The current boom in M&A markets feels very different to the heady pre-crisis days of 2007, the last time we saw so much deal activity around the world. And it’s useful to ask why that is and what is driving the market right now.
To me the most significant factor behind the current level of deal activity is the availability of cheap money. Other issues are important too. The appreciation of the dollar means it’s a very favourable time to be doing deals if you are a dollar-denominated purchaser, for instance. Last year was a very opportune time to do tax inversion type deals. Both are great for U.S. cross-border investors and have been a catalyst for deals.
But cheap money is the most important factor by far and with equity returns so much stronger than the very poor returns available on risk-free assets, like government and even corporate bonds, corporate investors are being forced to look elsewhere to generate that return. If you are a company trying to grow your earnings, using cheap cash to generate returns through acquisitions is incredibly attractive at the moment.
And all the signs are that this will not be a short-lived phenomenon. Until the abundant liquidity that’s been produced in the past few years through quantitative easing (QE) starts to be absorbed and we start to see interest rates rise again, I’m not sure the story will change much.
There can, and always will, be shocks, of course. But that is another extraordinary thing about the current environment. The world has seen some pretty scary events in recent times and it’s something of a mystery why there hasn’t been more volatility. But, by and large, investors have kept their nerve and markets have remained incredibly calm.
It’s not clear how cataclysmic a shock it would have to be to bring things to a juddering halt. Certainly judging by investors’ cool nerves over the summer, it looks like something much bigger than Greece.
So short of a bigger shock than that, I see things carrying on for some time.
Choosing debt over cash
But there’s another really interesting feature of the current market.
Businesses are sitting on record cash balances and the numbers are pretty staggering. Companies in the S&P500, for instance, are currently estimated to be sitting on between USD1.3-1.4 trillion of cash. That’s the biggest amount in the S&P’s history and a remarkable change since the last boom.
But, interestingly, they are not actually tapping this mountain of cash to fund transactions. Instead, they are mostly using debt – also cheap and just as abundant – to finance their deals, perhaps seeing the cash cushion as a way to take some of the risk out of their debt-funded transactions.
That is a big contrast to the highly leveraged, relatively cash light environment of 2007.
But should it be a worry? Well maybe.
There has been very little paying down of debt since the financial crisis – either by institutions or households. Consumer debt continues to rise and, while companies have built up these huge cash reserves, there’s still a significant amount of corporate debt out there too.
Should the market fail, that would certainly be one of the more difficult issues to sort out.
PE versus strategic buyers
Another striking contrast between now and 2007 is that strategic corporate buyers are dominating the scene this time, where PE funds were in the driving seat just ahead of the crisis.
While PE Houses are still doing deals, they are mostly secondary or tertiary transactions between funds. Remember those 2007 headlines about big public companies being swallowed up by the nasty PE piranhas? This time there are fewer big, take private deals and fewer uncomfortable front pages – the so-called piranhas are mostly transacting with each other as they look to return value to their investors.
Nevertheless, PE Funds are themselves sitting on record amounts of cash, their appetite for deals is as great as ever and some of the secondary deals we are seeing are still very significant. The nature of PE investing has just changed somewhat.
By contrast, corporate buyers are out in force and particularly in sectors where we are seeing big secular shifts and rapid consolidation. Pharma is a case in point; technology and telecoms too. But gradually big strategic transactions are spreading to more and more sectors.
In some cases, it’s becoming something of a race to buy assets while financing is cheap. No one wants to be left behind when a sector goes through a period of deep restructuring and consolidation.
There are benefits and dangers here too. Consolidation can be a very good thing, but not always.
Just look at the recent history of the financial services sector. Ahead of the financial crisis, there was massive consolidation in banking both in Europe, as we saw with the RBS takeover of ABN AMRO, and in the U.S., where banks like Bank of America and Citi grew astronomically. That consolidation looked good at the time, but didn’t make those companies any stronger when the downturn came. Indeed, in some cases, the exact opposite was true.
So investors this time have to be wary. Some of the valuations we are seeing on later round investments at the moment – particularly in the tech sector – are already crazy and a cause for some concern, with investors paying way ahead of the fundamentals.
You can understand why. They are worried about missing the boat. They’ve looked at how equity markets have reacted to QE and are betting, not unreasonably, that the boom has got a lot further to run.
But the reality is that market valuations always return to the mean over time. Where we are seeing those valuations getting ahead of themselves, I think we can expect to see a degree of pain at some point.
Investing through the cycle
So CEOs need to move quickly, but with great care in this exuberant environment.
At Virgin Group – where our job is to manage the investments of the Branson family and their brand – we are long-term investors, investing through the cycle, and we have always been, and remain, a partnership business.
But we have evolved our investment strategy in recent times, looking to invest alongside like-minded investors with similar goals, because that approach is more likely to generate stability, predictability, cash flow and an agreed timetable for exit. Increasingly our natural allies are pension funds, family businesses and Sovereign Wealth Funds.
So, for example, we and our former partners CVC recently sold an 80% stake in Virgin Active, our lifestyle health club business, to Brait, the investment vehicle of the Wiese family of South Africa, with Virgin Group retaining a 20% interest in the business. When we raised USD725 million of equity to build new ships to launch Virgin Cruises, we brought the Ikea family office on board together with Sovereign Wealth Funds from Abu Dhabi and Singapore. Our partners in Virgin Hotels are family investment firms. The alignment of interest over the longer term with partners who are willing to invest through the cyclical will remain a fundamental part of our strategy.
We’re remaining focused on five sectors – travel and tourism, financial services, telecoms and media, leisure and entertainment and health and wellness – and I don’t expect that to change. These are all industries where we think our brand can bring the greatest value because they are all businesses where the customer experience is a priority. As we look for further opportunities we’re always looking for places where the brand can be most successful. So we keep the brand at the centre of our investment strategy, rather than buying an asset and then trying to retrofit the brand to it.
Within those five sectors, though, the range of investments remains diverse. In health and wellness, for instance, it runs from primary healthcare through to fitness with Virgin Active. And as markets shift and opportunities present themselves, business models develop and change and there is always the chance to do new things – that applies to all the markets we are targeting.
Shareholder value must drive deals
In this hectic M&A market, CEOs are still looking to do two things essentially: to grow earnings and expand the multiple of the business. You do both those things by maintaining the right focus and discipline in your core business. M&A, by itself, is rarely a panacea for either.
For a CEO, looking to plunge back into the M&A market after a long absence, the most important question to ask is this: Will the deal create a greater shareholder return over the longer term?
And I would urge all of them to think really long term when asking this question. Don’t focus on the next quarterly earnings report or this year’s annual results. Look instead over the next five, 10 or 20 years.
Strategic M&A can be a great tool to achieve earnings growth but only if you stay focused on your core strategy and on long-term shareholder value. As the current M&A market continues to boom, that truth remains as important as ever.