M&A surge is creating froth on the stock markets

The lawyers and investment bankers are in clover. Corporate mergers and acquisitions are back with a vengeance, and the fees for advising on deals are rolling in.

The list of companies involved gets longer almost every day and now spans almost all sectors of the market: Rupert Murdoch’s Fox is hunting fellow media behemoth Time Warner; US biotech AbbVie is buying Shire Pharmaceuticals of the UK; and there is even a revival of M&A in banking, courtesy of former Merrill Lynch boss John Thain, whose CIT Group has agreed to buy OneWest.

Little wonder that Ken Jacobs, chief executive of Lazard, the M&A adviser, boasted that his business was in the “sexy part of the market” right now.

The elevated levels of activity, and the evidence that we are just at the start of an M&A cycle, pose the question of whether investors are prepared. It seems many are not.

Fixed income investors, in particular, find themselves in double jeopardy. Nervous equity investors may have underestimated the solidity of the current market.

Larry Fink, chief executive of BlackRock, the world’s largest investment manager, says M&A activity underpins equity market valuations. “It is creating a scarcity.”

With cheap financing available in the debt markets, companies are funding their acquisitions in large measure with cash, which leaves investors in the acquired company hunting around for something to do with the money.

Meanwhile, the joyless manner in which equities have reached record territory is in sharp contrast with the euphoria that usually characterises the top of a bull market. This suggests we are not at the top.

Doomsayers see bubbles everywhere, yet stock market valuations remain within the range of average on all but a few fashionable metrics such as Robert Shiller’s cyclically adjusted price/earnings ratio.

The upswing in M&A activity ought to be an answer to the naysayers. It reflects one factor that is supportive of equity valuations above all: confidence. The more-benign economic environment on both sides of the Atlantic has given executives and boards enough confidence to make bold strategic moves.

What began last summer in the US has begun to pick up in Europe since the start of this year, Jacobs said. “M&A cycles are funny,” he told Lazard investors on a conference call. “They never happen gradually. This year we have seen a slew of larger transactions, and that kind of jump is what is associated with the beginning of a cycle.”

The value of worldwide M&A activity was $1.8 trillion in the first six months of the year, according to Dealogic, the data provider. This was up 73 per cent on the same period last year and showed no sign of slowing down in July.

Inevitably there are investment losers, however, and Fink’s comments hint at who it might be. The financing available to companies is indeed cheap. More so, in fact, than ever. Perhaps it is too cheap.

According to the Barclays Aggregate index, fixed income investors are now getting yields of less than 3 per cent on a typical US investment-grade corporate bond, and barely 100 basic points of yield over and above risk-free Treasury rates.

That is great for borrowers, but bond investors may come to rue not having built in any cushion for increased credit risk.

On the one hand, the low rates and spreads are explicable. Good-quality corporate bonds, which have very little default risk, trade more in step with Treasuries, where yields have also fallen. An improving economy should improve corporate credit quality across the board, too.

Yet companies have already been tempted to borrow to fund share buy-backs over the past few years, and cash piles that were built up in many corporate treasuries after the shock of the credit crisis are being whittled down.

M&A provides another justification for levering up, taking on extra debt to pursue a deal, eroding a company’s creditworthiness in the process.

DoubleLine, the fixed income specialist based in Los Angeles, decided near the end of last month that investors were no longer being appropriately compensated for the risks and cut its exposure to investment-grade corporate bonds. The investment committee specifically cited “M&A risk” in its decision, according to people who were there.

One might add the risk that interest rates start to rise to reflect the strengthening economy and the strengthening business confidence that ought to make it sustainable. Corporate bonds would do poorly in a rising interest rate environment, too.

Doomsayers paint the M&A boom as a desperate attempt by companies to buy growth that is not being generated organically in a permanently stalled economy, and the last dollop of froth on the top of an equity market that is well into bubble territory.

This is a stretch. More probably it reflects the healthy return of confidence after a long period of trauma, and a natural development in the business cycle. If so, equity investors will be in clover for a while too.

— Financial Times