The Turn in the M&A Tide?

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The year isn’t over, but the volume of mergers and acquisitions activity in 2015 has already exceeded its 8-year old record. So far, $4.35 trillion worth of deals have been struck worldwide, with a little more than half in the U.S. Interestingly, while private equity played a significant role in earlier M&A booms, the sector has been much less active this year. So far, financial firms have accounted for only 14% of the U.S. total.

According to The Wall Street Journal, private equity firms have been “hamstrung” by two factors: regulator’s efforts to clamp down on leveraged lending, which I discussed in “Dark Clouds Looming for Private Equity,” and their reluctance to be involved in deals where traditional valuation thresholds don’t seem to apply. Simply put, many of the companies being bought and sold are overpriced by historical standards, and even still-ample quantities of committed capital haven’t been enough to alter PE managers’ perspectives.

High multiples and demanding investors

There are a number of reasons why corporate America has been willing to pay up for ostensibly overvalued companies. For one thing, the stocks of many if not most of the parties involved in this year’s deals are trading at relatively high multiples. That is largely a reflection of the broader investing environment. Six years of aggressive central bank accommodation have encouraged investors to drive up the prices of shares in risky and safe sectors alike in a quest for higher returns.

Many companies have consequently felt pressure from “activist” funds and other demanding investors to improve performance and validate the lofty valuations. Along with a lackluster operating environment, this has spurred companies to engage in relentless cost-cutting. However, with no real sign of an economic turnaround and the prospect that conditions could actually worsen in the wake of an impending Federal Reserve tightening, corporate managers have sought to combine their firms with others in an attempt to reduce expenses further and enhance pricing power.

Industries in transition

Such efforts have been especially pronounced in the health care industry. Based on data compiled by Irving Levin Associates, more than $549 billion had been spent on such transactions as of late-November, a volume tally 42% higher than the 2014 record. Among the largest deals announced so far is the $160 billion merger between Pfizer and Allergan, the $55 billion tie-up between Anthem and Cigna, and Aetna’s agreement to buy fellow insurer Humana for $34 billion.

One of the biggest factors supporting the sector’s urge to merge is Obamacare, which has boosted demand for medical services and pushed prices higher. According to the U.S. Census Bureau’s latest Quarterly Service Report, spending on hospitals, doctors and social services rose by 5.6 percent on a year-over-year basis in the third quarter. Moreover, until fairly recently, the health care industry has been somewhat fragmented. According to The New York Times, providers and insurers are seeking greater economies of scale so they can bargain more effectively, improve efficiency, and adapt to a changing landscape where at least some may be forced to assume more of the financial risks associated with patient care.

In Pfizer’s case, tax considerations also played a role. A number of U.S. firms, including Medtronic and Actavis, have in recent years capitalized on a loophole that allows them to combine with an overseas firm and reduce their tax burden in the process. Although these “tax inversion” deals have accounted for a relatively small share of overall M&A activity--about 4 percent in 2014 and 2015, according to CNBC–they have raised the ire of Congress and the Administration alike. Speculation that the U.S. government might step in and bar such transactions reportedly encouraged Pfizer to act sooner rather than later in its deal with the Irish-domiciled Allergan.

Strategic imperatives

In other industries, strategic considerations have undoubtedly been a priority, with many companies seeking to fill gaps, expand reach, and achieve synergies that have a payoff beyond current circumstances. The biggest deal in the energy sector, for example, has been Royal Dutch Shell’s $70 billion agreement to acquire British Gas, the United Kingdom’s largest energy supplier. No doubt some future moves in this area will be driven by concerns about survival. With energy prices having been under pressure for some time, buyers and sellers are seeing expectations converge, especially as external capital becomes scarce.

Market pressure on semiconductor pricing has helped to boost activity in that sector. Citing data from Bloomberg, the Silicon Valley Business Journal reported that there have been “more than 150 chip company deals worth more than $100 billion so far this year–the most in any year except at the end of the dotcom boom in 2000 when M&A hit $115.5 billion in the sector.” The paper highlighted Dialog Semiconductor’s $4.6 billion Atmel acquisition, Avago Technologies $37 billion takeover of Broadcom, and Intel’s $16.7 billion purchase of Altera.

One notable development associated with this year’s wave of M&A has been the relatively large size of many of the deals being done. According to Thomson Reuters, the number of transactions worth $5 billion or more is 128, beating the previous record of 125. That trend, as well as overall volume levels, have fostered hopes that the current boom will continue into 2016. Based on readings from consulting firm EY’s 13th Capital Confidence Barometer, 74% of executives surveyed “expect to actively pursue acquisitions in the next 12 months,” while “57% of companies currently have three or more deals in their pipelines.”

Deteriorating sentiment

There are reasons to be cautious, however. Among other things, history has shown that industry sentiment tends to be the most exuberant when activity is at or near its peak. As it happens, a recent survey by research firm IntraLinks is signaling deceleration in the coming quarter. According to Matt Porzio, vice president of M&A Strategy, early-stage activity “is increasing at the slowest rate in 2.5 years as concerns over the global economic slowdown grow.” He noted that “all of the negative sentiment felt by dealmakers is ‘really weighing on deals.'”

Regulatory factors will likely also become more of an issue, especially in the run-up to the U.S. presidential elections. Concerns have already been raised, for instance, about the antitrust implications of mega deals in the health care sector, which many opponents believe will exacerbate the trend of rising medical costs. General Electric’s decision to call off the sale of its appliance unit to Electrolux after the U.S. Justice Department moved to block the transaction is being seen by some as a sign of things to come.

As in past booms, the top has not always been apparent until well after the fact. That said, it’s hard not to think that we may be seeing it right now.