After several years of falling rates and declining spreads, companies finally seem comfortable this year making acquisitions. According to Bloomberg data and our calculations, $802 billion of acquisitions have been announced year-to-date across 148 transactions, the third-highest total in the past 15 years. At the peak, in 2007, $1.1 trillion of deals were done along these same parameters; today’s pace annualized would exceed $1.5 trillion.
We think the present market environment will likely foster more deals — and large ones at that. For managers of long-short credit funds, M&A transactions have become investment opportunities. As deals are announced, there needs to be a framework to analyze the trends in the market and to determine how to capitalize on the deal flow.
To start, we should first recognize what is driving the deal flow. The obvious answer is cheap capital. With average yields for levered assets hovering around 5 percent for much of this year, the market is practically encouraging companies to lever up. And although additional debt may hamper a company’s credit profile, it seems that investors are happy to look in the other direction. In some ways, they are just grateful for more paper in a year when net supply forecasts call for only just slightly more issuance than the amount of coupon income generated by spread assets. But if the demand from fixed-income investors wanes and yields rise, will the M&A tide recede?
We think there are several reasons to assume the deal flow will continue. For one, the use of equity has enabled strategic acquirers to consummate bigger deals. Of the 50 largest deals done this year, 19 were financed at least partially with equity, which we think is in part a driver. The ten largest deals announced for 2014 so far collectively reach $388 billion: far greater than the $267 billion and $268 billion accounted for by the ten largest deals in 2007 and 2013, respectively. We note that this includes last year’s $130 billion Verizon-Vodafone deal.
Much has been written about the recently positive price impact of deals on the acquirer’s share price. But we think that companies are primarily looking for ways to grow revenues and earnings and, more recently, to use acquisitions as a way to unlock trapped cash or migrate to a more tax-efficient locale. This latest trend has been especially prevalent in the health care sector, as we’ve seen a number of tax inversions, where U.S.-based companies have announced acquisitions of European businesses in an effort to move their corporate domiciles and avoid U.S. income tax on overseas businesses.
While many companies have spent the past few years buying back stock and increasing dividends, it seems that many are now moving on to different (maybe even better) uses of cash, deciding instead to grow their businesses. With cheap financing, acquiring a company provides an immediate boost to the top — and often bottom — line, whereas organic growth tends to require a longer time frame before impacting results.
For investors, the M&A playbook has changed in the present market. Historically, the trade has been to short the credit that may be acquired, as the additional leverage on the structure (particularly in financial sponsor deals) pushes spreads wider, assuming a debt-funded transaction. In today’s environment, many large deals are strategic in nature, which makes it increasingly difficult to predict how spreads will fare. To find attractive investment opportunities, we at KKR ask ourselves the following questions when considering M&A-related trades:
What is the most likely transaction? Recent transactions demonstrate just how fluid deals can be. Take the Time Warner Cable buyout saga. Any one of the proposed deals could have moved spreads wider or tighter. And over the course of negotiations, they did just that. Over a few months, the company’s five-year bonds traded up 5 points, but the 30-year bonds increased 25 points. The art of trading events like this is determining who will do the buying and how it will be funded.
How will the deal impact the credits? Once a deal is announced, investors work to determine what will happen to the credit structure. Will debt be used to finance the acquisition, or will equity be issued? At which entity will the debt reside? Are the securities of the acquired company going to be repaid, or will they remain outstanding? What do the covenants dictate? With rates at historic lows, owning a bond that is going to be taken out via a make-whole call is like hitting the jackpot; some bonds have been repaid nearly 20 points higher than predeal levels.
Where is the trade? When evaluating M&A situations, we leverage our fundamental analysis to continually evaluate capital structures to seek the strongest possible risk-adjusted return, and we consider the potential paths the deal may take. Though it is much more challenging to predict which companies will be purchased, there are opportunities to trade after the deal is announced. We may see opportunities to buy assets, as the spread widening of credits may be overdone, as the combined structure’s riskiness may be overstated. Conversely, we may find bonds to sell, as investors may underestimate the impact a substantial amount of leverage could have on the capital structure. Lastly, investors must be flexible in their strategy and viewpoint. With so many possible scenarios, M&A situations are fluid.
Over the past year, we have seen a substantial number of opportunities to capitalize on the increasing quantity of M&A transactions. We think more of the same will continue, but we wonder how large transactions can grow and if we will see a repeat of 2008, when deals were hung — saddling underwriters with sizable bridge loans — when credit markets ground to a halt. In the meantime, we continue to be nimble in our investments and quick with our analysis, and to trust our instincts when it comes to M&A-related transactions.
Scott Henkin is co-head of KKR’s Credit Relative Value strategy, where he manages long-short credit trading and portfolio construction, in New York.
