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Here’s some good news for merger/arbitrage funds, market punters and corporate financiers. The fall in the cost of capital (equity and debt) is enough to support $2 trillion of global deals this year.
That’s the view of Citigroup strategist Robert Buckland, who believes we are in the foothills of a 5-6 year M&A cycle that will peak in 2013-14. As he argues:
Global M&A activity is beginning to recover. Since the start of the year, a number of large deals have been announced including Novartis buying Alcon ($39bn), America Movil buying Carso Global ($24bn) and MetLife acquiring ALICO ($16bn). Deal value in 1Q10 of $550bn is up 13% against 1Q09. It has been the second consecutive quarter of higher M&A activity. This includes completed or pending acquisitions involving listed companies and is equivalent to about 6% of global listed market cap.
Indeed it is. Arriva, the bus and train company, recommended a £1.58bn cash offer from DeutscheBahn on Thursday, while Qwest Comunications and CenturyTel are reportedly discussing a $20bn merger.
And given the fall in funding costs, Buckland says there is no reason to believe deal-making won’t continue.
M&A has generally slowed when the cost of capital has risen (ie markets fall). From 2000 to 2002, the average cost of equity rose, making it less attractive to do a deal. Similarly, from 2007 to 2009, capital markets froze, again deals were harder to finance and M&A activity slowed. More recently, capital markets are beginning to thaw. For example, the rise in world share prices has lowered the price of equity capital. On our measure, the cost of global equity financing has fallen by more than 70 basis points from 2009 averages. Meanwhile, tighter credit spreads have pushed down the cost of debt. Baa-rated corporate bonds in the US yield 100 basis points less than they did last year. As the global capital markets continue to recover, so should M&A activity.
At current costs of financing, we think listed company M&A activity can reach levels we saw in 2004 or even 2005. Back then there was $1.5-2.5 trillion worth of deals involving listed companies. We forecast about $2 trillion for this year.
As for the mountain of academic research which supports the notion that M&A just transfers value from one set of shareholders to another, Buckland says that will be ignored, because animal spirits always prevail:
It remains a fact of finance that CEOs of bigger companies get paid more than those of smaller ones. We illustrate the relationship between CEO compensation and company size in Figure 4 [below, click to enlarge:].
There is a clear positive correlation. CEOs of companies with a market cap of $80bn or more in the US enjoyed median compensation of about $1.8m in 2008-09. In some cases, it is considerably higher. Meanwhile, CEOs of companies between $10-15bn in market cap got paid about 40% less. Unfortunately for shareholders (and capitalism in general), we fail to find the same strong correlation when we look at the relationship between corporate profitability and CEO compensation.
At the moment most of the global M&A activity seems to be concentrated in the US. However, Buckland says that could change. with the UK and Europe as the biggest beneficiaries.
That’s because they are the cheapest equity markets in the world and the UK has (for the moment anyway) a history of allowing, large, cross-border deals.
We suspect that perhaps the most important driver of deal activity is that managements are personally incentivised to make their companies larger.
The lowest cost of equity (highest PE) is currently in Japan, Developed Asia and the US. It makes sense for companies in these regions to acquire using stock. The cheapest equities in the world are in the UK, Continental Europe and CEEMEA. Companies in these markets may be the most attractive M&A targets
And to finish, here’s a list of companies Citi thinks could be takeover targets. Most of them of UK-listed companies. Somebody better call Meddling Mandy.
Related link: Prospect of stiffer UK takeover rules – FT
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