Feature

The Golden Age of M&A

2015 could see the highest level of M&A transactions since 2007, the year before the financial crisis struck. But the market looks very different today than it did eight years ago. So what's driving this activity and will it last?

 

CHEAP CASH, STRATEGY AND THAT OLD DEVIL CALLED DEBT

Few companies have been such consistently successful investors as the Virgin Group. It licenses the Virgin brand to almost 100 companies around the world, many of which it continues to invest in, and others of which it has sold down over the last 40 years. Virgin branded companies employ more than 60,000 in 34 countries, generating a combined revenue of GBP15 billion. So how does the current M&A boom look to the man who oversees that investment strategy? Here CEO Josh Bayliss reflects on both the strengths and potential weaknesses of the current market.

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.

PROPELLED BY CONFIDENCE AND PEER PRESSURE

The current M&A boom looks resilient (at least for now) and, in some ways, less risky than previous market peaks. Although there is a chance that valuations will become overheated, activity is expected to remain at high levels in the short term.

The boom in takeover activity in the last year makes it quite hard to remember just how low the M&A market sank in the aftermath of the financial crisis, with a prolonged slowdown in deals that only finally began to improve in 2014.

Global M&A in the first half of 2015 was up 40%, seeing the strongest first half for M&A since 2007.  This growth has been fuelled by a 48% increase in the number of deals over USD5 billion.  So we are seeing a growing number of big ticket, strategic transactions going on in an ever-wider number of sectors.

Like most observers we expected the recovery to come much quicker. After all the economic fundamentals (low interest rates, strong equity markets, cheap finance) looked very positive a long time before deals actually bounced back.

From early 2013, we were all waiting for that elusive touchpaper deal – the big transaction that would ignite the market again. Eventually one or two key sectors, notably life sciences and TMT, did spark dramatically into life towards the end of that year and the rest of the market has followed in its wake.

That contrasting picture between 2009 and 2015, and the intervening drought, tells you a simple fact about M&A – it is, more than anything, a matter of confidence. It’s not that CEOs stopped looking for targets during the downturn. They simply didn’t have the confidence (or support) to make the leap. We know of several deals that were researched and prepared, were put on hold, only to get dusted off and completed much later on when that confidence was fully entrenched.

That situation has changed out of all proportion now. Armed with strong cash balances and access to cheap debt and, increasingly, urged on by supportive shareholders, CEOs are queuing up to do really big transformational deals. These big strategic transactions, in an ever-wider number of sectors, are precisely what drove deal values in the second quarter of this year near to their 2007 peak.

Peer pressure

Once activity gets as strong as this it becomes something of a self-perpetuating cycle. There’s a palpable peer-pressure factor at play, with boards and shareholders clearly expecting their CEOs to go out and join the fray, worried, perhaps, that they will miss out if they do not.

Other issues help too. The strength of key currencies, notably the dollar and sterling, has supported growth in cross-border transactions; debt (although set to get more expensive as interest rates rise) will remain very reasonable a while longer; and the attitude of competition authorities and sector regulators, while still rigorous, has become more transaction-friendly.

It’s a near perfect dealmaking environment and, for all these reasons, we expect the market to remain just as strong for the next 12 to 18 months.

Beyond that, however, we are a little more cautious – M&A remains highly cyclical and always prey to the dangers of boom and bust.

Reasons to be fearful

Macro-economic and political factors could once more come back into play. The market seems to have priced in the Greek debt crisis well in advance, but the longer term effects on the Eurozone are uncertain and could be more destabilising. More worryingly, the recent volatility in Chinese equity markets probably has the potential to cause much wider disruption if it persists. Tensions in Russia, Ukraine and the Middle East continue and important elections are coming up in the next 18 months, not least in Germany, France and the U.S. There is plenty to rattle investors’ nerves.

Also, as the current boom continues there’s also the danger of valuations overheating, deterring purchasers. It’s interesting that some CEOs in the hottest sectors are refusing to do deals at the moment, believing prices are already overblown. Interesting too that they are getting considerable grief from shareholders for taking this stance.

Having said that, there is good evidence that dealmakers in many sectors are being more cautious this time round. Due diligence processes are noticeably more careful, indicating there is a much higher appreciation of risk now than in 2007. That has to be a good thing – a moderating force at least.

At A&O we have made a concerted effort to build our Corporate practice and the last year has been a time of considerable achievement for the firm. In the year to April 2015 we completed a record total of 230 transactions worth USD221.8bn. Last year we advised on USD1.3 trillion of transactions (including debt and equity capital market (ECM) deals, loans and projects), a level unmatched by any other law firm.

We’ve built key parts of the practice, including our ECM, PE and anti-trust capabilities and invested heavily through the downturn to expand our global network of offices, as others retrenched.

That has paid dividends. At a time when cross-border transactions are once again growing strongly (they grew by 20% in the first half of 2015) our highly integrated global network has put us in a strong position to win mandates. While cross-border deals accounted for only 34% of total transactions in the first half – compared with a peak of nearly 45% in 2007 – they represent more than half the deals we’ve worked on.

Building really excellent relationships with clients – relationships that extend beyond the individual transaction – has also been an important part of our strategy. In these hectic markets, executives want guidance from trusted advisers who have a real understanding of their business, sector dynamics and wider business trends.

As the market continues to boom, we are urging clients to act decisively. They need to really understand the rationale for the deal, what they want to get out of it and how they are going to integrate the new business after completion. Building the right team – both internally and externally – is vital to this process.

But the key message is this: Don’t do the deal in a hurry, but, when you do it, do it efficiently. Keep examining the rationale as negotiations proceed and if it ever begins to look wrong, don’t be afraid to walk away.

To do so will be far less expensive than being saddled with an ill-judged acquisition.

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