By Dean Turner
The announcement a few weeks back that one of the world’s most high profile investors, Warren Buffet, was launching a bid for one of the world’s most famous brands, Heinz, reignited investors’ attention to the prospect that a new wave of Mergers & Acquisitions (M&A) activity might soon sweep the markets.
To be sure, the announcement of the takeover of Heinz was one of the most high profile deals for some time. However, activity in the M&A market has been recovering for a while, although it remains below the historic peak. Interestingly, even during the depths of the financial crisis and the turmoil that engulfed the eurozone last year the number of deals that occurred never fell to a level as low as was seen during years following the technology bubble bust.
The strategic merits of any deal are the hardest factor to quantify, as not all acquisitions take place in order to combine businesses. For example, a financial buyer could acquire a company as it is interested in its strong, stable business model; alternatively, a financial buyer may see an opportunity to extract greater value than the existing management can. In our view, it is usually the case that opportunities for financial buyers exist no matter where we are in the economic cycle; what matters more are financing conditions.
However, in the case of the more traditional M&A, where companies look to acquire competitors in order to generate growth, the economic cycle usually has a significant impact. A growing global economy – much as we are witnessing today – should give companies the confidence to think about growing and expanding their businesses. Part of this growth will come organically from investments, but we believe that companies will also look to expand through acquisition, which suggests that the volumes of M&A should continue around their current levels, and possibly even expand.
Robust financial conditions are another important factor affecting the M&A environment, as the majority of mergers or acquisitions use some kind of leverage. When interest rates are high, the cost of using leverage could ultimately make a deal unprofitable and therefore it is unlikely to go ahead. However, borrowing costs are only one part of the story, the other is access to funds which can either come from cash on the balance sheet, gearing up the balance (i.e. borrowing more money from the credit markets or a bank).
The final driving factor of M&A to consider is valuation. M&A activity is likely to fall if valuations of target companies are high, as the value that can be extracted from a deal will be proportionally less. Notwithstanding the recent run up in share prices as risk appetite has recovered in recent months, we believe that the valuation of the majority of equity markets remain attractive.
The conditions remain favourable for the relatively healthy levels of M&A activity to continue over the coming months, which is likely to be a driver of equity market returns going forward; M&A normally occurs at a premium to the target company’s share price, enhancing returns. Furthermore, M&A should also accelerate the process of “de-equitisation”, which refers to the shrinking amount of shares available in the market as cash is returned to investors. This can happen for a number of reasons but share buy-backs and takeovers combined with a lack of new companies coming to the market. This leaves the investors with fewer assets to invest in, which, ceteris paribus, will drive share prices higher as more money is chasing fewer assets.
In our view, the outlook for M&A activity is a relatively healthy one as we believe that the economic cycle, financial conditions, and valuations all look supportive. This should be supportive for equity market returns over the medium term, which gives us confidence in our overweight equity positions within portfolios.
Dean Turner is an investment strategist at HSBC Private Bank
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