Driving factors

After a record-breaking year for mergers and acquisitions (M&A) in 2021, last year began with heightened optimism. However, as inflation took hold globally, the M&A market rapidly declined during the last three quarters of 2022.

Compared with the broader deal world, M&A activity in the environmental services sector has remained strong, with transactions continuing to close at precedent-setting valuation multiples through the better part of 2022. While activity in the industry has not been completely immune to the challenges of the global environment, the environmental services sector has been a safe haven for investors, thriving despite various headwinds—from the COVID-19 pandemic shutdowns to the supply chain and labor constraints of the past year. So, as we sit in the early stages of 2023, the same uncertainty that has affected M&A more broadly is top of mind for the environmental services sector.

We believe five themes are driving M&A activity in the waste and environmental services sector:

1. Uncertainty remains in financing markets.

The primary variable that will drive the strength of the overall M&A market in 2023 will be when and how debt financing markets recover from a challenging 2022. Last year began on the back of a banner 2021 for debt capital, including the second-highest syndicated loan volume issuance this century, and the momentum looked likely to continue after a strong Q1. However, as the elevated “transitory” U.S. inflation rate endured, peaking at 9.1 percent in June 2022, the Federal Reserve started and continued aggressively raising interest rates. This caused a ripple effect through the entire debt financing universe, with banks unable to unload their commitments to outsized underwritten promises in support of mega-cap leveraged buyouts. This left them with the difficult choice of selling at a steep discount and crystallizing their losses or holding and tying up capacity for future issuances. Most decided on the latter, grinding the high-yield debt market to a halt through the entire second half of 2022. Year-over-year institutional loan volumes fell 64 percent from $790 billion in 2021 to just $285.5 billion in 2022, according to Refinitiv, a London Stock Exchange Group business.

Outside of balance sheet banks, direct institutional lenders providing private debt capital have played a bigger role in M&A financing over the past decade, a trend that accelerated in 2022, when traditional bank lenders largely were closed for business. However, this also allowed direct lenders more selectivity in their underwriting. Increased pricing, lower leverage caps, the return of fixed charge covenants and original issue discounts all have become the norm on new money financings. That is not to say that financing activity is absent, as evidenced by the still-suppressed default rate (U.S. corporate bankruptcies hit a 13-year low in 2022, according to S&P Global Market Intelligence via the Wall Street Journal). Financing remains available for good deals and M&A, albeit at less issuer-friendly terms than in 2021 and early 2022.

As inflation shows signs of a sustained retreat, the Federal Reserve has begun to decelerate its pace of rate increases. Subsequently, financing markets appear poised to normalize at some point in 2023. New capital structures are likely to look closer to the more balanced pre-COVID-19 period, as opposed to the issuer-friendly terms that became the norm in 2021. However, increased caution means that debt will continue to flow into the most resilient business models. We believe that environmental services M&A should be a beneficiary of that sentiment, and the industry is likely to be among the first to recover as conditions improve in 2023.

2. Buyers remain active in environmental services but have become more distinguishing on specific business models.

The environmental services sector remains in high demand by a multitude of investors and sponsors. Buyers gravitate toward the industry’s universal acceptance as an essential service, its recurring revenue streams, the high margins and the predictable return on investment organically and inorganically. The industry was helped by the strong performance of public waste management companies during the early stages of the COVID-19 pandemic; their consistent results drove elevated shareholder returns versus the broader market. This precipitated the all-time-high valuations for acquired environmental services platforms in the subsequent two years.

While the valuation multiples of the publicly traded businesses in the sector decreased incrementally during the broader market sell-off of 2022, they remain elevated by historical standards. However, with shares trading downward, strategic acquirers now face a closer trade-off between spending capital on acquisitions versus share buybacks. Also, given the heightened scrutiny on the industry by antitrust authorities, strategics increasingly are considering targets outside of their core solid waste services. This was demonstrated through a number of recent marquee transactions, including Phoenix-based Republic Services’ $2.2 billion acquisition of US Ecology and Canada-based GFL Environmental’s recently closed acquisition of Vertex Energy’s Heartland used motor oil collection and refining assets. Houlihan Lokey advised the sellers in both transactions.

For financial sponsors, private equity firms remain committed to the space, while infrastructure funds entered the market enthusiastically over the past few years, creating new demand for Tier 1 assets. KKR, I Squared, Stonepeak, Macquarie and Apollo all closed new, multibillion-dollar funds focused on investing in infrastructure assets over the past year, in addition to existing dry powder from some of the other largest money managers in the world, including Blackstone, BlackRock and Brookfield. This dynamic is well-illustrated by the Houlihan Lokey-advised sale of Covanta to EQT Infrastructure. While infrastructure funds might appear to be acquirers of choice in light of their large equity check sizes and lower return targets compared with many traditional private equity funds, some of the growth characteristics and consolidation opportunities make many environmental services models appeal to a broader set of investors in the sponsor community.

3. Postcollection capacity is at a premium.

Municipal solid waste (MSW) landfill capacity in the U.S. is shrinking and not being replaced at the rate required to keep up with the consistent volume of waste produced. This is especially true in the Northeast, resulting in accelerating tip fees for the limited disposal outlets available in the region. Traditional cogeneration waste-to-energy facilities help support certain markets, but many are aging, and new facilities are not being built. Private-equity-backed platforms that own or operate most of these facilities have focused on extending their lives and increasing capacity; but, in certain instances, they are accepting higher-valued waste to the detriment of MSW volumes.

The biggest implication these disposal trends have on M&A is that vertical integration will be increasingly important, and platforms that own disposal capacity in select markets or critical postcollection assets, such as transfer stations and material recovery facilities (MRFs) in disposal-neutral markets, could command a premium. Houlihan Lokey has witnessed this firsthand as Waste Connections has been spending aggressively on businesses with long-life landfills, including two clients from last year: Rogue Disposal and Recycling in Oregon and Lone Star Disposal outside Houston. However, owning a landfill might not be a long-term guarantee of a successful exit.

4. Everyone will need a solution for landfill diversion/ZWTL.

The most important long-term driver affecting the volume of landfilled waste will be the push toward universal landfill diversion solutions. This zero-waste-to-landfill (ZWTL) theme has attracted a triad of environmental, social and corporate governance-conscious corporates, government entities and consumers who want to know that their waste is being beneficially reused. While meeting this goal presents challenges, innovative companies have been founded and funded based on the role they play in furthering landfill diversion. A growing network of MRFs, advanced recycling facilities, anaerobic digestors, composting sites and other organizations is handling the increasing waste volume.

Houlihan Lokey advised the GreenWaste Recovery family of companies, which was acquired by Macquarie in December 2021. GreenWaste Recovery began as a single, terminal C&D landfill in 1985. Over the course of 35-plus years of private ownership, the business was transformed by its entrepreneurial management team into a leading, integrated waste management company serving the San Francisco Bay Area. It achieved success by employing innovative processes and technologies for a variety of waste streams to maximize beneficial reuse and generate industry-leading landfill diversion rates.

Our prior client VLS Environmental Solutions also has a portfolio of landfill diversion solutions for industrial generators, including using advanced processing technologies to create fuel blends from solidified and shredded industrial waste streams. These engineered fuels are used to power cement kilns and industrial burners in place of traditional fossil fuels.

5. Regulation is generally positive.

The regulatory picture for M&A in 2023 should become clearer because many topics appear to be close to resolution. These include a final determination on the regulatory regime to control and eliminate perfluorooctanoic acid/perfluorooctyl sulfonate from waste and water supplies, finalization of the Securities and Exchange Commission’s proposed rules on climate-related disclosures, allocation of funding from the Infrastructure Investment and Jobs Act of 2021 and implementation of environmentally focused provisions from the Inflation Reduction Act of 2022.

Locally, New York City is expected to enact its Commercial Waste Zones Implementation Plan (Local Law 199), including announcing final zone awards, and begin implementation this year, which will limit the number of commercial haulers in the country’s largest city.

At the same time, other topics remain open questions, especially at the state and local level, where proposed legislation on organics treatment, landfill diversion and extended producer responsibility for packaging and other waste streams is creating a moving target with vastly different rules in different states.

While the M&A markets are experiencing a few widely reported headwinds, reasons for optimism exist, especially for the environmental services sector. The industry has faced multiple challenges over the past three years but remains stronger than ever.

Innovative industry participants are confronting the defining tests of our future, not just for the waste industry but for the environment as a whole. We are confident that acquirers recognize the long-term value of environmental services and will continue to be bullish on the sector despite any near-term challenges.

Scott Sergeant is managing director of the Houlihan Lokey Environmental Services team and Jordan Mendel is the team’s senior vice president. They can be contacted at SSergeant@HL.com and JMendel@HL.com.