How leverage transformed the M&A business
In business school they teach you that rising equity markets drive increased mergers and acquisitions activity, but perhaps it is really the debt markets that have driven the booms and busts in M&A. Some of the smartest practitioners in financial advisory look back over their careers.
Companies were buying other companies, taking each other over and merging long before the emergence of the international capital markets that Euromoney was established to report on in 1969.
The largest securities firm in the world, Merrill Lynch, Pierce, Fenner & Beane, had been created from a string of mergers of partnerships in the 1940s. When did the business of such partnerships advising on international M&A in anything like its modern form first appear?
“I would say what we call M&A today was first practiced by Lazard in Paris in the 1920s and then reinvented in the US in the early 1960s again by Lazard, then led by André Meyer and Felix Rohatyn,” says Ken Jacobs, chairman and chief executive of Lazard today.
Robert Kindler, who went on to be global head of M&A at Morgan Stanley, started in the business in 1979 at law firm Cravath, in the days before industrial corporations had their own big legal teams or corporate development departments handling M&A in-house.
Maybe Cravath invented M&A?
Kindler says the two types of advisers started off on a level playing field in advisory.
Robert Kindler, Morgan Stanley
“In 1979, the investment banks and law firms that worked on M&A deals were all small partnerships,” he says. “Cravath had about 45 partners in 1979. The investment banks were not public. The senior partners of law firms and investment banks were paid far more than the chief executives of public companies.”
That certainly has changed, as the cult of the chief executive took hold in the 1980s and 1990s and pay soared. But 40 years ago, the power dynamics between companies and their professional advisers – legal and financial – were different.
“A chief executive would not bring a major transaction to the board without including what were then a small handful of prestigious law firms and investment banks,” Kindler says. “Corporations did not have significant business development or legal groups and relied on one law firm and one investment bank without shopping the business around.
“And this was in the days before investment banks even had specialist M&A groups. Bankers doing M&A were generalists who did everything, including taking companies public.”
By the time Jacobs arrived in the thick of the action in the early 1980s, the first advances in computerized analysis of corporate financials and their underlying cash flows were unleashing a huge wave of turnover in the equity markets. And as institutional investors pounced on mis-valuations, so too did corporations, raiders and private equity investors.
After high interest rates had slain inflation in the 1970s, the equity markets and the M&A business marched forward together in lock step in the 1980s. The same advanced cash flow analysis allowed bidders to take on much more debt.
Cross-border deals were also coming into vogue.
Goldman Sachs, one of the leading firms in the US, was just establishing an operation in London, from which it quickly advanced into European M&A.
Jacobs says: “I was a young associate; what I remember was the vision, focus and commitment of John Thornton who began this enormously successful expansion outside the US of the firm’s M&A business – which itself still felt like a rather new business – from that first beachhead in the UK.”
Jacobs saw it from the inside for three years before decamping to Lazard where he has made his career ever since, rising to the top of the firm.
If the business felt new back then, it was about to get feisty. There were the so-called tobacco wars, when Hanson PLC bought Imperial; and there were air wars too. Caledonian Airways took over British United and then fell to British Airways. Thorn EMI, itself the product of a merger in 1979, tried to combine with British Aerospace. And then there was Guinness – a byword for insider trading and illegal shareholder support schemes – that began when Argyll launched an outrageous bid for the much larger whisky company Distillers, which then sought Guinness as its white knight.
This was a battle that revealed the so-called gentleman bankers of strategic advisory to be as greedy and ruthless as any Essex boy trading in the new foreign exchange markets.
In the US too, things had changed.
“Hostile bids were unusual at the start of the 1980s, especially among blue chip firms,” says Kindler. “I remember advising Royal Dutch Shell on buying in the minority holders of stock in Shell Oil, which it already owned 80% of, and it was criticized for making a hostile offer for what was in effect its own subsidiary.”
But things changed.
“Ted Turner took his run at CBS in 1985 and Unilever launched its hostile bid for Richardson-Vicks,” says Kindler. “There also was activism in the 1980s, often involving accumulating stock in the hope of having the target itself buy the stake back. There were fewer activists, notably Carl Icahn, Asher Edelman, Hanson PLC, the Belzbergs and Shamrock.”
For years, you didn’t hire a firm – you hired a person who was really good when you were under attack or needed to acquire an asset - Ken Jacobs, Lazard
Edelman even taught a business school course in corporate raiding. That time passed.
“The greenmail they looked for is no longer palatable,” says Kindler
But the business began to get far more aggressive in the run up to the era-defining moment when Henry Kravis had first agreed with the chief executive of RJR Nabisco to buy out the company, then launched his own bid financed by junk bonds.
For a while, it looked like the M&A genie would be rammed back into its bottle as congressmen and senators lined up to attack the new money men taking over established US corporations – and big employers of their voters – with this new form of junk debt, later carefully rebranded as high-yield bonds.
“It wasn’t so much a backlash against hostile takeovers per se,” says Jacobs. “There had been plenty of corporate battles in the early 1980s, for example in the oil sector. Outsiders like Ivan Boesky, who were at times more like raiders, were the new element, using junk bonds to buy shares and extract a premium to go away, or like Ron Perelman’s use of leverage to take over and break up companies. It looked like a threat to the establishment, and there was political pushback.”
But the argument won the day that debt could unlock shareholder value – and shareholder value was king. As for displaced labour after a break up, well people could retrain couldn’t they?
“It resolved itself with a series of court cases in Delaware that clarified the way forward and which imposed a responsibility on boards to consider offers, if bidders could finance them,” says Jacobs. “And then, if the board agreed to sell, established their responsibility to consider other offers so as to maximize shareholder returns.
“It also made it more difficult to pay a minority shareholder to go away,” he adds.
|Ken Jacobs, Lazard|
The new financial technology also shook up the power structure on Wall Street where M&A had not been driven by capital but by ideas, by relationships between advisers and industrialists and by name bankers who brought along their apprentices.
There were Michel David-Weill and Rohatyn at Lazard; John Weinberg at Goldman, who famously resisted advising on the hostile side in takeovers, and then Stephen Friedman and Geoff Boisi; Eric Gleacher at Morgan Stanley; and Bruce Wasserstein and Joe Perella at First Boston.
“For years, you didn’t hire a firm – you hired a person who was really good when you were under attack or needed to acquire an asset,” says Jacobs. “As the business and the fees got bigger, the practices and tactics started to become more familiar and eventually firms developed specialist M&A departments. However, the top practitioners as individuals remain in high demand.”
But money changes everything. For banks, M&A became a tool to earn revenue in other areas, especially providing finance and hedges for finance costs, foreign exchange on cross-border takeovers and other, sometimes large, contingent expenses.
“In the mid to late 1990s, the big universal banks beefed up around corporate finance and advisory as a new way to make money and a means to deploy their growing balance sheets,” says Jacobs. “Banks built industry verticals, seeking to amass sectoral expertise as a way to compensate for the lack of big-name individuals or trusted relationships with clients.”
In 2006, the leveraged buyout of HCA, which was $33 billion, required us to gauge the depth of the bond and loan markets. It was an eye-opener as to how big LBOs could go, being the largest since RJR Nabisco, way back in 1989 - Sarang Gadkari, Bank of America
/table> The distinction between banks and investment banks blurred. Just as banks got into securities markets and M&A, so the investment banks came into loans as leverage finance increasingly drove M&A.
“I was an intern for three summers at Merrill Lynch starting in 1991,” recalls Sarang Gadkari, co-head of global capital markets at Bank of America Merrill Lynch, “when Glass Steagall was just coming to an end but the investment banks had not captured leadership in loans and commercial banks had not captured leadership in securities.
“When I properly started in 1994, everyone around me at Merrill Lynch was dealing in bonds and I was the first analyst asked to look at loans. The credit work was quite similar but the two disciplines remained separate until the late 1990s, when the firm merged loans and bonds into a leveraged finance department. It was easier for me to work on both, while some people who had grown up working just in bonds or just in loans were not so comfortable.”
Leveraged finance added fuel to the M&A fire.
“A key deal I remember was American Electric Power buying Yorkshire Electricity in 1997,” says Gadkari. “The financing was simple, but it was a fascinating insight into strategic, cross-border M&A. At the time, US companies wanted to understand how UK utilities were operating as deregulated platforms, because they could see deregulation was coming in the US.
“Then in 2006, the leveraged buyout of HCA, which was $33 billion, required us to gauge the depth of the bond and loan markets. It was an eye-opener as to how big LBOs could go, being the largest since RJR Nabisco, way back in 1989.”
Amid the leverage cycles of the 1980s and the run up to the great financial crisis, investment banks brought us some great deals and some terrible deals.
Euromoney reported in depth on Olivetti taking over Telecom Italia; Vodafone taking over Mannesmann and, of course, all the great bank mergers, such as Sandy Weill’s Travelers incorporating Salomon Brothers then getting together with Citibank to create the ultimate financial conglomerate; also Chase with JPMorgan; and CSFB with DLJ.
We also reported on a few that nearly happened but not quite. Who remembers Deutsche Bank almost merging with Dresdner – Christian Sewing should read up on that one – and Morgan Stanley with SG Warburg?
“AOL Time Warner still stands out as probably one of the worst; Abbott Labs buying Knoll Pharmaceutical from BASF, also in 2000 was one of the best. For just $7 billion, it was arguably the most value-creating deal in the history of pharma,” says Jacobs.
But some of the best deals may have been the ones that never happened at all.
“A number of times, I defended Cummins Engine in the 1980s, from activist attacks by Hanson PLC and by Ron Brierley of New Zealand,” says Kindler. “Cummins was a relatively small company dealing with stiff competition from foreign engine suppliers. Cummins fended off these activists and invested heavily in engine technology, while at the same time reducing near-term margins by cutting pricing.”
That might be a tough call to make today.
“They did the right thing long term,” says Kindler, “and today it is a $25 billion market cap company.”
How has the financial advisory business changed over his 40 years in it?
“As I think back to the late 1970s and compare it to today,” says Kindler, “then there were only four or five law firms a blue-chip corporation could turn to for M&A, and now there are 15 to 20. And corporations have large legal departments and chief executives rely more on their general counsels than outside lawyers.
“On the banking side in M&A, there are fewer banks with large market shares. Over time, the three leading investment banks for M&A, Morgan Stanley, Goldman Sachs and JPMorgan, have significantly increased market share and are well above the next tier.”
It is really only in the last decade, since the financial crisis, that people have finally come to realize that conglomerates don’t make any sense. The culmination of that is the breakup of GE - Robert Kindler, Morgan Stanley
But some things remain the same. There used to be raiders calling for the breakup of conglomerates and now there are activists – a slightly softer name – calling for, well much the same thing.
“It is really only in the last decade, since the financial crisis, that people have finally come to realize that conglomerates don’t make any sense,” says Kindler. “The culmination of that is the breakup of GE.”
Investors no longer see the benefit of being in everything from light bulbs to entertainment to financial services.
“Some of the demerging is the result of activism and an important reason why I think we will not see conglomerates again is because of activism,” says Kindler.
Jacobs agrees that increased activism since the crisis puts a renewed pressure on management teams.
“I would say that in the bull market of the 2000s, shareholders, boards of companies had a fairly easy ride. Since the financial crisis, you have seen the rise of activism, which began as a focus on governance but has morphed into pressure to maximize shareholder returns over shorter time frames.”
But now, he says, added to the mix are two new factors.
“First, companies that began adopting ESG [environmental, social and governance] models to bolster their image with customers and employees are now grappling with the question of how far their responsibilities extend to society as a whole, and how to balance that against maximizing long-term shareholder returns.
“Second, the power of technology, and particularly the ability of AI to operate on large data sets, will impact M&A in new ways.”
For Jacobs, media content is one of the most interesting areas.
“A decade ago people were still producing TV programmes to secure an audience, monetize through advertisers and maybe from syndication,” he says. “And now you have Netflix moving beyond licensing content to creating its own for-subscription revenue in a fairly traditional model. But you also have Amazon creating content to drive memberships of Amazon Prime. And you also have AT&T and Comcast using content to reduce subscriber churn. Some of the largest creators of content today are using it to drive an entirely different business.”
Kindler sees two other trends. First, related to the breakup of conglomerates, is the requirement for clear industrial logic: “If you propose an M&A deal to a board and ultimately shareholders but cannot explain its industrial logic in the first 30 seconds, then it is not going to happen.”
Second, actually making it happen – even if the industrial logic passes the 30 second test – can take far longer than ever before.
“Now that you have more global companies, they are all answerable on any proposed large M&A deal to multiple competition and other regulatory regimes all across the world, as well as to national takeover codes. And that has implications. Instead of months, it can take years to get a big deal across the line – and even if you do, it often will require disposals.”
While M&A has boomed recently, it isn’t getting any easier.
“You now have CFIUS [the Committee on Foreign Investment in the US] considering national security questions,” Kindler says. “It remains to be seen how many other countries will bring out their own versions of that.”