Will volatility thwart M&A ambitions in 2016?
Markets have recovered from their dire start to 2016; but lingering uncertainty will keep them in a volatile holding pattern for a while yet. Thus far, this doesn’t seem to have seriously dulled companies’ deal making appetites. We are seeing fewer ‘mega-deals’, but a robust core market in the $1bn-$10bn range reflects a strong underlying need to transact that can survive some market buffeting. Indeed, out current market instability and companies’ need for portfolio adjustment share many of the same drivers.
Volatility does, however, presenting some practical challenges. Valuation is obviously trickier when prices are bouncing. Debt markets can turn less liquid and lenders more cautious. There is just enough of a balance between demand and supply for most companies to find financing right now, but issuers will need to keep their options open and think about alternatives.
You’re hot then you’re cold…
In many ways this last week epitomises our topsy-turvy markets. Iron ore rose 20% in one day, perhaps on the back of one flower-show related shutdown, only to fall back down. Yields on Japanese 30Y bonds fell by their most in three years, only to rise by almost the same amount the next day. Oil crept over $40 a barrel, but struggled to stay there as doubts about the supply freeze grew. Equity markets raced up on positive US jobs news, Chinese growth hopes and ECB stimulus expectations, came down on the reality of the weakest Chinese export figures for three years and then yo-yoed as the ECB met high stimulus expectations before quelling speculation about further loosening. The Euro traded between $1.0822 and $1.1218 in one day.
The market isn’t as universally downbeat as the start of 2016, but we’re effectively stuck in the same volatile pattern. Investors are still on edge and confidence seems inextricably linked to escalating central bank action, which itself is driven by concern. Normal interpretations of good and bad news have been lost somewhere in the last seven years. Picking through the noise, the actual news in the last week – as opposed to hopes, forecasts and speculation – continues to indicate a mild US recovery, a mildly weaker outlook for China, patchy Eurozone growth, weak inflation prospects and (still) oversupplied commodity markets. As the IMF noted this week, the global economy is at a difficult juncture, still resolving its legacy debt issues whilst encountering new risks in low growth, low inflation and low-to-negative interest rate environment. But, there is nothing yet that indicates imminent recession.
This does give us the potential to move onto firmer ground later in 2016, if geo-political uncertainties ease and economic signals become strong enough to convince investors focus on the fundamentals – i.e. beyond the next central bank move. There are some tentative signs of a US revival that could be a catalyst; but we’re the realms of chicken and egg here. What comes first, improving market sentiment or economic activity?
M&A keeps on keeping on…
Perhaps a steady stream of deals will help build confidence? In terms of corporate sentiment, volatility doesn’t seem to have done too much to dent M&A activity. Global deal values and volumes are down year-to-date against 2015; but deal values in February were actually 26% ahead of the same month in 2015. Mega-deals aren’t as prevalent, however it’s the ‘core’ US$1b – US$10b value band that we see as the main engine room of deal making and that’s still going strong. There were 43 deals in this band in February, worth a combined US$130b. This is up from 2015 (34 deals, US$106b) and in line with the median monthly value, and volume seen since the deal market accelerated in 2014. UK activity is lower, although not significantly. UK ‘core’ M&A is down on 2015, but at a similar level to 2014 and 2013.
In one sense, increasing M&A activity is a rational response to the current volatility, which is also at least partially driven by problems of a slow growth, low inflation, and oversupplied world. Add in the pressure to respond to disruptive technology, sector convergence and changing consumer behaviour and it’s only rational for companies to take action. Volatility might turn companies off bigger deals, but doing nothing just isn’t an option for companies when their earnings – and even their entire business model – are under pressure.
Our latest review of activity in the power and utilities sector shows how companies and investors are using strategic deals to adapt to changing sector dynamics. In 2015 P&U deal value hit a six-year high, up 13% on than 2014. Companies were using deals to increase their avenues for growth through convergence with other utilities or via technological partnerships. They were gaining access to renewables to comply with regulations and reduce exposure to volatile coal and gas. Emerging markets still attracted investment, despite growth concerns with reforms driving opportunities. And disruption is in play here too. Energy storage, and its supporting IT integration applications, are becoming a mainstream investment for utilities, many of which formed partnerships with technology companies and telecom companies.
So why aren’t we seeing more activity in the oil & gas sector. Weak oil prices encouraged industry consolidation at the end of the 1990s. Consolidation and capital rationalisation would appear to be one solution to falling prices – and high levels of debt – amongst US shale businesses. However, US oil and gas industry deals fell by 30% last year, according to Dealogic and volatility seems to be part of the problem. Heavily fluctuating commodity and – by extension – equity prices have made it especially tough for parties to agree on valuation in the sector. And gaps in multiple expectations aren’t exclusively an oil & gas problem, not when equity markets are so volatile and companies are in a quandary about whether to buy now or wait to see if prices fall.
But what about funding?
Loan and bond issues have obviously fallen in 2016, compared with 2015, but that is in part due to lack of demand from quieter M&A markets and the fact that equity investors are increasingly looking to “stay invested” in M&A deals. There are various reasons for this, but the biggest is the lack of alternative investment options. This is driving the larger deal structures, with mergers and reverse takeovers with a big equity component likely to be the main focus of deals in 2016.
This has helped to balance lender supply and corporate demand in primary debt markets, along with a drop-off in refinancing activity after the surge in activity in recent years. Debt markets clearly aren’t immune to uncertainty and volatility, whilst increasing regulation and negative interest rates present further challenges for banks. But, the ECB’s announcement yesterday that it will buy investment grade corporate debt on the secondary market, as part of the extension of its QE programme, should support prices and encourage supply. Large credit funds, which aren’t regulated like the deposit taking institutions, have already raised their capital and are ready to lend. Banks are also still putting debt into well-structured credits and this should remain the situation unless conditions significantly deteriorate. Spreads have widened in recent months, but this has been largely offset by a reduction in benchmark yields. All-in debt funding costs for M&A at investment grade remain at or close to historic lows across both the European and US markets – and the ECB’s action could take this even lower.
Nevertheless, even investment grade companies still need to factor in a credible plan B (and C) when they are raising debt in public debt markets, particularly if they are on the ratings borders and especially if they operate in under pressures sectors, where market volatility and sentiment will significantly affect prices. Confidence is falling amongst bondholders, according to Fitch. Uncertainty makes markets fickle and subject to sudden closure around significant events. The highest level of defaults outside of recession will focus the mind as will the rising number of ‘falling angels’ – companies moving from investment grade to ‘junk’.
Borrowers will need to keep their options open, especially below investment grade and in the issue of junior debt, where prices have fall dramatically and banks have been left with loans after failing to syndicate. It’s not impossible to include, but increasingly this is via private placement with an increasing pool of alternative lenders ready to supply.