ECM bankers thrive on M&A boom
THE CLASSIC M&A arbitrage strategy – you hold the stock of a target company and short that of a bidding company – evolved for good reasons. The target’s share price should always be expected to rise because if you try to buy a company you will have to pay a premium in order to gain control. The bidder’s share price has good reasons to fall: the bidding company takes on the risks of trying to execute a plan to turn one plus one into more than two. This is a challenge that is only theoretically more manageable in real life than in mathematics, a fact borne out by academic studies, which show that the vast majority of M&A deals end in tears and the destruction of value.
What then should we make of the current wave of M&A deals? Investors have greeted many recent deals with uncharacteristic enthusiasm, pushing up the share prices of bidding companies as well as those of their targets. According to JPMorgan, the five-day excess return of European bidders in large deals of more than $5 billion has averaged 2.37% this year.
Investors’ enthusiasm for deals is such, notes Morgan Stanley, that if an investor had bought at the close of the announcement day, they would have found that bidders have actually tended to outperform targets in European M&A deals this year.
Bidders and targets
The market’s new-found fondness for deals has led brokers such as Citigroup to recommend that investors buy bidders as well as targets in order to benefit from the M&A activity sweeping the market. Although it’s hard to argue with such advice in the short term, given the market’s reaction to deals at the moment, it’s questionable that the current wave of deals is so different from previous value-destroying ones. If it isn’t, enthusiasm might later turn to disappointment.
“At this stage in the business cycle, you would expect the market to be increasingly receptive to takeover bids,” says Paulo Pereira, European head of M&A at Morgan Stanley. “The other aspect is that we are still at the stage where transactions are using significant amounts of cash, so an additional driver of bidders’ stock price
performances is the fact that the combined capital structure is being optimized through the transaction. Restructuring balance sheets to optimal debt levels is a positive factor.”
Some of the unusual share price behaviour can also be explained by the fact that fund managers are awash with cash. The strong performance of equity markets has attracted huge inflows that investors are struggling to utilize. The combination of a strong secondary market and lots of cash to spend makes investors hunger for exciting opportunities and so more prone to taking risks and giving company managers the benefit of the doubt. “People want to believe in new growth stories,” says the co-head of equity capital markets at a bulge-bracket investment bank. “The big question is: will the market continue to be rational? Historically it will start overpaying at some point.”
So far, there are grounds to argue that the market is rewarding bidders because deals are being done at reasonable prices. Bid premiums in 2005 remain well below their long-run averages, according to research into global M&A trends by Dresdner Kleinwort Wasserstein. On an overnight basis, bid premiums this year so far average just 9% compared with 20% since 1995. One-month prior premiums meanwhile are 17%, compared with 26%.
Sensible deals
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Pereira: restructuring balance
sheets to optimize debt is a
good thing |
Bid premiums have tended to rise as M&A activity picks up, but not this time. Although it could be argued that this shows that companies are now doing more sensible deals at better prices – despite the strength of corporate balance sheets and cashflows – it is too early to tell. M&A statistics, particularly in the large-cap category, are easily swayed by particular deals.
Also, bid premiums do not tell the whole story. According to Dresdner Kleinwort Wasserstein global sector strategist Phil Isherwood, what bid premiums really reflect is the availability and cost of finance and whether or not it is buyers or sellers who are the more desperate. “It is very difficult to claim that value opportunities are the force behind M&A,” says Isherwood, “because the take-out P/E multiple moves pro-cyclically with all the other major measures of M&A.”
The pro-cyclical relationship between take-out P/E multiples and M&A activity shows that high prices do not deter buyers in a boom, just as low prices do not attract them in a slump. This, argues Isherwood, adds more ammunition to the idea that market exuberance rather than actual value is often the swing factor in M&A activity.
The current average take-out P/E multiple of 27x is below the post-1995 average of 29x, but bull and bear phases are marked by the rise of large-cap take-out multiples above or below the overall average level. Large-cap take-out multiples in 2005 average 31x, so it is very difficult to say if deals this year really are about value.
It doesn’t help that companies, like investors, are also under huge pressure to do something with their large and growing cash piles.
From 2000 until 2004, companies were not sufficiently confident to do anything with cashflows except pay down debt, because that was the only thing investors wanted. But the level of corporate indebtedness, in terms of assets to equity, is now at its lowest level globally in 15 years and falling. “Investors are aware that profit margins and return on equity are quite high relative to history,” says Ian McLennan, global equity strategist at UBS. “If companies continue to be cautious about investing and instead use cash to delever their balance sheets, return on equity will begin to go into reverse.