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Economic and market conditions are coalescing in favor of a surge in merger and acquisition (M&A) activity. For that reason, investors should consider adjusting their tactical asset allocations to increase exposure to disciplined, early-cycle acquiring companies and to smaller firms that are likely acquisition candidates.
They should also consider merger arbitrage strategies. M&A volumes tend to follow the stock market with a lag, and stocks have had a sharp recovery globally over the past 13 months. Large corporations, which are responsible for most M&A dollar volume, are sitting on record levels of cash, and lenders are opening the credit spigots for such companies. As the economic recovery gains momentum, both buyers and sellers are becoming more confident and willing to pursue transactions.
Acquirers can be broadly classified as either strategic or financial. We focus here on strategic buyers, as they represent the vast majority of M&A dollar volume. (Even at the private equity peak in 2007, strategic deals accounted for four times as much dollar value as did financial purchases).
S&P 500 companies are sitting on an estimated $1 trillion of liquid assets, or over 11% of total assets, up 40% over the past two years. This stockpile is earning almost nothing, while the real cost of capital is extremely low, a combination that is putting pressure on cash-rich companies either to deploy their stash or to return cash to shareholders. While share repurchases and dividends are increasing, low interest rates favor increased deal activity.
Although most investors are mindful that the majority of M&A transactions destroy shareholder value for the acquiring companies, very few are aware that recent research also shows that acquirers participating in the early phase of an M&A cycle generally add value. So, there is an early-mover advantage for those corporate management teams bold enough to initiate deals while their peers remain defensive.
Cash on the balance sheet can be a motivating factor in two ways. Excess cash may leave smaller and mid-sized companies vulnerable to the predations of a larger firm, adding to the external pressure from shareholders to deploy cash in an accretive manner. From a shareholder perspective, the prospect of more deals completed with cash (as opposed to stock) is a plus. Empirical evidence shows that the market reacts more favorably to cash transactions and that cash acquirers are less likely to overpay.1 Over half of the consideration in announced deals so far this year has been cash, according to Thomson Reuters.1 Loughran and Vijh, “Do Long-Term Shareholders Benefit from Corporate Acquisitions?,” Journal of Finance, December 1997; Dobbs, Goedhart and Suonio, “Are Companies Getting Better at M&A?,” McKinsey Quarterly, January 2007.
