Takeaways: M&A activity usually winds down in summer, but July brought another US$500b+ of deals and August has started in the same vein. Why so active? In low growth markets, M&A – or more precisely a robust approach to capital allocation – is looking like one of the best ways for companies to outperform their peers. In this context, uncertainty in China (& elsewhere) and poor earnings are deal incentives. The Fed’s potential move in September provides a further hurry up…although in this we find a caveat. Debt markets are already beginning to look less accommodating. Not too much at investment grade, but more so lower down the scale. Plenty to reasons still to do deals; but will there be enough fuel to continue this record breaking momentum?
M&A continues its successful innings…
It’s about mixing patience with aggression, knowing when to get on the front foot and when to leave well alone. The ability to build resilience to your rivals’ attacks is vital. The capacity to adapt your strategy to different conditions is critical. What works in one country might not cut it in another. The important thing is to guard against short-termism…..as in test match cricket, so it is in M&A strategy.
So far in 2015, companies have certainly built up more momentum than Australian batsmen – and shown more strategic nouse. Last month brought another US$500b of deals, driven by spins, major consolidation moves and some truly innovative, forward thinking cross-sector plays. Companies have also announced well over US$100b of deals in the first four days of August. It must be quiet on the beaches…
Just to put this in perspective. If we exclude real estate then July 2015 was the highest monthly value on record. If we add real estate back in, M&A levels are only 11% behind 2007. This level might ring alarm bells; but we can’t see evidence of a short-termist debt fuelled supermarket sweep. To stretch our cricket analogy to its limit, this isn’t M&A Twenty20 style. Yes, companies are using debt to fund acquisitions, but not as yet with 2005-7 abandon or mainly for short-term earnings boosting goals. The long-term logic behind most of the major deals we’ve seen remains sound, as is the overall strategy of using acquisitions at this point in the cycle to meet the challenge of low growth and disrupted markets.
Actually, it’s more than acquisitions; it’s a more active approach to capital allocation. Disposals and reallocation of capital are also part of the armoury – as we’ve discussed previously. Add in the low cost of capital and companies have a great chance to outperform their peers and the wider market, if they make the right moves.
…trickier wicket in H2?
So we’re on track for a record 2015 in M&A; although at this point we must add the near-universal caveat of Fed uncertainty. Companies are using their cash piles, but also record issuance of investment-grade corporate debt to fuel this M&A boom. Combine this exceptionally high level of supply with falling Chinese demand, plummeting commodity prices, lacklustre earnings and a potential Fed rate hike in September and it’s hardly surprising that we’re starting to see some market indigestion. Thus far it remains relatively mild. A rise of around 0.3% in average yield since the start of 2015 isn’t much of a borrowing deterrent when yields are this low. Nothing much to see here yet, but a US rate rise might at least distract investors.
There is more concern building along the curve. The Bank of America Merrill Lynch’s High Yield index is averaging above 7% again. Shadow banking has picked up some of the slack from US banks inability to fund loans over 6 times EBITDA, but gaps remain. Leveraged loan issuance has fallen by almost 30% in H1 2015, according to Thomson Reuters. Moody’s recently issued a warning that highly indebted companies could struggle to refinance their debts. It estimates that $255bn, or 33.2%, of existing leveraged loans fall outside of the guidelines. In terms of M&A volumes, this isn’t devastating. Most current deals are going on at investment grade and high yield remains a highly differentiated market. Issuers with a track record are still welcome. The vast majority of current deals fall within accepted parameters.
So again, we’re not hitting the panic button on M&A or fund raising. Nonetheless, the capital environment is changing: yields are rising, new issuers are having a tougher time and recent sell offs suggest that HY markets could freeze quickly, particularly at the margins – especially if yield tourists bail.
Tougher debt markets might limit the means to transact, but the motive to do deals looks set to remain strong. Weak growth remains one of the fundamental drivers for the current M&A boom. Earnings for S&P 500 companies are on track for their worst performance since the second quarter of 2009. UK profit warnings dipped in Q2, but have picked up again in Q3 – an indication that uncertainties are mounting, led by an un-virtuous circle between China, commodities and the strengthening dollar.
The move by People’s Bank of China to devalue the renminbi by almost 2% – the biggest move on record – has added more negative momentum to this dynamic, strengthening the dollar and weakened commodity prices even further. Markets are taking the move as a message that the Chinese economy is slower faster than expected, particularly as it comes after some weak trade data over the weekend. Whatever the motive and seriousness of the slowdown, this keeps the spotlight firmly on economies vulnerable to dollar, commodity and Chinese exports. In particular, Brazil – which has China as its biggest market and is expected to record no growth in 2016 – and Malaysia with high Chinese and crude exposure with internal ‘issues’ to boot.
Again it’s ‘where’ almost as much as ‘what’ businesses do that will matter – all the more reason to keep the portfolio under review.