M&A bankers can rest easy, at least for now, argues Robert Buckland from Citigroup in his latest Global Equity Strategy note to clients. We are witnesses a great, global debt/equity swap — and until either equities get substantially up-rated or debt gets a lot more expensive, the flow of deals will continue.
The assumption that we are in a takeover boom to end all booms just doesn’t stack up, Buckland argues, especially when weighing deals against total market capitalisation. And it’s important to focus on the two key differences between this M&A boom and the last, in 1999-2000 — this boom is being funded in cash, not equity, and private equity activity is rather more important now compared with then.
So far, so routine. But Buckland has plotted the common, underlying theme - namely the de-rating of public equity against corporate debt.
Says Buckland:The derating of equity and re-rating of corporate debt (through a combination of low government yields and falling credit spreads)has offered an historic opportunity to the global private equity industry. It is no surprise to us that the buyout industry was not a big player in the last M&A boom. Their trade (issue corporate debt to buy assets in the public equity markets) made no sense when the corporate bond yield was 500bp higher than the earnings yield — equities were too expensive relative to debt. But now that gap has closed and we are
seeing one of the biggest arbitrage trades in financial market history — borrow off the debt markets to buy in the equity markets. Recent movements in asset valuations have done little to threaten the opportunity highlighted (in the graph above). Corporates who use cash or debt to buy other corporates are, in effect, putting on the same trade.
The Citigroup man argues that it is just too simple to say that M&A is now being driven by cheap debt — instead it is the combination of cheap debt and lowly rated equities that has led to the surge in cash/debt financed takeovers.
If the earnings yield on the global equity market was 4% (P/E 25x), then we suspect that LBO activity would stop — it would be very hard to get the economics to make sense. A 200bp rise in global BBB yields (to 8%) might have a similar effect. And perhaps this arbitrage opportunity will be closed off by a combination of the two (a rerating of equities and a derating of debt), but for the time being that is not happening and so we would expect this debt-financed global M&A binge to continue.
So, while we hear lots about how private equity can manage companies more efficiently, accurately aligning the interests of managers with that of owners along the way, it is worth noting that that was also the case back in the late 1990s when the buyout brigade had but bit part on the M&A stage.
So forget PE alchemy. Equities were previously just too expensive relative to debt. “But now that gap has closed and we are seeing one of the biggest arbitrage trades in financial market history.”
