M & A
Posted on 7 August 2015
"Most of the time, M&A represents the net retirement of equity in exchange for cash, which should in theory exert upwards pressure on wider equity market valuations."
Global merger and acquisition activity has been on a fairly steady rise since 2014. Barely a week seems to go by at the moment without the announcement of a deal of one form or another. This upturn in deal activity has not been unexpected. M&A has a cyclical component and while the financial crisis cast a long shadow, CEO and CFO confidence has now more visibly recovered, complementing objective drivers of M&A that have long been in place. For these reasons, M&A has been a recurrent investment theme for us over the last several years. There are many ways to benefit from this theme, some more risky than others, but the primary way to benefit remains ongoing ownership of developed markets equities. We explore this in a bit more detail below.
Excluding the financial sector, corporate balance sheets have been on an improving trend since around the turn of the century. Including the financial sector, US and global corporate cash balances continue to be high relative to historic levels, even after the surge in M&A seen over the last year in particular. Many European companies are also in a healthier financial position than many realise. Alongside this, investor appetite for corporate bonds remains high and banks are more willing and able to lend. Post crisis restructuring, new technology and the ongoing search for consolidation continue to provide plenty of bottom-up business cases. PE ratios in developed equities are certainly no longer depressed, but as we explored in a recent In Focus, low interest rates mean that when viewed through the lens of discounted cash flow, valuations can still look inexpensive to would-be acquirers. As suggested in the above mentioned article, there remains scope for interest rates to rise and DCF-based valuations to continue to make sense for a little while yet.
What does M&A mean for investors?
It can be perilous to try and second guess the deals themselves. Lobbying, politics and regulation tend to get in the way of deal execution. Acquirers look for operating efficiency improvements, which means that targets are often relatively weak and inefficiently run. Recommending such companies to clients can pose problems, particularly if a takeover fails to materialise, leaving the client holding what might be considered a fundamentally unattractive business. Of course, scouring the market for potential targets is not the only way to try and get exposure. There are funds, for example, that look to exploit pricing inefficiencies in the wake of a deal announcement. Such specialist funds can be an attractive addition to the wider developed markets equity exposure that we see as the most easily accessible beneficiary from such increasing deal activity – most of the time, M&A represents the net retirement of equity in exchange for cash, which should in theory exert upwards pressure on wider equity market valuations.
Interest rates and M&A
From one angle, some of the sheen may well be taken off this theme with the arrival of higher borrowing costs. However, again it is important to remember that interest rates across the curve will likely rise as a result of increasing confidence in the outlook for global growth. Such confidence is already visible in the increasing deal volumes and suggests that there may yet be more to come.
William Hobbs, Head of Investment Strategy, Europe