If the financial crisis taught companies anything, it was the perils of having too much debt or not enough cash on their balance sheets. In the early stages of the crisis, CEOs went into survival mode and strived to de-lever their balance sheets, pay down and restructure debt back to more manageable levels, and in some cases actually be in a positive cash position.
This strategy was aided by the fact that, with major economies either in recession or growing slowly, there was significant spare capacity. Therefore, companies were not compelled to use large amounts of cash flow to fund capital expenditure (capex) programmes.
As stability returned and debt balances continued to improve, it was inevitable that shareholders and investors would want to know managements’ plans to use the increasing levels of cash flow that companies were generating. With limited growth opportunities, there was no need to reinvest in the business - debt was at manageable levels - so the clarion call of shareholders became ‘give it back to us!’ As a result, we saw a substantial pick up in share buybacks - companies that had never paid a dividend started to pay one - and those that did pay dividends announced significant increases. Companies that followed this path had some of the best share price performances and this created a virtuous loop, encouraging more and more management teams to follow suit.
The seed for shareholders’ desire to see cash returned to them did not necessarily lie in a lack of belief in management’s discipline. Truth be told, with deposit rates and yields on government and corporate bonds being so low, there was a genuine appetite for income, and dividends would do very nicely.
As long as net debt levels were not problematic, company managements sought to keep investors happy with this diet of buybacks and dividends. With access to debt improved, there was a further development in this theme and with it a substantial pickup in debt issuance (see Figure 1).
Companies that traditionally had not been active participants in the corporate bond markets raised debt in increasingly larger deals. What made it all the more interesting was that in many cases these companies, such as the technology giants of Microsoft, Apple, and Oracle, were raising debt while at the same time having ample cash levels on their balance sheets.
The level of demand from corporate bond investors (another bi-product of the search for yield globally) resulted in incredibly low interest rates paid by issuers and the maturity profile of the debt increasing - in some cases all the way out to 30 years and beyond. When companies announced these debt programmes, they were also upfront about what the money raised was going to be used for - share repurchase programmes and special dividends.
It is a fair question to ask that if these companies had so much cash on their balance sheets, why raise debt to fund these activities? Why not just use the cash? The answer, particularly for the large US companies, lies in where their cash was located. In accounting terms when looking at a company’s balance sheet, the location of assets (be they buildings or in this case cash) is not an issue. The only thing that is important is that you own them. The problem is that tax authorities don’t share the same view.
Given the global nature of many of these companies (and the favourable tax regimes of certain countries) much of their profit and cash flow is earned outside of their home country. In order to pay dividends or buyback shares, US companies need to have the funds in their domestic operations. But bringing cash back from overseas operations triggers a tax of 35% on those funds. Therefore, while credit markets were eager to lend money at attractive rates, managements saw little sense in paying the ‘unnecessary’ taxes associated with repatriating cash to return it to shareholders.
While placating your shareholders with cash has some merits in the short-term, it tends not to be a great strategy for the long-term growth of a company. At some point, companies need to reinvest in the business, be it in organic projects or acquisitions. Since late last year we have seen company management teams alter the script as they sought to wean their shareholders off their cash diet, with talk of the need to do ‘strategic’ transactions more and more prevalent.
This also came at a point when credit markets began to differentiate between domestic and overseas cash when it came to analysing the overall debt levels within a company. Credit investors became more conscious of the fact that ever increasing levels of debt were being offset by cash held in overseas subsidiaries and were less willing to give the companies the ‘full benefit’ when analysing the overall debt levels in the company. Therefore, CEOs sought other uses for their excess cash ‘trapped’ overseas - and with this, the focus moved to acquisitions.
So what is it that makes today’s transactions more ‘strategic’ in nature? The rationale for doing a deal typically falls into one of two categories: cost savings or revenue generation. There are of course some deals that generate both types of synergies but the predominant driver tends to be one or the other.
At this point in the economic cycle, most of the corporate ‘fat’ has been trimmed, either by the management themselves or by the private equity funds that were so active during the recession. We have seen companies increase their profit margins as we exited the recession to the point where we are now at multi-year highs.
As a result, many of the deals being done now are focused on garnering revenue synergies - in the form of new products, markets, or customers - rather than merely reducing the overhead costs of the combined entity. Companies are looking to bolster their growth potential by accessing markets adjacent to their core operations.
With such an appetite to do deals, it’s not surprising that the investment bankers have been busy. So far this year there has been over 400 mergers and acquisition (M&A) deals, with a value in excess of US$1 billion. As Figure 2 illustrates, total M&A looks set to surpass $1 trillion this year.
There have been a few high profile battles where, even though the bankers tried their best, the ‘bride and groom’ couldn’t be joined at the ‘altar’ but this has not prevented the acquirer from aggressively pursuing its prey - and in some cases, quickly moving on to the next target when their advances are spurned.
Given their large cash balances and their desire to minimise the tax burden, it would be natural to assume that US companies are the only ones doing deals. But while they do account for many of the deals, they are by no means alone. Deals are being pursued by companies in all regions with the targets well spread geographically (see Figure 4).
From an industry perspective, the activity has been widespread. Traditionally, sectors like Technology and Industrials have been the most active dealmakers, but so far this year they have been left behind as companies in the Healthcare and Consumer Discretionary sectors have stolen a march (see Figure 5). What has also proved noteworthy is that in most cases the deals have involved buying certain operations or assets rather than a full takeover of the target company.
Recently, a new term has entered the M&A lexicon, ‘The Inversion Deal’. At its core, an inversion deal involves a US company acquiring a foreign-domiciled company - typically in Ireland, the Netherlands, Switzerland, or the UK - and then moving its headquarters to the overseas jurisdiction upon completion of the deal, allowing them to take advantage of lower corporate tax rates. For the most part, these deals have been initiated by US companies.
What has been interesting so far has been that some of the target companies in these deals were at one time US-domiciled entities as well, before moving overseas to take advantage of lower corporate tax rates - as is the case with Medtronic’s proposed acquisition of ‘Irish-based’ Covidien.
Where this is the case, the targets usually have significant US operations and are listed on the US stock market, making both physical, legal and shareholder integration a little easier. Needless to say Uncle Sam is less than happy with the prospect of losing the potential tax revenue from the enlarged entity and we have seen a fair degree of sabre rattling from politicians in Washington as a result. With US mid-term elections due later this year, we could see this topic become a campaign issue, making such deals more difficult to achieve.
If the quantum of newspaper ink was any indication, you could be excused for thinking that these have been the only type of deals being done. In reality, however, they represent a tiny percentage of the total deals so far. The decision to move a company’s jurisdiction is significant and the monetary benefits may not offset the ‘softer’ repercussions of the decision. The recent high profile decision by Walgreens to remain headquartered in the US following its takeover of Swiss-based Alliance Boots is a case in point. As the largest pharmacy chain in the US with a nationwide footprint and many government contracts, customers might take a rather dim view of any decision to move abroad and act accordingly.
No matter what the rationale, the fact remains that companies now have the financial wherewithal and the strategic imperative to invest in the growth of their companies. Their willingness to move beyond the siege mentality of recent years is evidence of their belief in the global recovery and their desire to capture more of the upside for their companies. In time, as their conviction increases, this might progress to the extent that we see companies grow capacity through new greenfield investments but for now the ‘deal or no deal’ question is likely to be heard with greater frequency.