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Sense of the markets: Equities up, M&A lags

by contributor Jane Searle | Published May 8, 2013 at 9:30 AM

The market rally is acting as a handbrake on M&A activity as dealmakers balk at the contrast between pricey valuations and a lackluster economic outlook.

Both the S&P 500 index and the Dow Jones industrial average have rallied about 14.5% in the past six months to new highs, even as corporate earnings growth stays flat and gross domestic product lingers around 2%.

Advisers say that potential acquirers are paying attention to this discrepancy, even as equity investors turn a blind eye.

"The rise of shareholder activism is causing corporations to stick to their knitting to ensure they have a clear strategic focus for deals," said Eric Shube, head of Allen & Overy LLP's U.S. mergers and acquisitions practice.

"So there's a shyness about initiating transactions that might be accretive to earnings but are not necessarily a [strategic] must-do."

Strategic megadeals initiated in the first quarter included Warren Buffett's $23 billion tilt at H.J. Heinz Co. and the proposed $24.4 billion leveraged buyout of Dell Inc.

But practitioners point to fewer small and midmarket deals as symptomatic of low corporate confidence.

In the first quarter, 814 deals had a value of less than $1 billion compared to 1,019 deals in the prior corresponding period. Similarly, there were 624 deals with a value of less than $100 million in the first quarter of the year against 830 similar deals in the prior period.

Overall, 2,628 deals in the first quarter represented a drop of 15% on the same period in 2012 according to Dealogic.

Shube said conditions for M&A had never been better -- with zero interest rates, supportive equity markets, and plenty of corporate cash.

"But the number of deals are down and we have to ask, why? There's concern at the CEO level -- perhaps they're not as confident about the future as equity markets about earnings or the future political environment," he said.

Greenhill & Co. CEO Scott Bok also pointed to the dampening impact of strong equity valuations.

"The recent sharp rise in equity markets may have resulted in an increased gap between the valuation hopes of those looking to sell assets and the willingness to pay of those looking to purchase them," he told investors recently.

At its results in April, Greenhill management noted relatively few first-quarter transactions had reached the announcement stage, while rival Lazard said M&A revenues were down 37% for the quarter.

Some equity strategists argue listed company valuations are not expensive based on historical measures, pointing to previous booms in 2007 and 2000 when valuations were even higher but M&A activity was strong.

Instead, UBS chief equity strategist Jonathan Golub suggested poor economic fundamentals and a weak earnings outlook were of greater concern to potential acquirers.

"If you thought economic growth was self-sustaining, would the government be pumping in trillions and the European Central Bank be preparing [for similar stimulus]?" he said.

Golub said cyclically low M&A activity was a symptom of still-subdued corporate confidence.

"Corporate cash levels are high even though interest rates are low, so companies obviously don't think it's a self sustaining recovery either," he said.

As a result, Golub said equity investors were likely to be left holding the bag when the rally faltered, suggesting markets had run hard on diminished macroeconomic risks rather than an improvement in earnings.

Sidley Austin LLP M&A partner Stephen Blevit said the reason for a lack of activity was simple. "What I hear from clients is they're just not finding good deals at reasonable valuations," he said, echoing the idea that the rally had acted as a crimp on merger activity.

"The opportunities out there have high valuations and clients want good bargains."

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Sense of the markets: Equities up, M&A lags

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