After a pandemic-related low in the second quarter of 2020, the U.S. chemicals sector rebounded in late 2020 and continued to strengthen in the first half of 2021. Economies reopened and demand picked up across various end markets, ranging from autos to food and beverage. A key common denominator for increasing industrial demand has been reliance on supply chains in which many U.S. chemical companies are situated. Supply constraints and delays have led to a tight market further down the value chain for the automotive industry and plastic makers alike, and the U.S. chemicals sector generally has full order books and robust demand. This strength has come along with an uptick in M&A activity to spur growth, drive efficiencies, and diversify. M&A activity at the base of the global supply chains could mean more stability and profitability for the companies that make the most basic building blocks for products such as polyvinyl chloride (PVC), fire retardants and, smartphones. S&P Global Ratings examined a variety of recent transactions in the sector including special purpose acquisition company (SPAC) deals, private equity carve outs from large public companies, and strategic value-based acquisitions.

The Ratings Landscape

The COVID-19 pandemic caused direct attrition for many industries, but the chemicals sector suffered more from uncertain end markets. Due to pandemic-related risks and the potential negative impact it could have had on the global industries the U.S chemical sector relies on, S&P Global Ratings downgraded or revised the outlook to negative a large portion of the U.S. chemicals portfolio in mid- to late-2020. Companies largely put M&A transactions on hold at the onset of the pandemic, as they preserved cash to ride out a recession with an unknown duration. Additionally, shutdowns and limited travel curbed M&A demand as companies were largely unable to conduct site visits of potential targets. Since the height of the pandemic, rating activity has largely been positive, and conservative balance sheets have emerged, putting companies in a position to deploy cash to accelerate growth. Companies are learning how to operate despite the ongoing pandemic and some pent-up demand is now coming alive.

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Industry Specific Drivers Of M&A

We downgraded 16 U.S. chemicals companies in 2019 due to plateauing auto builds, weak commodity chemical prices, trade tensions, and competition from overseas. Now the sector is catering to the electrification of vehicles and domestic demand from customers emphasizing more resilient supply chains. Demand coming back online means companies can come out of survival mode and return to growth—and now setting record quarters in 2021. Being highly dependent on industrial output means GDP growth and PMI data are typically the best proxies and drivers for measuring the strength of the U.S. chemicals sector.

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For larger public companies, M&A can be an attractive avenue to supplement organic growth. With varying value chain positions, and a wide spectrum of end market exposure, every company's recipe for growth and stability will differ. Fine tuning this recipe enables chemical companies to overcome high capital intensity (particularly in commodity chemicals), grow margins, and reward investors.

Dry powder will provide robust growth

Increased availability of dry powder, low cost financing, and the proposition to further move U.S. chemical companies toward more specialty chemical products and better EBITDA margins has driven the private equity sector's interest in the U.S. chemical sector to grow stronger. Private equity has delivered robust returns to investors and sponsors have accumulated cash and an appetite for take private transactions as money moves out of competing spaces like hedge funds.

In 2021, PQ Group Holdings Inc. spun off two business segments and reorganized as Ecovyst Catalyst Technologies LLC. PQ Group sold Potters Borrower to The Jordan Co. LP and PQ Performance Chemicals (Sparta Cayman 2 LP) to Koch Minerals & Trading LLC and Cerberus Capital Management LP. We believe Koch's interest in the performance chemical business and Cerberus' previous experience with carve outs will drive margin expansion greater than 250 basis points (bps) over the next few years. Both transactions underscore how profitability and efficiency lead to stability for chemical companies, and the relative resiliency of specialty chemicals assets.

Following the same path but with a different approach, Westlake Chemical Corp. chose to look further downstream and complement its existing building products segment and as such, acquired Boral Industries Inc.'s building products segment. The $2.15 billion cash transaction will add about $1 billion per year to Westlake's topline revenue. Additionally, Westlake recently announced it will add to its vinyl products business with a smaller acquisition of recycled plastic processor Dimex. Synergies from both transactions will be accretive to Westlake's profitability and increase its scale, when compared with competitors.

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Ratings Implications

In a ratings context, a stronger business risk can give a company more financial flexibility within the current rating. Through a recession, diverse business segments can result in downside protection, which is especially key for the chemicals sector in which end markets (like autos, agriculture, and building products) can be volatile.

Focusing on core businesses

A peer of Westlake's, Eastman Chemical Co. is taking a different approach to this year's red-hot M&A space. Eastman, which we assess as having a stronger business risk but weaker financial risk than Westlake, spun out its tire additives business to private equity sponsor One Rock. For Eastman this means better overall profitability, $725 million in proceeds, and minimal impact on business risk, which we assess as strong. Eastman has stable revenues and high EBITDA margins compared with peers like RPM International Inc. and LyondellBasell Industries N.V., and strong market positions. Therefore, divestment from the lower-margin tires business does not have a material impact on Eastman's position among competitors or potential to generate returns.

Ashland LLC announced it would sell its performance adhesives business to Arkema for $1.65 billion.This transaction, with the purchase price representing approximately 20x the last-12-months ended June 30, 2021 EBITDA of the performance adhesive business, demonstrates the intensity of the 2021 M&A ecosystem. Both the Ashland and Eastman deals reflect chemical companies' desire to focus on the most core businesses, and drive growth or margin expansion in those areas. Excess balance sheet cash and cheap debt has fueled demand and allowed previously judicious parties to become interested, drumming up demand. Bidding wars mean transaction prices balloon as in the case of PPG's acquisition of Tikkurila, where a competing bid drove the price up to $1.8 billion from the initial $1.2 billion. Climbing transaction prices are reflected by the chart below.

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For companies with hot products like Perimeter Solutions, tapping the capital markets in an opportunistic way is a key strategy. SPACs are one avenue. EverArc Holdings Ltd. will acquire Perimeter Solutions from SK Capital Partners for approximately $2 billion. EverArc has publicly stated? its plans to just acquire Perimeter Solutions rather than multiple companies, as is typical with a SPAC. With a business largely dependent on the severity of a given year's wildfires, Perimeter Solutions will use future IPO proceeds to expand in international regions including Israel and Australia, as well as focus on areas like fire prevention. This also takes a rated entity that is currently capped by its financial ownership and provides potential improvement to its financial risk profile should ratios strengthen. Given EverArc's limited track record and unique plans, S&P Global Ratings will continue to monitor developments, particularly as it pertains to its financial policies and growth initiatives.

ESG characteristics

Perimeter Solutions is a unique ESG-themed investment because environmental damage drives the fire retardant and prevention business. The Dimex transaction also reflects Westlake's interest in environmental stewardship, given the focus on recyclability. The importance of ESG factors to investors is not fading, and we can expect ESG to be an underlying theme in transactions going forward, especially in the chemicals space as consumers grow leery of single-use plastics and reducing carbon emissions become a part of investment theses.

Fiscal and monetary drivers

Anticipated changes in the U.S. tax code are another spark for M&A activity across many sectors, including the chemicals space. With such high multiples come high capital gains tax when sales do occur – and the potential for an increase in capital gains tax is bringing sellers to the table. Although President Biden's administration has not yet enacted an increase, sellers are looking to close transactions before any risk of new laws takes effect—adding a sense of urgency.

A similar dynamic is at play with interest rates for buyers using debt to finance transactions. We expect a rate hike in the coming 12-24 months from historically low levels. Inflation has been a product of recent rate cuts and Fed interventions and S&P Global Ratings views some transitory inflation as a given in a rapidly heating economy. Chemical companies have dealt with significant raw material price increases in 2021 and have been able to pass on most increases. As the recovery plateaus, raw material prices should too, and S&P Global Ratings expects chemical companies will be opportunistic with pricing plans going forward.

Growth Will Slow Down Going Forward

As the economic recovery continues, S&P Global Ratings expects GDP growth to slow to 4.1% in 2022 and 2.5% in 2023. For chemical companies looking to grow, finding the right combination of capex and M&A spending will dictate their success expanding in the post-pandemic economy. Private equity sponsors who are looking to exit previous investments and deploy capital after attracting more through years of solid returns, will also heat up the M&A market for the next few quarters. The means can be carve outs, SPAC deals, or capturing synergies, but the end goal for the chemicals sector is to deliver for both investors and the rest of the value chain. The chemicals sector can expect to stabilize for the next 12-24 months as input prices for commodities like lumber and copper even out and the automotive market works past the ongoing chip shortage. The chemicals assets discussed showed their resiliency through a recessionary period and their ability to thrive has a direct impact on every supply chain.