No reason to fear M&A

M&A is making a comeback, but analysts are confident the market will not see a repeat of the mega-acquisitive and ultimately destructive strategies of the previous decade. Now the watchword seems to be ‘conservative’ M&A. Laurence Neville reports

After a number of false starts, it is now clear that US merger and acquisition activity is heating up. Figures from Thomson Financial show that in the first two months of the year, $202 billion worth of deals were announced—around $20 billion higher than the same period last year, but still half of the record total announced during the first two months of 2000.

Increases in activity can become self-fulfilling. In sectors such as telecom and retail, mega-deals tend to force a consolidation response from competitors. Deals like Sears/Kmart and SBC/AT&T mean that the rationale for M&A within those industries has become one of survival.

This leads many analysts to believe that M&A activity will continue strongly throughout the rest of the year. A recent survey for KPMG of tax and finance executives showed that 90% of respondents expected to complete one deal this year, and they cited the stronger US economy as the main motivation. For bankers in the M&A market, the pickup in deal flow means bonuses. But for bondholders the changed climate brings worries.

Although M&A can offer opportunities from spread compression, which occurs when the bonds of the acquired party tighten to the level of the acquirer, not all funds are able to use such strategies if, for example, the acquired party is non-investment grade. And more importantly, M&A activity often signals a change in the credit cycle: companies stop saving money and start spending it, often by increasing leverage. But while M&A deal flow seems certain to rise further, all may not be lost for bondholders.

“The strongest contrast to my mind of the last few years has been that between consumer behavior and corporates,” says Louise Purtle, senior macro strategy analyst at CreditSights and US Credit columnist. “While consumer spending and debt have continued to increase, the business mind-set has become extremely conservative.” She notes that capital expenditure at US companies remains historically low considering the advanced stage of the economic recovery.

A cautious approach

The reasons why businesses have been cautious are familiar. The series of shocks since 2000—the end of the technology boom, the stock market slump, Enron and other corporate scandals, 9/11 and Sarbanes-Oxley—have resulted in prudence being valued over flamboyance. It is too early to say whether this change is permanent. But it is becoming clear that companies are starting to approach the financing of M&A with an outlook that would have been unthinkable in previous economic recoveries.

Matthew Toms, global credit portfolio manager at Northern Trust in Chicago, says that M&A is being justified for historically unusual reasons. “Companies are looking for ways to wring out further costs from their business,” he says. But after years of internal reform and cost-cutting, “a lot of the low-hanging fruit internally has been taken.”

So companies seeking further cost rationalization are looking for M&A opportunities. “We think that it’s representative of the continuation of a cautious mind-set among corporate boards,” he says. “M&A is being seen as a way to continue to run businesses optimally as opposed to embarking upon far-flung and risky ventures.”

With companies making acquisitions for conservative reasons, it is not surprising that deal financing is also conservative. The principal sources of M&A financing are equity and cash. Doug Colandrea, head of corporate credit research at Bear Stearns in New York, notes that companies have spent the last few years strengthening their balance sheets. As a result, they have “cushions within their balance sheets and existing ratings”, he says. That cushion allows companies to use cashflow in different ways: share buybacks and special or increased dividends are common; and now cashflow is starting to go toward M&A.

With few acquisitions relying on debt finance the effects for bondholders should be benign or even positive. Northern Trust’s Toms says that spread volatility among companies involved in M&A has been limited as leverage is not being increased. “Within the individual deals you may see a basis point or two of volatility but that’s it,” he says. “Consequently, it has allowed investors to feel comfortable that similar deals will be financed in a similar fashion in the future. Of course, that remains to be seen.”

There is no guarantee that M&A will continue with its current benign characteristics. As memories of the early part of the decade fade, the appetite for grandiose empire-building may return. “As you go through the cycle there may well be more instances of bondholders being subjugated to the interests of equity holders,” says Purtle. “And the deals themselves will be done at more aggressive multiples.” Nevertheless, she thinks that acquisitions will continue to be about “bolt-on” deals that make sound business sense rather than “transformational” deals such as AOL/Time Warner in the late 1990s.

However, while corporate behavior may not change, M&A may be affected by external parties: either hedge funds or private equity players. “They are starting to play a more active role in pressuring firms such as Toys “R” Us and Circuit City to take the M&A initiative,” says Toms. “The strategic rationale for those sorts of investors will inevitably be different and their horizon will be shorter. They are interested in increasing risk because they want a quick return. So the participation of third parties such as private investors could result in the amount of leverage being used in M&A deals increasing.”

Strategies to benefit from M&A The traditional way for bondholders to play M&A has been to try and capture the spread compression that should occur when the debt of the acquired party is consolidated with the debt of the acquirer. Many traditional mutual funds have a basket of non-investment-grade bonds, perhaps 5–10% of the fund, to allow for instances where the acquired party might be non-investment grade. In recent years there has also been greater use of short strategies in M&A situations, both by players such as hedge funds and mutual funds. “Many funds can now play on the short side,“ says Doug Colandrea, head of corporate credit research at Bear Stearns. “The maturity of the CDS market means that you can go short the acquirer should you think its spreads are going to widen. Many accounts will put on pair trades-Nextel/Sprint was a recent popular one with people going short Sprint and long Nextel. Or some accounts might be able to go long the stock and buy protection.” Credit default swaps allow investors to leverage the potential gain from any compression. “If you’re in the spread compression game and there’s only the potential for a five basis point compression then a real-money investor might not get excited,“ says Matthew Toms, global credit portfolio manager at Northern Trust. “But if you can own both sides of the trade or lever it, the situation can become more interesting.“ However, Toms says that for long-term investors like Northern Trust, the absence of M&A in certain sectors might be the key to good returns. “We’re really interested in stock-picking: identifying those companies that don’t have share prices under pressure and which aren’t likely to be returning cash to shareholders. We want to find companies that are comfortable keeping cash and don’t feel they have to do something just because other companies in the sector are doing M&A deals,” he says.