Every year, it seems that the start of the festive season creeps forward just a little more. Stores advertise Christmas gifts not just weeks, but months in advance of December 25. And the Christmas displays that traditionally used to go up just after Thanksgiving now start appearing around Halloween.
This year, for a handful of lawyers and bankers who structure corporate mergers and acquisitions, it seemed as though Christmas Day itself was rescheduled for October 27. On that day alone, the roster of business consisted of $70 billion worth of M&A, the most in any one day since February 2000.
The financial sector saw Bank of America agree a $48 billion ticket for FleetBoston Financial. In the healthcare sector, Anthem and WellPoint Health Networks agreed to merge in a $16.4 billion transaction. And the consumer sector saw tobacco company RJ Reynolds link up with the Brown & Williamson subsidiary of British American Tobacco in a $3 billion deal.
By the end of October, global M&A volumes for the month stood at $162.7 billion, nearly twice the monthly average experienced in the first nine months of the year. North America accounted for $101.5 billion of that figure, representing a 58% increase over the US monthly average in the year to the end of September.
In some quarters, this flurry of merger announcements has provoked speculation that the markets are set for a new wave of M&A activity, marking increased corporate confidence in a recovering economy. But while the dealmakers begin to prepare for a rewarding season of hefty arrangement fees, participants in the corporate debt market are considerably less certain that a new wave of M&A would be good news for them.
After all, the results of the last flood of M&A have done little to convince bondholders that the long-term prospects of the companies involved will be secure. Five years after German automaker Daimler-Benz acquired Chrysler, for example, the US auto company is losing money at a rate of $1 billion per quarter, and the combined entity DaimlerChrysler has seen its credit rating from Standard & Poor’s decline from A+ to BBB.
As one credit strategist points out: “Historically, bondholders in the investment-grade space have not been rewarded for large M&A. There are always some exceptions, but in most sectors integration risk is very high: the mergers of AT&T and the TCI Group (Tele Communications), Tyco and CIT, and AOL TimeWarner are just some examples.”
And since the value-destroying mergers of the late 1990s are still fresh in bondholders’ memories, it is little wonder that this more recent spate of deals is causing a degree of discomfort. However, it seems that this time around, corporate bond investors may find less downside in M&A transactions than they have been previously led to expect.
For one, the rationale behind recent M&A activity is substantially different from the ambitious strategies of the last wave of mergers. According to a credit strategist at a New York-based firm: “These are not the marriage of titans or transformational-style deals done at the height of the equity boom that generally proved to be disappointing in their delivery of benefits to stakeholders.”
Instead, these deals tend to be piecemeal, bolt-on acquisitions allowing companies with languishing growth prospects to improve their competitive positions. Simon Ballard, a credit strategist at Bear Stearns, says: “For the moment at least, executives are thinking carefully about how to cut costs or adjust to changing industries, so the mindset is for common sense acquisitions – strategic alliances intended to improve a company’s footprint in their industry.”
The blockbuster deals announced on October 27, for example, were relatively credit-friendly: all contained balance sheet enhancing elements and expectations for increased competitiveness.
At Bank of America, the purchase of FleetBoston completes the bank’s coverage of the United States by acquiring a bank in the northeast, the one area where Bank of America was previously absent. The creation of Reynolds American by BAT and RJ Reynolds will allow the tobacco companies to compete more effectively with Altria (Philip Morris) and the large number of low-cost cigarette brands. And the combination of Anthem and WellPoint creates a company with broader national coverage, better placed to compete against companies such as UnitedHealth and Cigna.
At the same time, the recent spate of deals has been characterized by a shift in financing strategy. While the previous wave of M&A was often financed by increased leverage and regularly resulted in deteriorating credit quality, the stock market rally of 2003 has allowed for greater reliance on equity as an acquisition currency.
Of the deals announced on October 27, Bank of America-FleetBoston and RJ Reynolds-BAT were entirely financed by equity, and Anthem-WellPoint was financed with stock and cash. According to one credit strategist, mergers are unlikely to rely on increased leverage any time soon. “Corporate America has been de-leveraging for about a year, but the trend has real roots which are unlikely to be upset by reckless M&A in the near future.”
For credit investors, the obvious downside to this financing strategy is the reduced potential for new issue supply in the corporate debt markets. However, bondholders will nevertheless be reassured that America’s boardrooms have adopted a substantially more cautious approach to M&A financing.
One reason behind these more prudent tactics, say analysts, is that corporates are now critically aware of the need to protect their debt ratings. The turmoil experienced in the corporate debt markets since the turn of the millennium has reduced investors’ risk tolerance, and the companies know it.
This calculated approach to M&A means that the pace of activity is considerably slower than during the late 1990s. The slew of deals in the last week of October sent M&A volume in the US above $400 billion for the year-to-date, up from $355 billion for the same period in 2002. But in the previous wave, corporate confidence in the economy produced M&A volumes of $1.5 trillion for three years in a row.
Notwithstanding signs of an improving economy, new interest in mergers is being tempered by the associated costs. In recent deals, buyers have overpaid to get deals done. Anthem offered a 20% premium over the market stock price for WellPoint, and BoA agreed a premium of 42% for FleetBoston. As one credit analyst at a large bank says: “Bank of America may have raised the bar too high on the premiums that sellers will expect. Other companies who may have done deals may not now be able to match those terms.”
And as a result of these generous premiums, shareholders of acquired companies tend to make all the gains when deals are struck, and the share prices of the buyers plunge. The equity markets are simply not yet buoyant enough to support a raft of new deals, and since October 27, some mergers have been put on hold for fear that the market would show a similar reaction.
Bell South, for example, is rumored to have called off merger talks with AT&T because some Bell South officials were rattled by the reaction of the stock markets to the deal between BoA and FleetBoston.
So the anticipated boom in the M&A market after October 27 looks more like a blip on the chart. And while some analysts still see M&A as a negative risk for credit, the characteristics of the latest deals are certainly not the destructive traits of previous mergers. So even if bondholders cannot expect any big shiny presents under the tree this year, there will at least be no booby prizes.