Fantasy M&A is back again, again

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Companies buy companies when they’re expensive, not when they’re cheap. That’s been the rule of M&A since forever, though in the past couple of years the trend has broken down a bit. Chart from Barclays:

Why? Debt.

The effects of rising interest costs have been felt even harder in private markets:

And have been particularly hard for investment bankers:

But you know all this already. You’ve clicked for some fantasy M&A copium about rates rolling over, corporate balance sheets being healthy, dollar strength encouraging cross-border activity, and credit markets being ready to support some good old-fashioned value destruction.

Barclays provides:

The Fed pivot in December has reduced both the level and uncertainty about rates, and likely helped cement the now consensus view of a soft landing instead of a recession. We think the main impediments to capital market activity, therefore, look to be reversing all at once. Falling rates and more confidence in the economic outlook have already started to show up in M&A in Q3/4, with QoQ volumes and value picking up from the depressed levels of 2022/1H23.

For evidence of animal spirits returning, Barclays points towards a rally since November for PE and investment bank share prices. The bounce preceded reports such as this one that firms are finally willing to crystallise portfolio losses to unbung the fundraisings pipeline.

The bank also highlights that EU net-debt-to-equity ratios are below the long-term average in general and near trough levels in the natural resources, construction and autos sectors:

Stocks might look prohibitively expensive but that’s just US tech, Barclays says. Valuations elsewhere “remain quite subdued relative to the level of earnings they are producing, again likely due to the rates and economic uncertainty that has been stalking the markets”.

Sure, yields have gone up a lot. But measured by equity risk premium — forward earnings yield versus local bond yield — equities are cheaper than they were during the AOL-Time-Warner-to-RBS-ABN-Amro era:

And what would an M&A strategy note be without some heady measures of dry powder?

Add in $140bn of US investment-grade debt issuance in the year to date, the highest run-rate on record, and credit spreads at the lowest levels in 15 years. With credit markets so amenable you’d be mad not to buy something!

Then there’s the three-year refinancing wall. Barclays expects companies in sectors including real estate to be pushed by necessity into seeking a buyer:

How to trade it all? Fill your boots, says Barclays, whose buy recommendations include but are not limited to small caps . . . 

SMIDs have de-rated significantly since rates began to rise, given their higher leverage and despite their resilient earnings. Their lower valuations and resilient fundamentals could make them more attractive as potential acquisition candidates, while the latest ECB Bank Lending Survey showed a small increase in demand for loans to firms for the first time in two years. More broadly, we believe the valuation argument also holds for European and UK large caps, which are trading on depressed valuations vs. their US peers (even excluding big Tech). We note that European companies tend to become potential targets when the currency depreciates vs. USD.

… diversified financials . . .

We think there are two benefits for the private capital industry: 1) increased deal volumes and exits in PE should allow carried interest to be realised within portfolios, which should drive incremental revenue growth; 2) realising cash into portfolios should allow cash distribution either for redeployment to new deals or to existing investors, which in turn could speed up new fundraising cycles and thus support higher valuations. Exchanges could benefit from seeing a return of higher margin IPO activity. More broadly, the prospect of rate cuts may prompt cash reallocation away from money market funds and into fixed income / equity funds, benefiting asset managers. EU banks are also potential M&A actors themselves, and IBs should be set to benefit from any increase in transaction volumes, in our view.

… and miscellaneous others:

Our sector analysts see potential for a pick-up in M&A/capital market activity in Banks, Real Estate, Construction Materials & Infrastructure, UK Housebuilding & Construction, Airlines, Logistics, Aerospace & Defense, Telecoms, Internet and Pharmaceuticals. Within VC, we believe focus will remain on Artificial Intelligence enablers and applications as well as CleanTech.

If that’s all too woolly, Barclays also offers clients a quant basket of European companies that screen for high growth with low valuation, leverage and profitability. Here’s what the basket looked like in mid November:

Barclays says it can’t share with us its current list and the office Bloomberg doesn’t have the relevant permission to view constituents, so some of the names below might be stale. What we can say is that the basket’s down 5 per cent in the year to date, with a 52 week total return of minus 7 per cent, though that perhaps misses the point of an M&A screen.

And if all this stuff looks familiar, that’s because it is.

Further reading
— Mergers destroy value. Without reform, nothing will change (FTAV)