After Mergers and Acquisitions activity picked up in the second half of 2009, commentators, economists, and bankers alike were divided with regard to what 2010 held in store. The divide was vast, ranging from predictions of a “perfect storm” for M&A by Goldman Sachs to expectations of another downturn. While predictions of a robust comeback have yet to pass, after what has transpired the past few years M&A is doing better than expected. After a steep drop in 2008 and again in 2009, the value of overall deals has leveled out so far in 2010. When history is considered, even a breakeven year in the wake of such an economic contraction is something to feel good about. In the grand scheme of things, 2010 is currently on pace to transpire as a lukewarm year for M&A.
As I covered in January, M&A activity through the first half of 2009 was dominated by a few mega-healthcare deals (Wyeth/Pfizer and Schering/Merck), and a great percentage of investment banking revenue came via assignments to help companies of all sizes shore up their balance sheets. Activity on both the traditional M&A and Private Equity sides began to pick up at the end of the summer. The final three months of 2009 featured activity from industries across the board. Highlights included Exxon buying XTO energy, Warren Buffett buying Burlington Northern Santa Fe, and Comcast buying NBC Universal.
Looking back on M&A activity during the past three recessions, the cycle has been about two or three years from peak to nadir. This has been the trend regardless of the downturn’s severity. M&A experienced three down years during and after the 1990-91 recession, and two years after the 2001 dot-com bust. The latter was a particularly tough period, as bulge bracket firms were also reeling from the loss of revenue from underwriting tech IPO’s. Based on current numbers, this year could be shaping up to follow this pattern yet again. As of last week, total deal volume so far in 2010 is merely 1% off last year’s pace. After peaking in 2007, M&A saw year-over-year drops of 41% in 2008 and 22% in 2009, according to Bloomberg. While things are still touch and go, given the two-year cycle and this year’s pace, the M&A market appears to be holding up nicely while not getting ahead of itself.
Additionally, as we all know, the most recent recession has been deeper than the previous two in both its severity and longevity. According to data from the Bureau of Economic Analysis, the 1990 recession saw three consecutive quarters of negative GDP growth from Q3 1990 to Q1 1991. The 2001 recession saw two non-consecutive quarters of negative growth, in Q1 and Q3 of that year. Compare that to five out of six quarters of negative growth from Q1 2008 to Q2 2009, the one exception being Q2 2008 when the government’s stimulus checks helped out. ThomsonReuters columnist Rolfe Winkler wrote last week that, “considering the depth of the latest recession compared to the prior two, one might think dealmakers would still be in hibernation.” That said, it is all the more remarkable that M&A appears to be resilient, sticking to its two-to-three year cycle (refer to Chart 1).
Chart 1 – Annual M&A Volume 1988-2008
Partly in response to the pickup in late 2009, many were quick to predict that 2010 would be a robust year for M&A. A report endorsing this viewpoint was produced by Goldman Sachs in late 2009. Goldman’s view was based on the fact that companies have lots of cash on their balance sheets, with levels rising through and after the recession. In addition to rising cash levels (refer to Chart 2), the report pointed to the environment of low interest rates and the search for non-organic growth potentially leading to what was described as a “perfect storm for M&A.” Thus far, this has not come to pass. That is not to say that the report was completely inaccurate in its predictions, however. While the activity in late 2009 was promising, the momentum seems to have stalled somewhat in the first months of 2010. There are several reasons for this.
Chart 2 – Corporate Cash Balances September 2004 - 2009
First, the reduced activity during the first quarter of 2010 was partially the result of continued volatility in the equity markets. The Dow Jones Industrial Average ranged from just below 10,000 to above 11,200 within the first few months of the year. Heavy volatility is not conducive to M&A activity because buyers and sellers want to have a fairly stable equity environment before they act/make an offer. But that is not to say that big deals did not take place. Energy and Utilities led the way early in the year, with Schlumberger acquiring Smith International and FirstEnergy acquiring Allegheny Energy. As volatility lowered in April, activity saw an uptick, accelerating into May after the so called “flash crash” on May 6. Companies have taken advantage of the lower stock prices since then to make moves. A few all-cash examples of this include Hewlett-Packard’s acquisition of Palm on April 28 and SAP’s acquisition of Sybase on May 12.
Second, despite the largesse of cash on balance sheets, this in and of itself does not mean that companies will be going on buying sprees. While large cash positions increase the potential for activity, in the aftermath of 2008 companies have been treading carefully with regard to using cash for acquisitions, and especially for buybacks of stock. However, after going through an aggressive cost-cutting cycle through the recession, it is possible that companies will be looking in the near future for potential acquisitions where they can cut costs while creating growth, which is inherently difficult to do in a low-growth economy. A few recent examples are the aforementioned FirstEnergy/Allegheny Energy merger, the United/Continental merger, and Century Link’s acquisition of Qwest Communications. Although the latter transaction is all-stock, it is one of the best examples of a synergy-based deal so far this year. While both companies have been cutting costs, they are hoping the synergies from their merger, announced on April 26, will provide more than $500 million in new cost savings, according to ThomsonReuters.
Finally, another sector within M&A that could see a pickup in 2010 is one of its main engines: Private Equity. The reason is that not only do PE firms have lots of cash sitting on the sidelines, they are also potentially racing the clock with regard to investor’s funds. Private equity has largely been on the sidelines since 2007-08 due to the lack of credit, which provides the leverage needed to generate promised returns for investors. Obviously, this is a far cry from the over $1 trillion in buyout deals that were consummated in 2006-07 (refer to Chart 3). An editorial last week in Investor’s Business Daily reported that PE firms have $445 billion sitting on the sidelines that was raised during what is rapidly becoming known as the Second Golden Age of Private Equity (the first was during the 1980s). To have such a sum in one’s coffers doesn’t sound bad at all, but it’s more complicated than that. In short, when a PE firm raises a new fund, it usually has a pre-set time frame in which it can put those funds to work. Most funds have a five to seven year window in which they can legally invest capital, after which investors can start pulling their capital out to look for returns elsewhere. There is a popular saying within the industry that goes, “use it or lose it.”
Chart 3 – Total LBO Deal Volume 2006-2010
Indeed, there is a great amount of capital that will be lost if it is not put to work. Therefore, many firms may accept the reality of lower returns and start investing once again. Of course, this carries the risk that some bad deals may take place. That said, we have seen an uptick in PE deals so far in 2010 compared to 2009. A few of the bigger deals have included the acquisition of Interactive Data by Silver Lake Partners and Warburg Pincus, as well as the acquisition of Dyncorp by Cerberus Capital Management.
For the remainder of the year, there are two main factors that could set the tone for how the M&A sector plays out. First, as always, the equity markets. The events of May 6 sent the VIX to nearly 40, but it has since fallen back to the level it was at just before that day. However, with many market observers pointing to tepid economic data and expecting a pullback, this could change. Volatility could reassert itself, and that could potentially inhibit activity for the rest of the year. Second, as mentioned, private equity will have to continue negotiating with lenders to take advantage of the low-interest rate environment to make use of their investor’s funds. Their success or lack thereof in this will be a major determinant for M&A the rest of this year. Finally, another factor that could make a difference is the situation in the Gulf, which could lead to a few consolidations within the petroleum industry and the associated sectors. Already, the volume of M&A activity in the energy sector has doubled to date this year compared to the same time frame in 2009, according to ThomsonReuters. Total deal volume in the sector stands at $128.5 billion as of last week, compared to $57 billion in the same period in 2009, which also outpaces the volume of $122 billion during same period in 2007. With a robust second half, M&A in the energy sector could surpass the 2007 high-water mark.
In summary, it is reasonable at this time to assert that M&A will have a reasonably good year, possibly breaking the downtrend, but not great compared to some of the boom years. Deal volumes continue to recover and we continue to see companies across with board with cash-rich balance sheets, the same situation existing in private equity. Therefore, the real question should be how much potential activity is built up, and whether or not that potential can be unleashed within the current economic environment. The surest way for this to happen would be an improved economy that leads to increased lending by the banks. It adds a reason to hope the economic recovery continues through the remainder of the year.
Respectfully Yours,
Matthew R. Green
June 18, 2010
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