As one can sense from all the news about mergers and acquisitions lately, these deals are booming again worldwide. What's new this time is that markets are rewarding the buying companies and not just those being sold. Why is this happening?
Global M&A activity since January has increased at its fastest pace in 14 years. Big transactions, in particular, are surging; there have been roughly twice as many above $10 billion in value so far this year than at this point in 2013.
What is striking about the recent activity is that the companies doing the buying are being richly rewarded by the market. Usually, the market's response to buyers is negative or, at best, tepid. (The sellers are a different story.)
In particular, as a new report by my colleagues at Citigroup Inc. shows, in the 74 "transformational" deals -- deals that are either greater than $10 billion, or $5 billion to $10 billion, and at least 40 percent of the acquirer's market capitalization -- since 2011, the buyer's stock price has appreciated by an average of 1.5 percent, relative to the market as a whole, around the announcement of the deal. (Disclosure: I am the chairman of the Financial Strategy and Solutions Group at Citi, which produced this report.)
Also, during the year following the announcement, the buyer's stock has experienced, on average, a 5.6 percent risk-adjusted excess return. And for the smaller number of recent deals on which returns can be measured over three years, the extraordinary performance has continued for that long.
What could be causing the market to have such a strong positive view of recent deals? A combination of slow economic growth and low interest rates, along with diminishing returns for share buybacks, may help explain it. Here's how.
In a relatively sluggish economy, it's harder for companies to generate fast revenue growth, and investors seem to believe that it's becoming more challenging to boost earnings growth by further streamlining existing corporate operations -- the strategy that was deployed heavily over the past several years. Nonetheless, equity markets are still pricing in relatively rapid earnings growth: 2014 earnings projections are significantly higher than global GDP forecasts.
Because organic growth alone is unlikely to deliver the earnings growth investors want, strategic transactions that can deliver increased earnings are worth more than usual. During times when there are more opportunities for rapid organic revenue growth, in contrast, investors see less need for inorganic growth alternatives.
A related mechanism may be at work in the present M&A boom: Over the past three years, 15 percent to 20 percent of growth in earnings per share has come from companies buying back their own shares. Such activity typically has diminishing returns, however, as the market becomes skeptical about the sheer number of share repurchases. As companies approach this threshold after years of substantial buybacks, the relative return for mergers and acquisitions may increase.
A final characteristic that distinguishes the current environment is very low interest rates. The value of a merger sometimes needs time to take hold. Given the time value of money, earnings gains from a combination that take years to be realized are valued more when interest rates are low than when they are high.
Also, when interest rates are low, buyers have little trouble financing large deals. Strong stock markets make it easier to use equity as financing, debt markets continue to offer low-cost financing, and companies have large cash reserves that can be tapped. The markets have lately been happy with deals regardless of how they are financed, though cash- or debt-financed deals have done a bit better than others. Those financed mostly by equity had one-year excess returns of 4 percent, compared with 11 percent for those financed mostly by cash or debt.
If excess M&A returns stem largely from slow economic activity and low interest rates, then they are more likely to continue if the economy is truly experiencing "secular stagnation," in which low growth is the new normal. In a forthcoming column, I'll talk about the prospects for avoiding that and getting to faster economic growth.
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Peter R Orszag at firstname.lastname@example.org
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