M&A pressure builds under corporate cash mountain

AS EVERY SCHOOLCHILD knows, money burns a hole in your pocket. This truism does not necessarily translate to the corporate boardrooms of the world’s largest companies, but if it does the next few years should be interesting. Cash hoarding by corporates since 2007 means that by some estimates there is now $3 trillion sitting on corporate balance sheets worldwide – $1 trillion on US corporate balance sheets alone. In November 2010 Morgan Stanley published research calculating that cash levels at US investment-grade corporates are at their highest level in two decades. There must be quite a lot of pockets on fire. The M&A teams at the large investment banks certainly hope so, and have been predicting a boom in M&A activity in 2011 for some time. They must have their fingers firmly crossed in Europe – according to Thomson Reuters, fees from advisory work and underwriting activity in the region totalled $4.3 billion for 2011 to date, a 6% decline year on year, and fees from debt capital markets underwriting activity have fallen 8%. But in the US M&A activity is surging, chalking up a record of $257 billion of deals in the first quarter of this year alone. Elsewhere, by March deals involving Chinese targets totalled a record $27 billion for year-to-date 2011, 16% up on last year.

The assumption that corporates will come under pressure to put some of their cash piles to work is not unreasonable. However, predictions of a global M&A boom might be optimistic. So many conflicting factors are at work that many corporate pockets might now be lined with asbestos. First of these is the lesson that many learnt the hard way in the crisis: liquidity – there when you don’t need it, not there when you do. It will therefore be some time before corporate treasurers relax their conservative approach. The simple calculation of looking at cash as a percentage of market capitalization might no longer hold. "The requirement for liquidity has risen and people are being careful," says Larry Slaughter, senior banker for JPMorgan’s EMEA corporate clients. "Companies have learned to have sufficient liquidity." And it takes a lot more than just money in the bank to trigger deal flow. "It is simplistic to assume that because there is so much cash on balance sheets there will be knock-on M&A," says Matthew Ponsonby, co-head of M&A EMEA at BarCap. Corporates need three things to embark on an acquisition: confidence in the earnings outlook of the target, confidence in their own business and confidence that they have the support of shareholders for the deal. "The strategy must be right," says Mark Warham, co-head of M&A EMEA at Barclays Capital in London. "It is about teeing things up correctly and taking your shareholders with you." Requirements one and two on this list are difficult to achieve in an environment of uncertainty. "M&A is usually a feature of a rising market and people in Europe are less bullish on the economic outlook than their US counterparts," says Slaughter. Nevertheless, although these are unusual times the rules of corporate finance mean that sooner or later corporate cash balances will come down, or – in the words of Bank of America Merrill Lynch head of international M&A Adrian Mee: "Companies will generally seek to move to a place where their balance sheet structure is efficient." That usually means one or more of three things: share repurchases, special dividends or acquisitions.

The logic behind share buybacks is straightforward – they boost the share price and improve return on equity. But they are not always popular with investors if they feel there is not enough left in the till for acquisition opportunities. It is for this reason that recent share buybacks have been concentrated in the resources sector, which is particularly flush with cash thanks to the continuing surge in commodity prices. There have consequently been large buybacks at Rio Tinto and BHP. In February, Rio Tinto announced that it would buy back $5 billion of shares before the end of 2012, less than two years after it raised $15.2 billion via a rights issue. The company added $9.5 billion to earnings in 2010 thanks to high prices for such commodities as iron ore, copper, coal and aluminium. In the same month Anglo-Australian mining conglomerate BHP Billiton – under pressure from shareholders and having just racked up a 74% increase in half-year pre-tax profit to £9 billion ($14.7 billion) – announced a £6.2 billion buyback, together with a commitment to spend a further £50 billion on development.

Buybacks on this scale are the exception rather than the rule. However the concept could become more common among smaller firms as corporates begin to feel the weight of the cash at their disposal. South African insurer Sanlam, for example, has earmarked R4 billion ($580 million) discretionary capital for acquisitions, share buybacks and expansion in India, R1 billion of which will be for a share buyback.

But Slaughter at JPMorgan does not agree that more corporates will conduct buybacks. "The institutional investor base wants companies to do things that are strategically sensible and will reward them for it," he says, pointing to the fact that the share price performance of acquirers has been positive in absolute terms and relative to the market. Examples of this include the proposed mergers of Deutsche Börse and NYSE Euronext, ABB and Baldor, and Sanofi-Aventis and Genzyme. "In a low interest rate environment with a risk of inflation cash is not a good place to be. But investors favour growth and dividends over share repurchases. They want growth that they can touch and make sense of." Others agree that higher dividends are more likely – along with its buyback Rio Tinto announced an increase in its final dividend from 45c to $1.08.

These views were echoed by WPP chief executive Sir Martin Sorrell in March when, announcing a 28% increase in pre-tax profits for 2010, he said that his company would be increasing its target dividend payout ratio from 30% to 40% but would only minimally increase spending on acquisitions. "I think the view of our shareholders is that consistent increases in dividends are more attractive than even steady buying back of stock," he said.

Giuseppe Monarchi, head of M&A EMEA at Credit Suisse, says that firms may bow to shareholder pressure to buy back: "As corporates continue to build their cash piles, we may well see more of this cash returned to shareholders; this is certainly something that a number of institutional investors are asking for. Whether this is going to take the form of ordinary dividends or special dividends or buybacks will depend on many factors, including tax and legal considerations, as well as the desired level of flexibility."

Shareholder activism

But dividend windfalls will keep investors happy for only so long when they see such large cash balances lying idle. "Some CFOs may now be starting to shift a bit under pressure from equity investors," says one banker. "The creation of large cash balances will force the issue of smaller acquisitions. There aren’t many mega deals out there but there are plenty of €2 billion to €5 billion deals. If I were the CEO of a company I would be very reluctant to say that the best thing I can do is to give cash back by way of a buyback."

According to the Economist, global M&A activity hit $2.8 trillion in 2010 (up from $2.3 trillion the year before). The US dominated the market, with $895 billion of activity, with the UK on $180 billion and China on $170 billion. There is a strong likelihood that the latter two rankings will be reversed this year, but deals are starting to pick up in Europe too. For example, Louis Vuitton Moët Hennessy (LVMH) recently agreed to pay €3.7 billion for Bulgari – its biggest takeover in a decade. And in late March US cable operator Liberty Global agreed to buy Kabel Baden-Württemberg for €3.2 billion from EQT Partners. However, the mood in the market persists that an essential element for an M&A boom – confidence – is missing.

"I just don’t think people will rush out and do things just because they have cash," says Sam Small, senior managing director at Macquarie Capital Advisers. "Boards and shareholders are examining situations carefully – money is available but we have not seen it translate into a deal frenzy. There is no evidence that shareholders are saying to corporates that they have to spend." But they seem to be taking a far more active interest in what corporate treasurers are doing instead. If corporates are going to hold more cash on the balance sheet they want to see them doing something with it, and if they aren’t going to spend it they want to see dividends or buybacks.

"Risk has become a strategically important topic for corporates," says John Langley, co-head of risk solutions group at Barclays Capital. "With more cash on the balance sheet and very steep yield curves there is an increased cost of carry. Part of the risk management strategy is to manage the yield on this cash until such time as the company puts it to work." Corporates with larger cash piles should be reducing their costs by swapping fixed-rate assets back to floating rate and managing their cash positions more actively – ring-fencing working capital and adopting an asset allocation approach for the remainder. The dilemma in this market is the desire for corporates with long-dated assets to lock in interest rates. Although this is attractive for their all-in cost of funding it will result in a heavy cost of carry. "There are several pools of liquidity at a corporate level: short-term held for working capital needs, medium-term typically to cover capex requirements, and longer-term liquidity for strategic purposes such as acquisitions. Corporates will have an internal cash manager for the short-term piece and may place some of medium- to longer-term funds with an external fund manager," says Jim O’Neill, co-head of the risk solution group at BarCap with Langley.

But there is only so much that corporates can do with the cash they have before shareholders start to demand a return on their investments. "Over the last few years there has been an increase in shareholder activism," says Monarchi. "Shareholders are far more vocal in passing on their views to companies."

When British Tobacco resumed its buyback programme in February this year its shares actually fell slightly (despite a boost to pre-tax profits) because investors were disappointed at the smaller than expected size of the buyback (£750 million). The firm scaled it down from £1 billion to have funds available for acquisitions, something that investors clearly disagreed with.

And when BHP Billiton chief executive Marius Kloppers announced record results in February he was careful to play down any suggestion that the firm was looking to pursue further acquisitions after its last three bids had failed. BHP was forced to withdraw hostile bids for Rio Tinto in 2008 and Potash Corp in 2010 and also had to abandon plans to merge its iron-ore operations with Rio Tinto. In addition to cooling any speculation about further mergers (the unsuccessful bid for Potash cost it $350 million) the firm almost tripled its share buyback programme from £2.6 billion to £6.2 billion as a placatory move to shareholders.

"You can’t always assume shareholders are against M&A but they will hold the management to very high standards," says Monarchi. But with more and more cross-border activity between corporates operating in vastly different legal jurisdictions shareholder activism might prove impotent in the face of wider geo­political realities. When Russian mobile phone operator VimpelCom announced its planned $6.1 billion acquisition of the heavily indebted Wind Telecom from its Egyptian owner, Naguib Sawiris, Norwegian telecom operator Telenor, which holds a 36% stake in VimpelCom, vociferously opposed the deal. Telenor suggested that the deal made no strategic sense and that the Russian firm should pay out a $1 a share extraordinary dividend instead. With another Russian conglomerate, Alfa Group, holding a 44% stake, Telenor’s efforts to block the deal always looked slim, and it was approved in late March. VimpelCom is run by Mikhail ­Fridman, an oligarch with close ties to Vladimir Putin (see Orascom: A very modern tale of corporate finance ­Euromoney February 2011).

Strategy trumps opportunity

With shareholders keeping an ever-closer eye on proceedings one thing is certain – opportunistic M&A is off the menu for the foreseeable future. The only deals that do happen will be strategic. "There will always be people prepared to do opportunistic M&A in a time of uncertainty – they are the ones with the 80ft yachts," concedes one banker. But they will be thin on the ground this year.

Nevertheless economic uncertainty cuts both ways. On the one hand it certainly hinders M&A activity but on the other many corporate boards might see safety in size and look to become part of a bigger organization in times of competitive threat. This has been clearly seen in the recent wave of stock exchange mergers. In addition to the Deutsche Börse NYSE Euronext tie-up, the LSE has agreed a merger with TMX Group of Canada, while the Singapore stock exchange is looking to take over Australia’s ASX to become the fifth largest listed exchange company. A merger between Japan’s Tokyo and Osaka exchanges is also on the cards (see CME’s Donohue unmoved by exchange consolidation, Euromoney, April 2011).

Dealmaking exuberance will be tempered by the performance of the equity markets, capital structures available and the difficulties in establishing valuation in such a volatile environment. The impact of the latter should not be underestimated. "Establishing value can be difficult," explains Small. "Even if something makes sense strategically it is sometimes tricky to agree the right price." Even deals that make good strategic sense are proving time consuming and expensive to cement. The Sanofi-Aventis takeover of US firm Genzyme finally closed in February after nine months of wrangling over price. The $20 billion deal was finally agreed at $74 a share, a boost on its original bid of $69. The acquisition makes strong strategic sense for Sanofi-Aventis, which faces patent expiries on several of its blockbuster drugs in the near future. Genzyme gives it access to a new pipeline of established products.

If potential acquirers can establish valuation, they know that finance will not be a problem. Boards are not being held back from doing deals by an inability to raise finance, notes Warham. "Companies have cash to spend but acquisitions will still be financed very conservatively. Deals have to make sense and be structured properly." But as the Genzyme deal illustrates, acquirers are still prepared to pay full price for strategic targets. Another example of this was Telefónica’s acquisition of Portugal Telecom’s stake in Brazilian mobile phone operator Vivo Participações last year. The firm paid €7.5 billion for the stake, after three months of negotiations in which the bid was raised three times. "Telefónica paid a lot of money for Vivo but it was a strategic deal," says one banker. The final price tag was a 32% increase on the first offer, justified because the deal gives Telefónica an excellent position in the growth market of Brazil.

The market is expecting more of the same this year, and although financing is likely to remain conservative that does not mean it will be straightforward. "Where M&A happens there will be strong strategic logic and people may need to be inventive to make it happen," says Small at Macquarie. "There won’t be many plain-vanilla transactions and banks will have to work harder for deals." A good recent example of this is Rolls-Royce and Daimler’s joint €3.2 billion bid for German engine-maker Tognum, which supplies diesel engines and propulsion systems for off-road and military vehicles. Daimler already owns 28.4% of Tognum, which it sold to private equity group EQT six years ago for €1.6 billion. The €24 a share bid is a 22% premium to Tognum’s share price. Although Daimler has a €12 billion cash pile it has chosen to partner with Rolls-Royce on the bid, which adds transactional and managerial complexity but makes strategic sense.

Despite the fact that large cash piles are sitting on balance sheets in all sectors (IBM recently hit eight years without an acquisition – the longest time it has ever gone without buying anything – and now has $11 billion sitting on the balance sheet), likely candidates for future deals should come from the resources and FIG sectors along with M&A stalwarts pharmaceuticals and biotechnology. The reasons for deal activity in these two sectors are contradictory: the former has done so well and some of the latter so badly. Resources firms have had an astonishing run so it was no surprise to see Rio Tinto increase its bid for Australia’s Riversdale Mining to just over A$4 billion ($4.04 billion) in March. Higher commodities prices added $9.5 billion to underlying earnings at the conglomerate in 2010, which more than doubled from $6.3 billion to $14 billion. Less than two years ago the firm had to tap investors for a $15.2 billion cash infusion through a rights issue. Rio wants control of Riversdale because of its mines in Mozambique’s Moatize coal basin, which has some of the world’s largest untapped reserves of coking and thermal coal. To succeed it needs the backing of either Brazil’s CSN (which owns 19% of the Australian group) or Tata Steel, which holds 27%. Both have built their stakes in the firm in recent weeks. The theme of merger activity being driven by resource conglomerates’ drive for access to emerging market assets will be repeated time and again. BP’s potential tie-up with Russian state oil group Rosneft – which was announced in January – is driven by access to deposits in the South Kara Sea. But the market is well aware that demand for resources might not sustain these levels indefinitely. "Concerns over China have taken a bit of the froth off the market," says Small. "Chinese appetite to venture outside its own borders seems to have reduced a little recently and approvals take longer." The challenges facing the FIG sector need no repeating here but make it a fertile source of M&A business from likely forced break-ups and defensive mergers. These will range from the small to the very large. In the UK, for example, the FSA recently approved the merger of two smaller building societies: the Yorkshire Building Society and the Chelsea Building Society. At the other end of the scale, following AIG’s sale of its consumer lending business, American General Finance, to Fortress Investment Group last year, bidders are now lining up for Citi’s consumer lending unit CitiFinancial (to be renamed OneMain Financial). So far those understood to be preparing bids include BlackRock, KKR, Warburg Pincus, Blackstone, Carlyle Group, Thomas H Lee, WL Ross, Apollo Management, JC Flowers, Clayton Dubilier and Rice, and Banco Santander. A glance at the list of bidders underscores perhaps the most important variable in any prediction of M&A activity this year: private equity.

Sponsor appetite

Corporates are not the only ones with cash now burning a hole in their pockets; private equity funds have struggled to put money to work for some time, leading to a boom in secondary buyouts and some concern that they might become overly aggressive buyers rather than hand cash back to LPs (see Overhang threatens health of private equity, Euromoney, October 2010). "We are seeing a lot of private equity activity in M&A," says one financier. "We are seeing leverage popping up and some private equity houses are saying some very strange things in meetings. They may not be talking about the eight times leverage of old but they are talking about six times leverage as no problem." Others stress that private equity spending power, like corporate spending power, should not lead to distortions in the market. "Private equity firms are struggling to spend the money that they have, and have been for 18 months," concedes another M&A specialist. "But sponsors can only play where people are prepared to sell. There has been a mismatch in pricing but the two sides are getting closer together but it is difficult to have visibility of earnings." Monarchi at Credit Suisse agrees that private equity firms are remaining disciplined despite the volume of funds they have to put to work. "Sponsors are being very cautious on valuations and worrying about their next fundraising," he says. "Many firms are on the road to raise funds, but not all of them will succeed." Indeed, private equity bidders CVC Capital Partners and Hellman and Friedman dropped out of the bidding for Kabel BW last month with the company eventually going to cable operator Liberty Global.

Despite the enormous dollar numbers that are sitting with corporates and private equity funds, therefore, the expectation is that any resultant increase in M&A activity will be steady, measured and strategic. "LPs have no appetite for private equity funds to put risk into the portfolio and there is not an exuberance among shareholders that would allow people to move away from things that make sense," says Ponsonby. Activity levels in the US have certainly far outstripped those elsewhere, and sentiment is particularly strong in that market. JPMorgan’s $20 billion bridge financing for AT&T’s proposed acquisition of T-Mobile USA involves the bank as sole lender – and will be the largest single-bank loan funding for a takeover in history. There is no doubt that some of the deal terms that have been seen in that market (such as covenant-lite and PIK tranches) are reminiscent of the incautious behaviour that spread through the market before mid-2007. Much of the dealflow has, however, been driven by divestments. The AT&T deal is the result of Deutsche Telekom’s divestment of T-Mobile USA – a trend that is unlikely to be repeated in Europe according to JPMorgan’s Slaughter. "There have been more demergers in the US than Europe because there are many more diverse companies in the US and the corporate finance path [shareholder acceptance and tax treatment] of such deals is more favourable," he says.

But the danger in M&A is that each deal sets the template for the next and all it takes is one or two excessive deals for things to start moving very quickly in the wrong direction. "The credit markets have a risk-on mentality again and people will chase the marginal deal," warns one banker. "Because many corporates are cash-rich there is safety in numbers. If you were to see an equity market sell-off investors would become very disenchanted and this could become a big problem." And the M&A market mantra that: "M&A is about putting a buyer and seller together – whether it is a good investment is a secondary concern" does not instil an awful lot of confidence that discipline will hold. But there are more than enough external concerns to give any buyer pause for thought, so the great M&A boom of 2011 might turn out to be rather more measured than many bankers perhaps hope. "I simply don’t buy the thesis that it is the treasury function and interest rates that drive M&A," says Macquarie’s Small. "Even if there are strategic things that they want to do, many boards would rather hand money back and rely on the capital markets to deliver the right deal in due course."

see also:

M&A: The corporate view