Prepare for an M&A binge

It helps that 2020’s M&A activity offers a very beatable target. According to management consultant Bain & Company in its 2021 Global M&A Report – well worth downloading from its website – about $2.8 trillion (£2.0 trillion) of deals were concluded in 2020. That was 15 per cent less than 2019’s $3.3 trillion and the lowest total since 2013. Arguably, however, the encouraging factor is how strongly deal-making held up. In the third and fourth quarter, deal value was 30 per cent ahead of 2019’s comparatives.

It also helps that there is lots of ready money to fund deals. Loan capital remains dirt cheap; stock market valuations mean equity isn’t that much more expensive and private equity is groaning under the weight of committed funds – about $2.8 trillion-worth, according to Bain.

Perhaps more important, company bosses told Bain they expect M&A to contribute about 45 per cent of their companies’ revenue growth compared with 30 per cent over the past three years. In addition, the more that bosses said they were confident in their companies’ ability to make acquisitions, the greater the proportion of future revenue they imagined coming from M&A. While that might be logical, it is also worrying since so much research shows that, on average, M&A destroys more shareholder value than it creates. In that context, ‘confidence’ might really be another word for ‘hubris’ since company bosses serially overrate their ability both to do deals and to make real the benefits that are supposed to ensue.

That said, these are special times, calling for special adaptations, which might justify a greater reliance on M&A than usual. In particular, Bain reckons the challenge of the post-Covid world demands that bosses rethink their companies. This will result in more of what it labels ‘scope’ deals; in other words, more ‘horizontal’ integration (adding new corporate functions) rather than ‘vertical’ integration (adding more of the same in order to generate economies of scale).

The sort of deals Bain has in mind are last year’s $1.5bn acquisition of New York-based meals-delivery operator Freshly by Nestlé (SIX:NESN), the world’s biggest food company, and one by US telecoms provider Verizon Communications (US:VZ) to buy BlueJeans, which provides video-conferencing services. Both filled gaps in the bigger group’s corporate repertoire whose absence was exposed by the response to Covid-19. Or, as Bain’s report rather breathlessly puts it: “The crisis in 2020 made it even more expedient for companies to bring in house critical capabilities.”

It is interesting to speculate whether this will become a long-term trend. If so, it might substantially change the way that companies have been shaping themselves since the 1990s. Recall the classic explanation of why companies exist, as theorised by the Anglo-American economist, Ronald Coase in the late 1930s.

Coase suggested that companies exist when it is more efficient to bring various functions under a single corporate umbrella than to buy them in from the outside and they will expand up to the point where the cost of keeping the functions in house exceeds that of using the market place. More recently, Coase’s theory has been fine-tuned by another Anglo-American economist, Oliver Hart, for which he shared the 2016 Nobel Prize in economics. Hart pointed out that the messiness of contracts meant companies sometimes found it easier to bring hard-to-define functions in house rather than contract out such tasks.

So companies inflate or deflate depending on which notion is in favour – do-it-all in house, or contract out the peripheral stuff. The latter has been the way since the 1990s, leading in particular to the break-up of rambling conglomerates whose identity had been lost in the mists of countless deals. In their place came not just the lean-and-mean but, more important, the highly focused, the ones who knew their core competence and stuck to it.

Obviously, that’s a simplification. There was never just one way to skin the corporate cat. One could never accuse Nestlé of being highly focused yet it was – and is – highly successful. However, if the shortcomings in the specialised approach have been exposed by the special circumstances of Covid-19, then the trend may go into reverse. In which case, that would be great for the M&A market as companies beefed up again.

True, the process would begin with a hot pursuit of ‘new world’ companies, the ones that have demonstrated their importance since the pandemic. Almost by definition, however, these are in short supply and will therefore be expensive – priced in multiples of revenue rather than anything so old-fashioned as profit (usually because they don’t make any).

The dash to M&A may be further propelled by another consequence of the pandemic, suggests Bain – the need to bring supply chains closer to home. Nearly 60 per cent of companies told Bain this would be a significant factor in their forthcoming deals. Indeed, this trend is already under way. Rising suspicion between China and the west means western companies are already changing their supply arrangements. Simultaneously, the propensity of Chinese companies to buy up the world is diminished. As recently as 2016, 25 per cent of their M&A by value was spent on companies outside Asia. Last year, that proportion was down to just 5 per cent. More generally, bigger companies will use the downturn as they always do – as an opportunity to outspend their weaker competitors and, in the process, grab market share.

In which case, the almost-inevitable question arises, how should the equity portfolio of the average retail investor shape up in this would-be world of jungle warfare? This is less a matter of ‘do you own shares in predators?’ and more one of ‘do you hold shares in those about to be gobbled up?’

The table is a quick-and-dirty assessment of those FTSE 350 companies looking vulnerable. This concentrates on three factors:

●  A weak share price; the 20 in the table are drawn from the 57 whose price is at least 20 per cent lower than a year ago. That implies there may be bargains among them.

●  The ability to generate free cash from trading. All of those in the table produced free cash in their most recent full year, in some case yielding amounts well over 10 per cent of their share price. This implies an ability to handle the debt that, in effect, a predator is likely to dump on them. True, the FTSE 350 is a collection of mostly well-established, old-world companies. Even so, within them will be the usual mix of dross and top-class expertise that comes with corporate longevity.

●  At least lowish levels of net debt. This, too, indicates the ability of a predator to fund its acquisition with debt. However, expressing this as a ratio of debt to the market value of the equity (rather than to equity’s book value) may also indicate how depressed are some of the share prices – Imperial Brands (IMB), for example.

Almost every diversified portfolio will have candidates at least similar to these. For example, within the Bearbull Income Fund sits GlaxoSmithKline (GSK), which, as I suggested just the other week (Bearbull, 12 February 2021), is high-yield takeover fodder. Where are yours or will you have to buy them in?

Email: bearbull@ft.com