The return of risk appetite to the boardroom, boosted by vaccine rollouts and strong growth over the summer, has led to a surge in global mergers and acquisitions activity. Around $4tn of deals have been announced since the start of the year, putting 2021 on track to break the previous record set shortly before the financial crisis (strong though these numbers are, the volume of activity, if adjusted for growth in equity values, is below the previous peak).
Deal volumes move with the economic cycle. M&A activity peaked during the booms that preceded the recessions of the late 1990s, the dotcom bust of the early 2000s and the financial crisis. A recession, or a shock like the pandemic, reduces risk appetite, making management wary of extending their balance sheets. As the economy recovers, acquisitions rise, aided by low interest rates and more attractive valuations.
This cycle has been different. Extraordinary levels of government and central bank support have raised asset prices and valuations. After the dotcom crash and the financial crisis, it took six years for US equities to regain their previous peaks. Last year US equities recovered in just six months and today they stand 30% above the peak seen on the eve of the pandemic. This has meant fewer ‘cheap’ assets than in the wake of previous recessions.
This cycle is different in another way. The private sector has emerged from recession with ample funding to buy assets. Levels of cash on company balance sheets have never been higher. Interest rates are low, making debt, the preferred method of funding deals, attractive. Buoyant equity valuations enable acquiring companies to make purchases through stock offers.
Private equity firms represent another source of capital. Private equity firms had accumulated $2.5tn of undeployed capital by the middle of this year . The purchasing power of this capital is magnified by low interest rates which enable private equity to deploy debt finance on a large scale. Low interest rates have also depressed the return on traditional assets, such as bonds, and led wealth managers and institutional investors to increase the amount of capital they allocate to private equity.
The weight of money competing for opportunities is driving up prices. Last week the FT reported that private equity firms are offering the highest premiums for listed companies in more than 20 years, an average of 45% above the share price for European companies. Some recent bids have been even greater. US private equity firm Clayton, Dubilier & Rice offered a 61% premium for the UK supermarket chain Wm Morrison.
M&A is also spurred by the disruption of existing industries and processes, and the pandemic has been a disruptor of historic proportions. Businesses are positioning for lasting change. M&A offers a quick route to increased capacity, different business models and new, often digital, capabilities. The increase in M&A has been broad-based, but with a focus on acquisitions designed to accelerate technological change. Earlier this year Microsoft announced the acquisition of Nuance Communications Inc, an AI and speech recognition software company focused on the healthcare industry, for $19.7bn and recently Uber purchased US food delivery service Postmates for $2.65bn. The acquisition of technology firms has accounted for 25% of deals so far this year.
Rethinking supply chains will also drive business change. In recent decades the production process has been broken into small components in search of efficiency. Today’s supply shortages demonstrate that it has also created vulnerabilities. Vertical integration of operations, reversing some of the earlier disposal of assets, offers a way of mitigating such vulnerabilities. M&A offers a quick way of doing just that.
A number of factors operate to support M&A activity in the UK – a significant private equity industry, the large number of multinationals based here, liberal takeover laws and liquid capital markets. Inward M&A has been boosted by the UK’s fast vaccination drive and strong growth. Relatively cheap equity valuations – the price/earnings ratio of the FTSE100 is well below US and European levels – and a weak pound, make UK assets attractive to overseas buyers. Refinitiv reports that the number of UK buyouts in the first half of this year was 60% higher than in the same period in 2019, while across the EU it had risen 14%.
But can the surge in M&A last? Supply shortages and rising inflation have created new headwinds and will weigh on activity in coming months. The degree of disruption is looking more persistent, and widespread, than had been thought. Worries about a return to stagflation and higher interest rates have mounted. Set against that, a continued, if bumpy recovery, abundant capital and deep structural change would be supportive of M&A. This doesn’t preclude swings in activity – M&A volumes are choppy at the best of times. But it seems early to call time on this M&A cycle.
PS: UK and European natural gas prices whipsawed last week, setting new record highs before falling back on news that Russia might increase deliveries. Supplies remain uncomfortably low heading into the winter, although European storage levels are making up some of their lost ground. Although the UK’s consumer energy price cap rose 12% last week, the prices suppliers can charge are still well below their wholesale costs. Industrial companies that are directly exposed to wholesale prices have curtailed operations, with British Steel saying that it is unprofitable to produce at certain times of day. Higher prices will squeeze consumer spending power and dampen activity. But price caps and subsidies run the risk of boosting demand ahead of supply, and this is one of the factors contributing to China’s current power shortages. If supply and demand do not budge on their own, the weather will be the deciding factor. A mild winter would reduce heating demand and faster wind speeds would increase wind power and ease demand for gas. As of Friday, UK gas futures showed gas prices falling after the winter but remaining historically high in 2022, only returning to pre-pandemic levels in spring 2023. That said, prices can move sharply on new information. If the supply picture improves or the weather cooperates, a sharp correction could ensue. Here’s hoping for that.
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