By Satyajit Das at MarketWatch
Merger and acquisitions activity worldwide reached $4.6 trillion in 2015, higher than the previous record of $4.3 trillion in 2007. But this latest M&A wave is perversely driven by weak, rather than strong, economic conditions.
A striking feature of the past five years, following the Great Recession, has been lackluster revenue growth across many industries. This reflects slow economic growth rates, low inflation, weak wage-growth, overcapacity, and a lack of pricing power. Higher profitability has been driven by cost savings, rather than increases in revenue.
M&A growth, accordingly, reflects the need for companies to adjust to a world of prolonged low-growth and disinflation.
Some transactions reflect a company’s goal of increasing scale. The objective is industry consolidation, removing excess capacity, and reducing costs through economies of scale and scope.
Other transactions are focused on buying growth, in form of new products or entering new markets. For example, pharmaceutical companies increasingly are externalizing research and development. With new drug development and commercialization now expensive and difficult (estimated at around $2-$3 billion for a new treatment), larger, less-flexible firms now rely on smaller firms and start-ups for new products.
Technology companies as well have purchased smaller firms to provide add-ons to their existing portfolio or customer base. Retailers and financial services firms have acquired innovations to address changes in client behavior, delivery platforms, and to participate in the high-growth technology area.
Firms also have purchased businesses that give access to emerging markets, where growth is stronger, or to link into cheaper supply-chains to lower production costs. In Japan, for example, demographic factors influence cross-border acquisitions among banks and insurers, along with companies involved with beverages, cigarettes, and media.
Other M&A transactions are opportunistic and take advantage of environmental factors, such as low commodity prices. Mergers and acquisitions in resources and oil services by stronger players are motivated by the financial weakness and low valuation of lesser rivals.
Another factor in the M&A boom is a change in investment strategy. Sovereign wealth funds are increasingly diversifying away from financial assets to real businesses. This reflects their concern about highly manipulated and illiquid financial markets, as well as a priority on having direct access.
Emerging-market firms are also buying operations outside their home country to diversify political and economic risk. For example, Chinese companies are aggressively investing outside of China in areas such as energy, technology, semiconductors, agro-chemicals and financial services. Key drivers include China’s slower domestic outlook, the weakening yuan, and growing political uncertainty.
Some transactions, meanwhile, are tax driven, with companies seeking to invert their jurisdiction or domicile using acquisitions in order to lower effective tax rates as a mechanism for increasing shareholder returns.
Loose central-bank monetary policy also has facilitated M&A activity. Ample availability of funding at historically low rates and credit margins has helped finance activity. Facing subdued loan demand, banks have been keen lenders into such transactions. Searching for yield, capital market investors have been eager buyers of debt, both investment and increasingly non-investment quality, originated to finance mergers, acquisitions, and corporate restructurings.
Low interest rates and quantitative easing programs have also lowered equity risk premiums, driving stock prices higher. This has increased share prices, allowing companies, particularly in technology and biotechnology, to use their own stock as currency for purchasing businesses at elevated valuations.
There is little new in this latest round of corporate activity. As in previous cycles, valuations are now increasingly stretched. Average deal multiples (purchase price as a multiple of earnings before interest, depreciation, and amortization) of around 10.5 are marginally below the 2007 level of around 11.0. Problems in high-yield markets and rising credit costs also point to shifts in the financing environment that may affect transactions.
Yet history shows that the vast majority of transactions will result in destruction of value. Integration of new businesses will likely prove expensive and problematic. Cost reductions will be difficult. Synergies will be elusive. Unknown liabilities will emerge. Undoubtedly there will be transactions which join the pantheon of disastrous mergers.
From a broader perspective, mergers may reduce jobs and lower incomes. Given that most developed economies are based on 60%-70% consumption, this would dampen an already weak recovery.
It also points to crucial changes in industrial structure. Companies once concentrated on researching, developing, manufacturing, and selling new products and services. Over time, some evolved into brand management, marketing, and distribution. Today, businesses increasingly are asset traders, with some attached residual operational functions. They are difficult to distinguish from fund managers who identify, purchase, and sell investments.
Mergers and acquisitions have underpinned stock prices, generated fees for investment banks and consultants, and allowed private equity to prosper. But the impact on the economy at large may be less positive.