- M&A activity has slowed down in 2016 but may increase as BREXIT, China worries cool off and central banks print money.
- Price to EBITDA premiums have surpassed 2007 levels.
- The average premium for targets is 37%, which is a pretty good additional return on your investments.
A beautiful situation in investing is when a company you own is being taken over at a lofty premium. In this article we are going to discuss the current M&A market, what it means for the market in general, and take a look into the sectors that offer the best consolidation opportunities.
Low interest rates push corporations to make acquisitions, but high valuations also make doing so risky. The valuations paid for acquisitions have hit highs not seen since 2007, with the average price to EBITDA multiples being above 11.
Figure 1: Price to EBITDA in acquisitions. Source: Bloomberg.
With many market uncertainties—like the BREXIT, the FED and interest rates, and the upcoming elections—M&A activity has slowed down, with the aggregate deal value being nearly half of what it was in 2015, and with the number of deals also declining.
Figure 2: Aggregate U.S. deal values. Source: FACTSET.
2015 was a record year for M&A with a total $3.8 trillion spent on deals, which was higher than the previous record set in 2007. In October 2015, 60% of managers expected to make an acquisition in the next 12 months but the small market crisis this winter, which in fact lowered prices, pushed down the M&A confidence barometer to 50% in April.
Figure 5: Expectations to pursue acquisitions. Source: EY.
High valuations force companies to make big deals. The figure below shows how the five biggest deals of Q2 2016 make up almost 20% of all M&A activity.
Figure 4: Five biggest deals of Q2 2016. Source: Bloomberg.
M&A Destroys Shareholder Value
An oft posed question is: why do managers insist on M&A when it is known that it destroys shareholder value? This is especially true at high multiples and as seen above, the higher the multiple the more M&A activity there is.
Well, managers are becoming better at acquiring companies and assessing their value, and there are fewer and fewer acquisitions where the main target is the other company’s brand new corporate jet. The added value has recently been slowly climbing.
Figure 5: Added value in M&A measured by increase in stock price after announcement. Source: The Economist.
However, increases in stock prices might mean that the market is in an optimistic mode. A longer term perspective will show us that the returns are terrible for companies that engage in M&A. By looking at returns after 3 years or longer from an acquisition, the returns are clearly negative.
Figure 6: Longer term acquirer returns (three years). Source: Schroders.
According to the National Bureau of Economic Research, only small firms can benefit from making acquisitions. Over the past 20 years large firms have destroyed $226 billion of shareholder wealth, while small firms have created $8 billion.
To sum it up in style, it is best to quote NY Stern Professor Ashwath Damodaran’s lecture:
I think valuations in M&A are a waste of money and a waste of time. You know why? The value of a target company is always whatever you decide to pay plus $10. Why do we go through this charade? And think of why. You’re my investment banker right? I come to you for some advice. ‘I’m thinking about buying this company, should I buy this company?’ Now think about the two possible answers you can give. ‘You know what, based on the numbers, the deal doesn’t make sense.’ In this case what do you get? The undying gratitude of my stockholders. But try paying bonuses with that. The other is that you can tell me: ‘the deal makes sense.’ In which case you make $50 million.
This is a no brainer. This is like walking up to a plastic surgeon: ‘Is there something wrong with my face?’ What’s the plastic surgeon going to say? ‘You’re perfect.’ His job rests on finding something wrong with your face. There’s too much bias in the process. And its not the investment bankers’ fault, because if the deal maker is also the deal analyst, you’re begging for this kind of conflict.
I’ve never understood. We’re going to talk about the acquisition process, which I think is the most screwed up process. More value is destroyed by acquisitions than any other single action taken by companies. And I think at its root the process is screwed up. Until we fix the process, the valuations are pointless. I guarantee you there is a valuation of AOL in some investment bankers folder somewhere that justifies what Time Warner [paid]… You take the worst deals in history, there is a valuation back there.
With the high valuations and historical negative returns, there is one clear conclusion, it is better to be acquired than to acquire. Therefore, to create positive returns we have to look at smaller companies as they usually have positive returns, both as a target and as an acquirer.
The sectors where the biggest number of acquisitions are expected are oil and gas with 59% of companies ready to make deals in the next 12 months. This is due to low oil prices and many companies being under heavy liquidity pressure, thus the more liquid companies will hunt for bargains and hope for an uptrend in oil prices. Look for debt stressed companies with low cost producing assets.
The same 59% level is in the consumer product and retail sector where low margins and competitive pressures make M&A look like the only option for growth. Unfortunately at high valuations, this will destroy shareholder value, but if you are on the target side some nice returns can be made. The latest example from the sector is Walmart acquiring Jet.com for $3 billion.
The power and utilities sector is also busy with 58% of companies expecting to make an acquisition in 2016. This sector is one of the most boring sectors, and the best way for growth is through M&As. Companies that have a business and geographic territory that bodes well for a bigger player might be a great target, especially if interest rates start to increase. Locking up a long-term low interest rate to make a profitable acquisition looks like a good thing to do at this point for power and utilities companies.
Another sector where growth is related to GDP is the diversified industrial products sector where M&A are the only option to achieve above average returns. 55% of these companies expect to make an acquisition in 2016.
Smaller chemical companies might also be targets as German BASF has assembled a task force to help it look at potential targets.
M&A are good to keep in mind when creating a portfolio. If you buy AAPL, you can be sure that no one will take it over. But by buying smaller companies that can be an attractive bait for large corporations, you increase potential returns by an average one time hit of 37% at the announcement of an acquisition.
On the other hand, holding big corporations that take over a lot of targets can be risky because their acquisitions create growth but that growth doesn’t result in increased shareholder value, by increased shareholder value we mean increased earnings per share.
To conclude, from an historical perspective, the latest M&A activity and deal valuations signal an overheating market. As always, we do not know exactly when the market will turn bearish, but a good acquisition premium on some takeover targets in our portfolio might be a good reward for the current market risks.