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The greatest ever merger wave is changing shape—but it may not be breaking yet.
Economist Staff, The Economist
January 3, 2008
"It's a bump in the road, but not an unhealthy one," says David Rubenstein. The morning after paying $21.3m for a copy of the Magna Carta dating from 1297, the boss of the Carlyle Group, a big private-equity firm, is in the mood to take the long view. The golden era of private equity is probably over, he concedes. "After a great ride for five years, private equity is entering a more challenging period," he predicts. Returns are likely to come down, if only because they have been so high, he says. But the industry has been through downturns before, and each time "changes were made and private equity came back stronger."
The future of the merger wave that has been sweeping all before it since 2003 now depends on how deep the downturn in private equity proves to be and how long it takes to recover and come back stronger. In the first half of 2007 deal activity was so rapid that last year was still the best ever for merger activity, according to Dealogic. But when credit started to crunch in the summer, activity slowed dramatically, particularly by private-equity buyers, which in the second quarter of 2007 accounted for an unprecedented one-quarter of all deals.
Almost overnight, instead of breaking new records every other week for the biggest ever private-equity acquisition, the scramble was to complete deals that had already been agreed on. Hard-pressed banks found themselves unable to syndicate private-equity debt and switched from practically giving away credit to supplying it at a high price, with strings attached, if they supplied it at all. Several high-profile deals fell apart, including some from blue-chip private-equity firms—a trend that has continued into the new year. A few minutes into January 1st PHH, a mortgage company, announced the collapse of its $1.8 billion sale to a consortium led by Blackstone Group.
Many of the wiser heads in private equity quietly admit that, thanks to easy credit, white-hot prices were paid by an industry that tends to do its best deals in cooler markets. Growing fears that the credit crunch will be followed by a recession, at least in America, have added to concerns about the quality of firms in many private-equity portfolios. During the recession of 1991-92 that followed the first boom in private-equity deals—which were known at the time as leveraged buy-outs—many of the firms that had been bought at the top of the market ended up in bankruptcy, unable to finance all the debt that had been used to buy them.
So far, defaults on corporate debt remain at record lows, though market prices predict this will change. But Mr Rubenstein is not alone in thinking that private-equity firms are "much better prepared for a slowdown" than they were. For one thing, deals have generally involved less leverage than they did in the 1980s. And the terms on which debt was raised mean that the banks are less able to force private-equity borrowers into bankruptcy.
Furthermore, private-equity firms are sitting on record amounts of capital and continue to be able to raise large sums, notably from pension funds, despite the credit crunch (though private-equity distressed-debt funds and emerging-market funds are now flavour of the month, not mainstream buy-out funds). As a result, private-equity firms have plenty of cash to shore up the balance sheets of their firms, should they run into difficulties. This should enable them to stave off a rise in bankruptcies that could harm private equity's appeal to investors.
These days private-equity firms also look more to wring profits from improving the operations of their firms. That strategy is more recession-proof than relying on financial engineering, as in the past. A downturn may even have a silver lining for the industry if it curbs the recent political attacks on private equity, suggests Mr Rubenstein. "Politically, it can't hurt to not have headlines every day about another company being bought by private equity," he says—though the industry may also have to grapple with the bad publicity of low returns and bankruptcies.
The downturn in private equity has come entirely at the top end of the market. Private-equity funds smaller than $1 billion have seen "almost no slowdown in deal activity, and lots of deals will be closed in the first quarter of this year," says Jeff Temple of ProAction Group, a post-merger consultancy. Mr Rubenstein says that he expects to see deals in the $3 billion-5 billion range by mid-2008, with "perhaps the occasional $10 billion-plus", which would be a big improvement on today's state of affairs. But financing for mega-deals worth $30 billion-40 billion will be hard to come by, at least for leveraged buyers, he predicts.
All this creates a big opportunity for "strategic mergers"—that is, the old fashioned sort in which one company buys another. When private equity was in its pomp, strategic corporate buyers often found themselves priced out of the market. Now they have a big opportunity, says Gregg Nahass, a merger specialist at PricewaterhouseCoopers (PwC), a consultancy. Corporate balance-sheets are strong, he says, with relatively low levels of debt. The companies in the S&P 500 index have combined cash and liquid securities of $1.7 trillion.
And the wave rolls on
The mergers and acquisitions (M&A) market got a boost in November when BHP Billiton, a mining giant, made a $140 billion offer for its rival Rio Tinto, a bid that is fast becoming hostile. A few more deals like that would keep the business flowing. Mr Nahass also expects the merger wave to change shape as the weak dollar makes American firms into attractive targets for both foreign and domestic buyers. In PwC's 2007 survey of global chief executives, 61% of North American bosses said they intended to make acquisitions in North America, up from 35% in 2006.
In his annual new-year forecast for merger activity, Martin Lipton, a legendary takeover lawyer, notes that many of the factors that created the latest merger wave remain in place. These include the desire of countries to create national champions and sometimes (Russia, China) global champions, the dismantling of takeover defences, the opening of new countries to M&A, the growing enthusiasm of institutional investors and hedge funds for M&A deals, the march of infrastructure privatisation, and pressure on firms to focus on core activities and spin off the rest.
Mr Lipton says that it is impossible to predict M&A activity this year "with any degree of confidence", but says his best guess is a decline in global deals of "more than 25%" in 2008. The wild card, he rightly points out, will be mergers by companies from commodity-rich countries and, above all, investments by their sovereign-wealth funds. Nobody knows much about most of these funds or their investment strategies. But if they continue their recent spate of deals, which has included taking several stakes in financial firms hit by the credit crunch, and provided there is not a serious political backlash against them in America and Europe, sovereign-wealth funds have the resources not just to keep the merger wave going—but to make it bigger than ever.