Mergers and acquisitions: Conditions are ripe, CEOs have been wary
With conditions ripe for M&A activity, it may seem surprising that CEOs in the U.S. have remained reluctant to engage in widespread deal-making. What is holding those at the helm of cash-rich large corporations back? The keys to unlocking pent up demand for transactions lie in greater policy certainty, stable economic growth expectations, and higher CEO confidence.
Residents of the United States, please read this important information before proceeding
Please read this important information before proceeding.
Cautious CEOs hold on to their cash
Conditions for mergers and acquisitions activity appear ripe: Large corporations have record-high cash balances, are having trouble generating revenue growth organically, and have the benefit of interest rates that are near all-time lows. But despite this positive backdrop for M&A activity, CEOs of major corporations have instead chosen to hold on to their cash. Deal count for 2013 is roughly 20% below the 2007 peak while volumes are 50% lower (Figure 1).
CEOs have faced many obstacles since the end of the recession in June 2009, including: uncertainty in Washington surrounding both regulations and the tax code; weaker than expected (and relatively unstable) GDP growth; external shocks to the US economy from Europe’s debt crisis; growth scares in the Emerging Markets; and geopolitical tension in the Middle East. These factors have contributed to oscillating CEO confidence, and given the lengthy deal making process, it is easy to see why corporate chieftains could get cold feet at any point in the process (Figure 2).
Overcoming challenges and finding opportunities
Macro landscape improving
There are certainly challenges to overcome, but there are also very compelling reasons for CEOs to consider putting cash to work in the near-term given the macro environment. Though corporate cash balances have been high for years, in the second quarter of 2013 they reached a new all-time high. This cash is sitting on corporate balance sheets, earning nothing. At the same time, interest rates remain low for buyers interested in financing.
Expectations for M&A activity in 2014 look decidedly more optimistic than recent years
As well, and maybe most importantly, the economy appears to be on stronger footing than last year. For starters, government spending has moderated with sequestration cuts, and revenues are up as a result of tax increases earlier this year, shrinking the budget deficit. Additionally, the unemployment rate has fallen almost 1% in the last 12 months. These job increases, along with rising stock and home prices, have propelled consumer confidence to a new post-recession high this summer. Confident consumers spend more, driving sales and earnings growth for companies. With the consumer looking more stable, this could take one large uncertainty out of the equation. With a little more confidence at the macro level, CEOs may be more willing to pull the trigger. In fact, there is a relatively strong relationship between CEO confidence and M&A activity: the correlation is 0.62 (Figure 3).
Compelling micro environment
Beyond the improving landscape, several microeconomic reasons should entice CEOs to engage in M&A deals. CEOs are looking to deploy capital for productive purposes such as increasing the company’s earnings power, expanding the business geographically, diversifying the revenue streams, and simplifying the supply chains. For interested CEOs, compelling growth opportunities like these can be found at the individual company level which, on their own, warrant investment. When paired up with the favourable macro environment the case is even more attractive.
2014 outlook and how to benefit from a pick-up in M&A activity
As we turn to 2014, the stage is set for an increase in deal making. Dykema Gossett, a national law firm, conducts a nationwide M&A survey annually to gauge the interest of CEOs and deal makers. This year the survey is decidedly more optimistic than in recent years. When looking at expectations for both the economy and M&A activity, the results point to a much rosier picture (Figures 4 & 5). An impressive 68% of respondents expect stronger M&A activity in 2014 versus the past 12 months.
CEOs are looking to deploy capital for productive purposes
As far as what might entice CEOs to spend, respondents cited general economic conditions as the number one driver of deal activity. The availability of capital and favourable interest rates also ranked high. The survey also points out that, with stock prices up significantly over the past 12 to18 months, companies possess a strong acquisition currency in the form of their stock.
In terms of what might hold back spending, economic uncertainty, availability of a quality target, and valuations were mentioned the most. Interestingly, concerns around the US political situation did not rank very high on the list of key issues for those surveyed, indicating we may be moving past the period where debates in Washington keep CEOs on the sidelines. All things considered, the results look very promising, with the increase in optimism shown in a selection of quotes from the survey below.
“There is a lot of capital that’s parked on the sidelines. If the economy is neutral to positive we anticipate that there will be investments, before interest rates creep up.”1
“I believe that with modest improvements in the economy… …there will be increased pressure to put excess capital to use or utilize cheap long-term capital. In general when M&A activity starts it will snow ball as companies don’t want to get left behind as their competitors spend.”2
Taking advantage of investment prospects
If M&A activity is set to pick up, how might investors take advantage of this development? One way to benefit from an increase in M&A activity is to own the stocks of small and mid-sized companies, which are the targets of cash-rich large acquirers.
Small and mid-cap stocks
Small and medium sized businesses tend to operate more locally, deriving their revenues from surrounding communities. As the US jobless rate has come down and consumer confidence has increased, these companies have been very successful at growing their revenues, driving earnings growth with top line increases. In contrast, since the end of the recession, larger corporations have been more prone to grow their earnings through cost cutting measures and managing their bottom line (Figures 6 and 7). As these large corporations consider what to do with record high cash balances earning essentially nothing, with a little more confidence they may look at buying revenues and earnings by purchasing growing small and medium sized businesses.
Growth in revenues for these companies, as well as the potential for an increase in M&A activity, could drive a continuation of the 2013 SMID cap outperformance versus large cap. Allocations to small and medium sized stocks should feature prominently in portfolios as we turn our attention to 2014.
In addition to having a particular impact in the small and mid-cap segments, M&A activity can help underpin the wider stock market. To the extent that it is backed by cash or borrowed funds, as opposed to share issuance, it boosts net inflows to the market. At this stage of the cycle, when non-financial companies are holding a lot of low-yielding cash and are arguably under-leveraged to begin with, it can improve the efficiency of balance sheets. Moreover, the conventional wisdom that says that large cap M&A destroys value is mistaken: careful analysis shows that shareholders collectively can benefit from it, particularly on a long-run view (see for example Robert Bruner’s “Deals from Hell: M&A Lessons that Rise Above the Ashes”).
1 Dykema Gossett, 2013 Annual Mergers & Acquisitions Outlook Survey
2 Dykema Gossett, 2013 Annual Mergers & Acquisitions Outlook Survey