions of aftermarket supply chain players and used serviceable materials suppliers. We also expect to see efforts to increase defense exposure by some companies.

On the defense side, private equity investors are likely to be more attracted to technology innovation. This could include acquisitions of avionics suppliers and companies working in highly sought-after defense capabilities like artificial intelligence, quantum computing and hypersonic technology.

A slowdown in 2020

The jump in activity will contrast what we saw in 2020. Over a few short weeks in 2020, the COVID-19 pandemic and an accompanying collapse of economic activity wiped out hundreds of billions of dollars in market capitalization for publicly traded companies in aerospace and defense. While a hardship for the sector, it could be a unique opportunity for sharp-eyed private equity investors who can see the long-term value in the sector’s enterprises once the pandemic subsides.

In 2020, the number and value of mergers and acquisitions in aerospace and defense dipped dramatically as a result of the pandemic and the absence of large deals. The disclosed cumulative value of transactions was only about one-fifth of 2019’s total, a decline largely attributable to the absence of a mega deal like the 2019 merger of Raytheon and United Technologies. The number of deals dropped about 23 percent. Buyers were taking a “wait-and-see” approach, holding off until there were some signs of economic recovery in the travel sector and the presidential election in the United States was over.

On the supply side, low interest rates and supportive central banks curtailed most credit and liquidity-driven divestitures, common in prior economic downturns. Still, the lack of fundamental aerospace economic activity caused cashflow problems that forced management teams to seek out new sources of capital, even if they needed to come to market with depressed earnings and poor balance sheets.

While private equity activity hit a low in the second and third quarters of 2020, the fourth quarter showed signs of life as air travel demand slowly began to recover and public equity valuations in A&D remained depressed reflecting glutted aerospace inventories and balance-sheet pressure. By the end of 2021’s first quarter, the S&P Aerospace & Defense Select Industry Index was down six percent from its level on January 1, 2020. That’s contrasted by the S&P 500 which was up 23 percent over the same period. 

Aerospace and defense valuations are still lagging the overall market
Comparison of total index returns (from Jan. 1, 2020 through March 31, 2021)

Low valuation opportunity

But the continued low valuations will prove a plus for A&D, allowing it to attract private equity investors looking for an undiscovered treasure. Based on this combination of nascent recovery and low valuations in aerospace, we expect 2021 to show a renewed burst of M&A activity, particularly among more patient private equity investors.

While airlines should start seeing an uptick in business this summer and more substantial recovery next year, aerospace manufacturers and their supply chain will be under pressure for years to come. Original equipment manufacturers (OEMs) and parts suppliers must first work through a backlog of undelivered aircraft and wait for new orders from carriers to pick up before the industry returns to 2019 levels of production.

The supply chain, especially suppliers downstream, will also have to compete with sizable inventories of new parts and used serviceable materials, including green-time engines. These inventories are likely to take many months to burn through. But those lags in recovery will keep valuations low and give private equity time to invest in or buy outright some attractive assets in the sector. 

Private equity maintained a wait-and-see posture in 2020 until Q4
Private equity activity by number of deals for aerospace and development (from Q1 2019 through Q1 2021)

How 2021 will play out

The situation facing the defense industry is markedly different from commercial aerospace. Defense spending continued through COVID-19 in the United States and globally. While the total number of A&D deals lagged in 2020, the tally would have been even lower were it not for the strong 2020 defense deal volume.

When evaluating announced A&D mergers and acquisitions in 2020, there were noticeable differences between the two sectors. An increasing proportion of deal activity in commercial aerospace was completed by private equity firms and other financial sponsors in 2020 as many strategic buyers were sidelined because of weakened balance sheets, capital constraints, and higher borrowing costs. Oliver Wyman expects these favorable conditions for financial sponsors to persist through 2021. 

For aerospace and defense, M&A lagged in both value and volume in 2020
M&A activity summary in aerospace and defense1 by volume and value in $US billions (from Q1 2019 through Q1/2021)

Prior to the COVID-19 pandemic, large vertically integrated commercial aerospace businesses had limited appetite to sell off attractive operating units less critical to future growth plans. But a prolonged downturn has transformed many of these non-essential gems into assets that companies can consider selling to bolster their liquidity and solvency. Thanks to the economic fallout from the pandemic, the motivation behind M&A activity in commercial aviation has shifted away from vertical integration strategies and will focus on divesting some of these previously unavailable assets.

While challenges from 2020 persist in 2021 and projections for aircraft production and aftermarket spend remain below 2019 levels, there is renewed optimism associated with a faster than expected recovery and more promising forecasts. At least now, there is a recognizable quantitative baseline upon which to build a business case for both sides of a transaction.

With the optimism, valuations are up from all-time pandemic lows and are pushing airlines, OEMs, and other aerospace supply chain entities to divest non-core assets as a strategy to strengthen balance sheets by consolidating. Ultimately, the new environment is increasing the probability of successful recoveries for more enterprises.

Angelo Ibrahim contributed research and insights to this commentary.