When -- and why -- will this M&A market party come to an end?
How long can this hot M&A market persist? What factors affect its duration and robustness? M&A cycles tend to coincide with six to seven-year economic cycles. We at Mirus believe this cycle started in 2004 and will peak in late 2007 or early 2008. We identified five key indicators that stand to extend or compress the cycle, including: availability of private equity and debt capital, the return of strategic acquirers, the persistence of the macroeconomic environment, maturation of London's Alternative Investment Market and a more accommodating Nasdaq IPO market.
In the absence of an IPO market, the private equity community has been happy to provide liquidity for exit-constrained companies. Private-equity sponsored M&A should continue based on the confluence of a lot of available capital (of $199 billion raised in 2005, only $56 billion is deployed), a growing backlog of profitable targets that can support leverage, and a more capital-efficient VC model which moderates exit expectations.
Another factor that would extend the current cycle is that corporate buyers are returning in force to the M&A markets after years of inactivity. As of second-quarter 2006, cash represented 7.3 percent of the market value of the S&P 500. European corporations are also expected to put their $770 billion to $1 trillion stockpiles into M&A, and cross-border activity is on the rise.
The persistence of the current macroeconomic environment (solid GDP growth, low interest rates and inflation, strong stock market, etc.) will also continue to support today's strong M&A market.
On the public-market side, companies listing on London's AIM have done so for fund-raising rather than liquidity purposes. Investors are also concerned about the lack of liquidity for AIM-listed companies from downstream buyers or secondary investors. Similarly, while Nasdaq could eventually absorb all the float of a listed company, it's not clear if AIM will do that. These factors limit AIM's viability as an exit option and indirectly bolster the M&A market.
At the same time, venture capitalists have flocked to M&A exits for lack of a viable IPO alternative. M&A is less risky and complicated, less expensive and faster -- and many rich transactions with private acquirers have eliminated the liquidity premium traditionally available from publicly traded companies.
Factors that compress
Looking at factors that could shorten the current M&A cycle, interest rates are rising, and lenders may turn conservative if a few highly leveraged companies default on their loans. Though default rates are at all-time lows, a June poll by the Turnaround Management Association of Chicago foreshadows an increase in default rates in the near term, with 90 percent of respondents predicting a downturn by the end of 2007. It is unknown how hedge funds and similar alternative lenders will behave in that environment.
What's more, a glut of sellers, combined with indigestion by serial acquirers, could retard strategic acquisitions. There is a huge exit backlog of 1,912 private venture-backed companies in the United States, Europe and Israel that have not received financing in several years and will need to be sold. At the same time, in some segments (like enterprise software), there are fewer buyers now than there were five years ago.
Looking at the macroeconomic environment, if the economy deteriorates then M&A will quickly follow. The International Monetary Fund has recently revised its projections of U.S. economic growth downward to 2.9 percent for 2007, though the global economy is expected to see substantially higher growth, at 4.9 percent in 2007.
Among the public markets, leading British financial institutions are increasingly seeing small-cap AIM-listed companies as an attractive asset class. If AIM evolves toward facilitating liquidity events (through secondary offerings and acquisitions), as presaged by the greater liquidity on AIM versus Nasdaq of companies with capitalization of $95 million to $285 million, AIM may grow at the expense of the M&A market.
As for the Nasdaq, many venture investors express guarded optimism that the public markets will improve. The Securities and Exchange Commission has begun to realize that Sarbanes-Oxley might have gone too far and jeopardized U.S. capital market leadership, as evinced by the formation of the Commission on Capital Markets Regulation. This independent commission will soon issue recommendations on how to improve the competitiveness of the U.S. public capital markets, which could reinvigorate the IPO market.
We believe the current M&A environment will continue into 2008. Nevertheless, owners and investors need to diligently monitor the key indicators to ensure a timely and optimized exit.
Peter Alternative is a partner at Burlington-based investment bank Mirus Capital Advisors. He can be reached at alternative@merger.com.
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