Where are the mergers and acquisitions?
Consumer confidence is high. Equity values have been climbing for years, and the markets have seen a significant bump since the presidential election, with the Dow Jones Industrial Average climbing 22% and the Nasdaq Composite 24% [as of Sept. 19].
And yet M&A activity appears stalled. Through mid-September this year, just $2.4 trillion in deals have been announced; that’s 23% lower than the value of deals by this point in 2015. Despite a few blockbusters like Amazon’s acquisition of Whole Foods and United Technologies’ bid for Rockwell Collins, this year there have been only 24 megadeals — those totaling more than $10 billion in value — compared with 38 over the same period in 2015.
Even the size of megadeals has shrunk: The average one in 2015 was $24.5 billion. This year, it is $17.6 billion.
Markets and mergers have diverged before — in 2015, for example, M&A activity hit an all-time high even as the Dow Jones Industrial Average wandered erratically. But why, in 2017, is deal value moving south while equity values are moving north? Three factors explain the current gap.
The first is the change in tax inversion rules that the Treasury Department put in place in April 2016. In years prior, companies announced numerous deals (many were not consummated) whose principal thesis was not strategic, but rather were aimed at reducing tax obligations by “moving” to lower-tax domiciles. Most of these deals — the scuttled merger of Pfizer and Allergan was perhaps the most prominent — were megadeals, given requirements regarding the size of companies acquired for purposes of an inversion relative to the size of the acquirer.
The new rules have, however virtually eliminated the tax incentive for an inversion, so these types of deals are unlikely to return.
Second, executives have far less certainty when it comes to tax policy. The current presidential administration campaigned hard on the topic of tax reform, but the protracted health-care drama has raised doubts among business leaders about whether tax reform will ever come to pass. Executive teams are finding it hard to predict the future cash flows of many assets they might acquire, because they cannot predict what the future tax obligations of those assets will be.
Finally, too many of today’s executives still treat capital as a scarce resource. That was true for most of the past 50 years, but global financial capital has more than tripled over the past three decades and now stands at roughly 10 times global GDP. Its cost has plummeted accordingly: For many large companies, the after-tax cost of borrowing is close to the rate of inflation, meaning that real borrowing costs hover near zero.
Although the cost of capital is now rising, it is likely to rise slowly and steadily. At Bain, we believe that capital superabundance will last for at least a decade to come.
Yet few companies have incorporated this new reality into their hurdle rates. We find that many companies have not adjusted their hurdle rates significantly in 20 years or more, or intentionally maintain a high hurdle rate as a hedge against future risk. By our estimates, hurdle rates at most companies are 650 to 750 basis points higher than their actual cost of capital.
In an environment where company valuations are at historic levels (in large part because of the abundance of capital) but hurdle rates remain high, it is increasingly difficult for M&A managers to structure deals that pencil out. Even if their companies do manage to get a deal done, they have to take more action, sooner, in order to generate the value required by their models.
In terms of corporate taxes, there is little that business can do to break the gridlock in Washington other than to remind our political leaders that uncertainty comes with real economic costs. It’s a major reason companies are passing up value-creating investments today.
But to CFOs, we would say there is something you can do in the meantime: Take another look at your hurdle rates. You are probably passing on projects — and not just acquisitions — that would offer real returns if you reconsidered them using a hurdle rate that accurately reflects your cost of capital.
Dale Stafford is a partner with Bain & Company and leads its mergers and acquisitions and corporate finance practice in the Americas.