Special Report, The M&A Cycle: The M&A premium
With announced M&A deals during 2014 reaching levels not seen since the start of the financial crisis, investors could be forgiven for concluding that a significant portion of current equity market valuation reflects the possibility that almost any company might become the target of a richly-priced takeover bid. The values of smaller companies inflate most of all at a time when large corporations are flush with cash.
But fund managers and M&A advisers say premiums for takeover and merger activity exist mostly on a case-by-case basis, primarily for companies that are well-known to strategic acquirers in particular industries. At the same time, sectoral factors have reduced, or obliterated, M&A premiums in industries that face difficult fundamentals. In other sectors, nimble smaller companies have developed global leadership in attractive niches – attaining lofty valuations that acquirers cannot justify, thereby removing potential synergies that are essential to make deals work financially.
Nevertheless, investors ignore the potential of an M&A boom at their peril, and it’s often at the smaller-cap end of the market where the biggest profits can materialise.
“The pick-up in M&A indicates a more attractive environment for investing,” says Sam Cosh, who manages small cap funds for F&C Investments. “We’ve been talking about the potential for this to happen for some time, and it’s certainly helped performance.”
After the unfulfilled expectations of 2013, the past year saw more deals, bigger deals, and strategic deals, according to the M&A index compiled by legal advisers Allen & Overy – 730 public deals through October 2014 compared to 537 in the same period of 2013; 1,135 global cross-border transactions for the period, up from 891 in 2013; and 70 deals over $5bn (€4bn) compared with only 52 in 2013.
Advisory firm Deloitte says nearly 85% of the 2,500 corporate executives surveyed in its M&A Trends report expect sustained – and perhaps accelerating – merger activity in 2015. Overall, M&A participants expect to see a growing number of small to mid-sized strategic deals as abundant cash on balance sheet forces corporations that have already engaged in share buybacks to consider acquisitions as a means to increase shareholder value. Deloitte projects financial sponsor-related deal volume could see a notable recovery as allocation into alternative equity continues to improve, pressuring deployment of pent-up dry powder at private equity firms.
But no single deal can affect the index value, and dealmaking activity by itself “certainly hasn’t translated into a premium”, says Cosh. Far more important, he says, is for investors to answer a basic question for each company – “Why would I buy that?” All companies in a sector aren’t equally attractive, he notes, and the answer sorts winners from also-rans.
“In my portfolios, I own some really great businesses that I believe are very well positioned and have very strong cash flows,” says Cosh. “If the wider market doesn’t realise the value of that, then corporate acquirers, who are flush with cash at the moment, will.”
Orange SA’s offer to buy Spanish broadband provider Jazztel illustrates the high stakes that strategic deals can involve for an acquirer. Building its own fixed-line business in Spain would be prohibitively expensive for Orange, says Cosh.
“If they didn’t buy Jazztel, they’d have to exit the market,” he says. But Orange can extract “a massive amount of synergy” from Jazztel, which has a footprint of 3m Spanish households that would be a market for Orange’s mobile services.
The offer reflects the potential value. Orange bid €13 for each Jazztel share, a premium of 34% compared to the volume-weighted average closing price over the 30 trading days preceding the offer. Orange plans to finance the bid with a capital increase of no more than €2bn and the issuance of hybrid bonds. The combination will generate additional revenue and cost savings amounting to €1.3bn, the company said. Including those synergies, Orange said it’s paying 8.6 times the target’s projected 2015 EBITDA.
The TMT sector has been active globally in 2014, as companies strive to secure large positions in evolving broadband and mobile segments in key markets, prompting nearly $460bn of transactions through October 2014 alone, according to Allen & Overy.
The picture is different in other sectors. In energy exploration and production, a sector that’s historically included many smaller-cap names, stock prices are responding solely to the plummeting oil price. “Analysts are struggling to model the right valuations for these stocks,” says Trevor Green, head of institutional equities at Aviva Investors. “Any M&A premium has just evaporated.”
The broader issue preventing markets from incorporating a healthy M&A premium is that managements are simply much more conservative with their capital allocation these days, according to Green. “They’ve got either the high-risk M&A angle, or the low-risk option of buybacks or dividend increases,” he observes. “Shareholders have been very persuasive with management to go the latter route, away from M&A, unless companies are really convinced [that a transaction will generate value].”
Who can blame them? Deloitte found that 90% of corporate executives believe that at least a portion of their past deals failed to generate the expected ROI, and 55% of corporate executives and 54% of private equity managers cite “failure to integrate” as a top concern. The operational and financial projections used to justify deals are too rosy – 28% cite “execution gaps” or failure to capture hoped-for synergies as reasons for M&A moves to fall short of targets.
Despite the pitfalls, M&A data confirm that corporate executives have a hefty appetite for acquisitions heading into 2015, and getting in front of potential small-cap targets can be an attractive strategy. The pursuit of potential small-cap winnings is perhaps most aggressive in the sphere of US equity. After a steep decline that took small caps down by more than 10% during September and early October, the asset class looked undervalued, and global investors wary of weakness in the EU and other markets began moving into US equities. The iShares Russell 2000 ETF attracted $2.93bn in net asset inflows in a single week in October, more than three-times as much as the next most popular ETF.
Do strong inflows foretell small-cap outperformance? “That’s a harder one to argue,” says Cosh. But it’s a sector where cash-rich acquirers will surely be looking for bargains. “One of the attractions of investing in small caps is that the people who make money out of acquisitions are generally not the acquirers, but the ones being acquired.”