Optimism boosts scope for mergers

19 October 2009 | By Bill McQuaker

Bill McQuaker is head of equities and head of multi-manager at Henderson New Star


Equity markets have been buoyed by activity returning to the mergers and acquisitions (M&A) arena - witness Disney’s $4 billion (£2.5 billion) takeover of Marvel Entertainment and Kraft’s unsolicited bid for Cadbury. With companies able to raise capital cheaply, sentiment remaining strong, and equities at their current levels, we could be entering a boom time for such activity.

Globally, markets are up by about 50% since their low point on March 9, as the vicious spiral of negativity following Lehman’s bankruptcy has gradually given way to tentative optimism. Manufacturing and consumer confidence surveys have generally troughed, improvements in global GDP forecasts are fuelling optimism for a swifter-than-expected recovery, and earnings reports continue to be generally in line with, or better than, expectations. Yet share prices still look inexpensive on an historical basis, many companies are flush with cash and chief executives are looking for deals that will allow them to reshape their companies and create value for shareholders. Correlation between equity markets and M&A activity has historically been strong, typically with a lag of two or three quarters. Fundamental data also supports a resurgence in M&A: cash relative to share prices in 2010 will be at its highest in at least two decades, while debt financing for acquisitions - particularly investment grade credit - is more readily available.

The M&A boom in the 1980s was driven by strong economic growth, rising equity values and the formation of the junk bond market that provided funding for leveraged buyouts.

Hostile bids were popular as acquirers took advantage of the relatively depressed market value of takeover targets. It all came to a rather sticky end after Black Monday on October 19, 1987, when equities and the junk bond market collapsed.

Out of the 1980s M&A boom emerged anti-takeover strategies - a backlash to the hostile bids that had typified the boom. These included “poison pills” and “staggered boards”, which could prevent takeovers or at least secure a higher price for shareholders. These were popular until the late 1990s when memories of the 1980s finally dimmed and markets were spurred on by the prospect of the next M&A boom. This lasted until 2001 when the collapse of the dotcom bubble took the wind out of M&A’s sails. But then, economic recovery came in 2003 and a highly liquid market propelled it on once more. Acquisitions covered many sectors and sovereign funds and Bric-based (Brazil, Russia, India and China) companies played a larger role.

“The risks of derailment are higher than in previous upturns”

The last boom peaked in 2007 and deal levels are back where they were in 1997. We may be at the trough in this cycle. So what is the likely shape of the next M&A boom? Recent examples suggest that deals will be driven by a clear business strategy and be between similar companies where there are clear synergies. They are likely to be funded by a mixture of cash and shares and, while some of that cash could be debt-financed, it is unlikely that we will see a return of private equity companies. Investors are likely to seek out growth companies and the healthcare, airline, financial services and media sectors look ripe for consolidation.

Despite such strong indicators, an M&A boom is not a done deal. Chief executives will not want to be caught out offering too much for a rival. There is also a risk that other countries could introduce protectionist policies to prevent takeovers by non-domestic entities as, almost certainly, globalisation will be a driver of future M&A.

Although the recovery in markets is likely to be sustained, the risks of derailment are higher than in previous upturns. As third quarter earnings come through, we need to see if risky assets can sustain their recovery. The correction may take some of the excesses out of the market and allow those investors still on the sidelines a chance to get in. Markets create a certain amount of natural volatility, but in a post-Lehman world, changes in the real economy have become a much bigger contributor to market volatility. There is a real risk that markets could play “Grand Old Duke of York” - relentlessly marching up and down for the next few years.

M&A deals are likely to be driven by a clear business strategy allied to a good sense of timing. Chief executives will be mindful of keeping their corporate credit rating secure and may prefer to use their own paper to make purchases rather than borrow money. Private equity firms are unlikely to be significant players, but we could see more hostile bids given the high cash levels of some companies.