OCEAN CITY — As we move toward the second half of the year, one of the more positive trends we see in capital markets is an increase in corporate mergers and acquisitions (M&A). This year has brought a notable rebound in transaction volume and corporations have indicated they are allocating more cash to M&A.
Through the end of May, we have seen over $1 trillion of spending on global acquisitions, more than three times the levels seen during the same period last year. Recent activity has led investors to again exclaim that the M&A cycle has returned, especially for deals greater than $10 billion, which remain at a record pace this year.
Why M&A now? One reason is corporations have accumulated more than $1.4 trillion of cash on their balance sheets. Until recently, they have preferred to return cash to shareholders through dividends and share buybacks, doing so to the tune of $311.7 billion for dividends and $475.6 billion for share buybacks in 2013.1.
Recently, investors have pressed companies to prioritize earnings growth, and corporations have increasingly turned to buying growth instead of building it, a more immediate solution. M&A typically corresponds with improvement in CEO confidence, a reduction in policy uncertainty and buoyant equity markets. We expect further growth in M&A given the relative calm in Washington and improving economic growth in the U.S. and globally.
As noted by our colleagues on the BofA Merrill Lynch (BofAML) Global Research Equity Strategy team, the ways in which companies spend their capital changes substantially over the course of the business cycle. When the macroeconomic environment is challenging, they focus on hoarding cash and if necessary balance sheet repair. As the macroeconomic outlook improves and confidence returns, there is an increased opportunity cost of holding excess cash earning low returns. Corporations begin putting that cash to work via capital expenditures, acquisitions, share buybacks and dividends. Since 2009 we have seen the “return of corporate cash” in the form of share buybacks and dividends. Now we see a focus on earnings growth, which shifts the capital allocation decision in favor of M&A as corporations buy growth and integrate with their one-time competitors to help control costs.
Over the last two years we have seen a significant decline in uncertainty over U.S. economic policy, as measured by Stanford University’s U.S. Policy Uncertainty Index. Economic policy uncertainty hampers M&A by making CEOs more reluctant to spend on acquisitions and instead take a “wait and see approach”. Current low levels of uncertainty support higher levels of M&A and we believe economic uncertainty in the U.S. will remain low as economic growth improves.
Another factor making the current environment attractive for M&A is the reasonable level of valuations, which can help make deals immediately accretive to earnings (in other words, increase earnings per share immediately). There’s opportunity to enhance earnings through M&A using either cash on the balance sheet or borrowing, since the earnings yield is higher than usual compared to the corporate bond yield.
Despite the positive backdrop, there has been much debate recently over the extent of corporate leverage. Using one of our preferred measures, Net Debt to Earnings Before Interest, Debt & Amortizations (EBITDA), leverage remains low relative to history. In addition, most corporations have taken advantage of low interest rates to restructure their debt, driving short-term borrowing to one of the lowest levels ever as a share of credit market debt — 19.8%. The low proportion should leave them less susceptible to short-term shocks from macroeconomic surprises and changes in interest rates.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)