M&A Activity - The Canary in the Coal Mine

Where is the economy going? Look at mergers and acquisitions activity for the answer to that question. The direction and level of M&A activity has been a harbinger of the economy for the past thirty years. M&A activity is always a leading indicator. Rising levels of activity mean an economic expansion is about to take place or is continuing. Declining levels of activity mean there will be a contraction. Not necessarily a recession, as that is defined, but certainly a contraction. M&A is the canary in the coal mine. Right now the canary is gasping for air.

Why is M&A a leading indicator?

M&A deals are exquisitely sensitive to the most current thinking on interest rate movements, capital markets activity and equity valuations. Whatever is about to be reflected in the broader economy shows up early in the M&A market. Constraints on capital will hit potential borrowers for M&A deals early in any capital crunch. Concerns about the direction of the economy will give pause to CEOs considering acquisitions for their companies.

The market for M&A debt always knows what’s next

For the last thirty years, the lifeblood of debt financing for acquisitions has been the syndicated loan market. Big banks don’t lend money for acquisitions and then hold those loans until maturity. Instead, big banks provide the initial debt financing to buyers of businesses in order to get a deal completed, so-called “bridge loans.” They then essentially sell off pieces of long-term loans to a multitude of buyers which repay the initial set of loans. This is a simplified version of a much more complicated process. But it means that the banks have to make two sets of calculations when asked to lend money to a prospective M&A buyer. The first determination is whether the buyer will be able to repay the debt and interest of the long-term loan put in place after the proposed transaction takes place. The second determination is whether in the next few months the lender will be able to sell pieces of the loan for at least as much money as the value of the loan.

If something bad happens to the borrower or to the economy overall between the time the bank commits to the loan and then tries to sell it, they won’t receive as much money from a buyer of that loan as the original lender provided to the borrower. If interest rates go up significantly during that period, it means a buyer of the loan will want a discount on what they pay for the loan, since the return is below the current rate of interest. If banks think that something adverse could take place to the borrower or the economy between committing to the loan and trying to resell it, they simply won’t agree to make that loan. Private lenders such as credit funds generally hold the loans they make and don’t attempt to sell them. But they simply don’t have the resources to make up for the pull-back in M&A lending by the commercial banks.

Unsettled equity markets hold up deal making

Similarly, if equity valuations are fluctuating due to volatility in the equity markets, it becomes harder for buyers and sellers to agree on prices. The uncertainty as to whether a moment in time is propitious to be a buyer or a seller means that potential deal participants pull back and wait for clarity to arrive in the form of a more settled market. If potential buyers think the economy is going to hit a rough patch in the near future, there is no reason for them to buy another business today if it will be cheaper in a few months or if the target business will have deteriorating results soon.

Adverse signals began a year ago

Lending by banks for M&A deals began to severely contract just over a year ago. Banks couldn’t lend since they knew that the Federal Reserve was beginning to raise interest rates, and also signaled that there would be an ongoing series of significant rate rises. Equity markets began to nose-dive. That is a toxic combination for M&A activity. And so, M&A activity began to fall. 2021 was the busiest year ever for M&A. Each quarter since then has shown double digit declines. Deal volumes in the first quarter of 2023 were 45% below the first quarter of 2022 and almost 25% below the fourth quarter of 2022.?April of this year was anemic, and showed no sign of any kind of upturn.

And look where we are today

As we look at the economic landscape in early May of 2023, there is tremendous uncertainty as to what lies ahead. Growth in GDP in the U.S. slowed to 1.1% in the first quarter of this year, something which is desirable from the Federal Reserve’s perspective in order to reduce inflation. This is the outcome they intended by the steep rise in interest rates. Unfortunately, it turns out that some financial institutions were not prepared to manage the transition from zero interest rates to nearly 5% interest rates. As a result, three substantial banks have had to be taken over by the regulators in the last two months. It remains unclear if yet more banks will face insolvency. But the credit crunch in M&A has spread to the broader economy over the last year. Deposits have fled banks to get higher rates from money market funds, which reduces the lending capacity in the banking market. ?The bank failures have further constrained lending by all banks, which limits the opportunities for growth in the economy.

Ominous signs ahead

A headline in the Wall Street Journal reads “Home Prices in March Posted Biggest Annual Decline in 11 Years.” The Financial Times says “Pension fund Calstrs braced for writedowns in $50 billion property portfolio.” Warren Buffet’s partner and right-hand man, Charlie Munger, says US banks are “full of” bad commercial real estate loans. Large, well known, real estate funds have let commercial real estate portfolio loans go into default. As of the end of April, office vacancy rates in New York City are over 17% and rents are falling. Valuations of office buildings have fallen nationally. Companies are reducing their office space as leases end which had remained in force throughout Covid. And hundreds of billions of dollars of mortgages will need to be refinanced in the next few years. The interest rates for new loans will be far higher and the buildings will be taking in far less in rents.?Looming just over the horizon is a crisis not just for commercial real estate owners but also for the banks holding the loans made to them.

The bottom line

M&A activity will reveal if the market thinks these challenges can be avoided or if danger lies ahead. An upturn in M&A deals in the near future would be a welcome sign of greater optimism on the part of buyers and the loosening of credit constraints by lenders. Continued declines in M&A activity would be a clear signal that significant challenges are imminent. We have no choice but to wait for what awaits us.