The merger and acquisition boom has further to go

Key points

• Merger and acquisition (M&A) activity has been a contributor to share market strength in recent times.
• This has been driven by a combination of factors, including abundant liquidity, the growth of private equity funds, low corporate gearing levels and reduced opportunities for organic growth.
• M&A activity is likely to have further to go - the value of M&A deals relative to share market capitalisation is still small compared to past M&A booms and its key drivers are set to remain in place for a while to come.

Introduction

The past few years have seen a significant pick-up in the number and value of M&A deals both on the Australian share market and globally. This has undoubtedly played a roll in share market strength in recent times. Some see it as a sign of speculative excesses and thus as a pointer to an impending share market top. Our view, though, is that M&A activity likely has further to go.

The key drivers of the surge in M&A activity

The recent pick-up in M&A activity reflects a combination of drivers, including the following:

• The opportunities for organic growth by companies (ie. expanding a business by investing in it) within developed markets such as Australia is limited, so one way to grow profits is via the synergies that mergers and acquisitions are perceived to offer.
• Companies are cashed up as a result of the surge in corporate profits relative to capital spending. Some of this cash is being used for dividend payments and capital returns to shareholders, but naturally some of it is also funding expansion via M&A activity.
• Corporate gearing is relatively low compared to the past, reflecting pressures to deleverage following the corporate debacles of the late 1980s and early 1990s in Australia, and the global tech boom several years ago. See the next chart. This provides an opportunity for more aggressive company owners and managers to boost returns by applying more debt for a given level of capital.

• The relatively low level of gearing today indicates that the corporate sector has been far more restrained through the recent favourable environment than was the case in the late 1980s when corporate exuberance was the norm and gearing reached exorbitant levels.
• The world is awash in savings looking for a home, coming in particular from Asia and oil producing countries* . Some of this excess savings is finding its way into private equity funds, which are playing an increasing role in M&A activity. According to the Reserve Bank of Australia, so far this year leverage buyouts (LBOs) by private equity funds have accounted for around 15% of Australian M&A activity, compared to below 5% in previous years. Globally, the value of LBOs surged to US$326.5 billion in 2005, up from US$108 billion in 2002. So far this year, more than US$542 billion in LBO deals have been done. Takeovers by private equity firms typically result in increased gearing levels. Because private capital firms are often prepared to take a more radical approach to re-engineering a company and improving the return on equity that its assets are generating, they are generally prepared to pay well above what typical passive shareholders or even competing companies may regard as fair value.
• The cost of debt is relatively low, reflecting low government bond yields and low credit spreads. For example, the one year forward earnings yield on Australian shares is 7% compared to a typical corporate bond yield of 6.6%. Normally, the corporate bond yield is above the earnings yield. In the US, it's even more favourable, with a one-year forward earnings yield on US shares of 6.8% versus a typical corporate bond yield of 5.8%. See the next chart. So borrowing to finance a takeover is an attractive proposition.

• Finally, industry specific developments such as the relaxation of media ownership laws in Australia have also played a role in recent M&A activity.

It has further to go

Our assessment is that the M&A boom has further to go. While the number and value of deals has increased dramatically, when looked at relative to the value of the market as a whole, M&A activity remains relatively modest compared to the situation in the past, particularly compared to the late 1980s. The current level of M&A activity is still too low to be regarded as a sign of excessive market exuberance as some commentators are suggesting. This is also the case in the US and Europe.

More fundamentally, though, the key drivers of the recent upswing in M&A activity are likely to remain in place for a while yet.In the absence of a hard landing for economic growth or a wages surge, both of which are looking unlikely, corporate profitability looks set to remain strong. The phenomenon of excess global savings looking for a home is unlikely to go away anytime soon. With inflation and interest rates likely to remain relatively low, the funding costs for M&A deals will remain low. And investor interest in private capital funds is likely to remain high given the solid returns they have been able to generate over the long-term.

It's also worth noting that generally speaking the M&A activity occurring today appears to be far more soundly based on generating a higher rate of return on capital than the speculative asset shuffling and casino type mentality that prevailed in the late 1980s, particularly in Australia.

Implications for the share market and investors

• Firstly, M&A activity tends to push the share market higher. This is because it typically reduces the amount of shares on issue in the market and puts cash into the hands of shareholders in the acquired company that usually has to be reinvested back into the share market. The latter is notably the case for companies acquired by private equity firms via LBOs and takeovers of domestic companies by foreign companies.
• Secondly, M&A activity makes stock-picking harder, particularly for growth style investing. The range of factors driving the recent bout of M&A activity have meant that a large range of stocks have been subject to such activity. The focus, though, often tends to be on companies that have been performing relatively poorly for whatever reason because they provide turnaround potential or are seen as cheap from a long-term perspective. This makes life tough for investors who may have rightly avoided such stocks due to a cyclical downturn in the industry they are in or due to perceived management problems.
• Finally, to the extent that M&A activity reduces the number of stocks on issue it may reduce the breadth and depth of a relatively small share market like Australia's. This is particularly the case where foreign takeovers are involved. However, this concern should not be taken too far. Bouts of industry/listed company rationalisation have always been a factor in the share market. Yet, if viewed over a long period the breadth of the share market has improved thanks to the growth and listing of new businesses, privatisations of public sector entities and of course the re-listing of companies that may have been taken private a few years earlier by private equity firms.

Conclusion

The value of M&A activity relative to the value of the market as a whole remains relatively tame compared to past extremes. Certainly current levels of such activity are too low to be regarded as a sign of excessive market exuberance. The forces driving M&A activity look set to continue for a while yet and this will help provide further upwards pressure on share prices.