by Thomas Kirchner, CFA
70% of mergers are all cash.
Large cash hoards reduce need for debt financing.
Regulations bigger concern than interest rates.
2021 set a new record of M&A activity, with global volumes reaching $5.1 trillion and U.S. mergers increasing 50% to $2.5 trillion from the prior year. Volumes in Europe and Asia continue to lag U.S. activity with $1.5 and $1 trillion, respectively . So far in 2022, the year is off to a strong start thanks to Microsoft's deal to buy Activision for $75 billion, which will make it one of the 10 largest U.S. mergers of all time. As always, the numbers are skewed heavily by a small number of mega mergers. Only 64 deals had over $10 billion in size, representing 0.4% of the number of mergers. However, these 64 mergers represented 24% of deal volume by dollars. [i]
SPACs flame out
SPACs contributed about 10% to global M&A volume and thus constitute a significant portion of the total. Of the 199 SPAC mergers completed last year, only 15 shares trade in positive territory. Only 8 have outperformed the S&P 500 [ii]. This performance is in line with past experience. As we wrote previously, the long-term performance of SPAC mergers is poor. Their poor performance was foreseeable when we wrote this in April 2021. SPACs are best viewed as a poor substitute for venture capital, where most investments result in a complete loss, with only a small fraction providing strong returns. Venture capital funds are successful only if the small minority of winners has such a phenomenal performance that it more than offsets the losers. Given these challenges, it is not surprising that despite all the hype, only the top quartile of venture capital funds beats the S&P 500 [iii].
Regulation is back
After four years of generally lax anti-trust enforcement – although the final years of the Obama administration also were not particularly tough – merger regulation is back. The appointment of Lina Khan as head of the FTC signals the implementation of President Biden's “whole-of-government” approach to regulation. The traditional anti-trust analysis involving consumer welfare is replaced by a broader review of the impact of mergers on the environment, labor and equality. These extra layers of bureaucracy will prolong the timeline of larger mergers.
A plethora of new regulations will, in the aggregate, impact merger activity negatively even though each new rule, taken in isolation, is not a big deal. For example, early terminations of the HSR waiting period will no longer be granted. It used to be standard practice that when the DOJ or FTC determined that a merger had no anti-competitive threat, they would let the merger go ahead immediately by terminating the statutory HSR waiting period early. This will no longer be done. Of course, this makes no sense: the regulators have determined that a merger poses no anti-competitive threat, yet it cannot go ahead until a pre-determined waiting period has expired, during which nothing is done. Clearly, this measure is more political messaging than tough regulation. It certainly is not smart regulation.
Similarly, the government now has the ability to extend merger review processes indefinitely. The underlying philosophy of anti-trust regulation was to minimize disruption to business activity by forcing regulators to act quickly or, if they can't get their act together promptly, drop merger challenges. The FTC is now keeping investigations open beyond the usual time periods and warns merger parties that if they go ahead and close a deal, they do so at their own risk.
Cash is king
70% of all mergers (by size) last year were all cash, only 9% were all stock, with the remainder having a combination of cash and stock [I]. With credit spreads still low by historical standards and corporate cash balances at all time records, we expect cash to continue to be the preferred form of M&A payment for the foreseeable future.
Moreover, private equity funds are sitting on over $1 trillion in dry powder [iv]. This committed capital needs to be put to work irrespective of the level of interest rates.
While rising interest rates will make cost of debt financing more expensive, the enormous aggregate amount of cash available means that buyers, on average, can reduce the amount of debt financing employed in M&A and simply use more cash when the cost of debt becomes too high.
Therefore, we do not believe that rising interest rates directly will impact M&A volumes. However, there is an indirect risk: should financing become unavailable due to higher rates – for example, if banks were to tighten lending standards or regulators were to clamp down on leveraged acquisitions – then an indirect impact would be sharply reduced M&A activity. We have last seen such an outlier in the 2008 credit crunch. However, for a credit crunch to occur, you need major components of the financial system to implode. Therefore, we highly doubt that a sharp reduction of M&A activity is on the horizon. A bigger concern than interest rates is the increase in regulation and enforcement, which quite clearly is designed to reduce M&A activity. U.S. business has benefited from large improvements in efficiency over the last 20 years, some of which was driven by the cost cutting that follows when duplicate overhead is eliminated as a result of M&A. If the government regulates such efficiency gains away, it will have negative long-term consequences for the economy overall.
[i] Camelot calculations based on Bloomberg data.
[i] Nikou Asgari, Patrick Mathurin and Chris Campbell: “Spac wizards run out of magic as returns prove weak” Financial TImes, January 22, 2022.
[iii] David Siegel: “Ventureball: A Primer on Venture Capital for Hedge-Fund Investors.” Data Driven Investor, January 15, 2020. However, we would like to point out that while the statistic about the top quartile is quoted frequently, there is a strong debate about its accuracy.
[iv] Kaye Wiggins: “Cash-rich private equity pays record premiums to snap up public companies” Financial Times, October 7, 2021.
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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.
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