M&A deals are becoming more expensive. Is the market overstretched?
With interest rates at historic lows and stock markets in record territory, a lot of merger and acquisition (M&A) deals are being done. This boom in expensive M&A activity also indicates that the market is overstretched
One of the laws of finance is very simple. If investors have too much money, they do not spend it wisely. This should be obvious to anyone, but a central banker. But since central bankers have devalued money, it has less value and is spent foolishly. One more recent example has been the boom in mergers and acquisitions.
Companies which feel that they cannot gain sufficient growth internally will often try to buy it. They usually use two different types of currency: their own shares or cash. They use their own shares when those shares are far more expensive than the rest of the market. This happened during the dot-com boom. Then shares of telecom, media and technology stocks had valuations that were far above those of other sectors. With the irrational valuations, they were able to use their stock to buy whatever they wanted.
The other currency is cash. Well not cash exactly. Really debt. During the last mergers and acquisitions boom in 2006-2007, it was easy to sell bonds, and loans were easy to get. So buyers used cash. Like today, with certain exceptions in technology and biotech, most sectors had about the same value. So there was no reason to use stock. Today, thanks to profligate central banks, debt is far cheaper. Even though the companies are very expensive thanks to record stock prices, there is still enough money around to finance the deals.
As you would expect with interest rates at historic lows, a lot of deals are being done. Depending on the metric, approximately $1 trillion dollars worth of deals have been done this year. If this rate continues, it will be the third busiest year behind 2006 and 2007. I assume, I don’t have to remind you of what happened in 2008. High mergers and acquisition activity is one of the many signals indicating that this market is over stretched and is likely to come down.
Another negative indicator is the type of deal. Stock markets are in record territory so even a friendly deal is bound to be expensive. This year according to information firm Dealogic, more than 15% of the deals are hostile. This is higher than any year since Dealogic began to track them in 1995 and the highest since 1999 a year before the dot-com crash.
The problem with hostile takeovers is the price. Hostile takeovers can involve raising the price to make it more attractive to shareholders or worse, a bidding war. For example, meat company Tyson Foods had to pay a 70% premium over the pre-bidding price to shareholders of Hillshire to beat out another suitor, Pilgrim’s Pride.
Even friendly deals are expensive. European private equity firms are paying an average price of 10.4 times earnings before interest, tax, depreciation and amortization (EBITDA). This compares to 8.7 times EBITDA last year and it is even more than the 9.7 times EBITDA that companies were paying at the top of the credit boom in 2007. The US deals are a little cheaper. They average about 9.2 times EBITDA up from 8.8 last year, but below their 2007 peak of 9.7.
Many deals by US companies are not even about growth. They are about taxes. The US tax rate for corporations is theoretically 35%, although there are many who pay much less. A recent report that studied 288 of the top 500 US corporations found that they paid an average rate of 19%. Twenty-six of the corporations, including Boeing, General Electric, Priceline.com and Verizon, paid no federal income tax at all, over the study’s five year period. A third of the corporations (93) paid an effective tax rate of less than 10% over that period. But as any taxpayer will tell you, any tax is still too much.
One method to avoid even more US taxes is to reincorporate in a more tax friendly jurisdiction. The scheme is called inversion. It usually involves a US Corporation buying and then merging into a foreign corporation and claiming that corporation’s jurisdiction as its domicile. The scheme allows the formerly US corporation to keep profits off shore and away from US taxes. It also allows US corporations to make use of off shore profits.
There so far have been 15 transactions of this sort over the past two years. Over 50 US companies have used inversion to establish domiciles over the past 20 years since tax planners developed the idea. The idea that these mergers make money has its own following of hedge funds, which have bet billions of dollars on companies they believe will be taken over in inversion deals.
The problem with all this activity is that it can be ended with a stroke of a pen. Tax law changes constantly. Congress has been trying to stop inversions by making small changes in the tax code. These haven’t so far worked well because they have been easy to get around. The best way to end inversions would be simply to cut the corporate tax rate to 25% and pay for it by getting rid of corporate allowance, deductions, credits, and exemptions. This could easily happen even with today’s divided Congress.
But the final and largest problem with the present mergers and acquisitions boom is not that it puts the companies into too much debt, not that companies are over paying and not that they are consummated for ephemeral tax reasons. The real problem with mergers and acquisitions is that they don’t work.
Depending on how you define figures, the failure rate from various studies range from a mere 50% to 90%. So there is an exceptionally high probability that a merger will harm shareholder value.
Another rule of finance is that all economies have cycles. Eventually interest rates rise. Booms end. But using excess debt to buy over priced companies that don’t help a firm to grow, can create problems that last for much longer.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)
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