Innovation Update

Return to Article

Liquidity Fuels M&A, Autos' Revival

Liz Rappaport

The trappings of excess liquidity in the financial markets are so easy to spot on these merger Mondays. The Monday before Christmas '06 was no different. Investors awakened to news of about $60 billion in M&A activity -- no small portion of which was driven by private equity investment.

The deals boosted the market for a bit, but stocks couldn't hang onto their gains amid lingering worries about what happens if and when the liquidity dries up.

After trading as high as 12,491 early on, the Dow Jones Industrial Average closed down fractionally at 12,441.27 while the S&P 500 slipped 0.3% to close at 1422.48. The Nasdaq Composite had the worst day of the three major indices, slipping 0.9% to close at 2435.57%.

Among the deals announced Monday, pharmacy services company Express Scripts(ESRX Quote) announced an unsolicited offer for Caremark RX(CMX Quote) for $26 billion. Their shares were up 1.9% and 10.5%, respectively.

Private equity firm Apollo Group was busy Monday, announcing plans to buy Realogy(H Quote) for $6.65 billion, sending its shares up 19.2%. Also, Harrah's Entertainment(HET Quote) jumped 3.4% on news it is reportedly close to accepting a higher, nearly $17 billion buyout bid from Apollo and Texas Pacific Group.

Health care company Biomet(BMET Quote) agreed to accept a $10.9 billion bid to be taken private by a consortium of firms including Blackstone Group, Goldman Sachs Capital Partners, Kohlberg Kravis Roberts and Texas Pacific Group, along with Biomet founder Dane Miller. Biomet shares slipped 1%, but that comes after a strong run since the deal was first reported.

Meanwhile, a group of private equity investors, including Appaloosa Management, Cerberus Capital Management and Harbinger Capital Partners, are joining with Merrill Lynch and UBS Securities to finance auto parts supplier Delphi's(DPHIQ Quote) emergence from bankruptcy in a $3.4 billion deal. The company is expected to emerge from bankruptcy in the second quarter of 2007.

While $3.4 billion is hardly the largest auto-related financing these days, the announcement is a reminder of how much the auto industry has ridden the liquidity boom and how far it still has to go ... fundamentally.

The incredible performance of junk-rated General Motors'(GM Quote) securities this year and the tremendous financing just accomplished by also junk-rated Ford(F Quote) are the ultimate evidence of excess liquidity in the financial markets. But their ability to take advantage of the friendly marketplace in 2006 does not erase the reality that the biggest threat to these companies' solvency lies ahead.

At the end of 2005, investors were endlessly debating if, when and how GM would go bankrupt. Nearly 12 months later, GM's stock and bonds have returned over 50%. The company has cut costs, has shaken off Kirk Kerkorian and arguably is making better cars.

The new auto-related worry is Ford -- the subject of a Wall Street Journal article Monday, which described how the company's recent refinancing was better for debt investors than for its shareholders. Separately, Jim Cramer raised concern about a Ford bankruptcy in a video interview Monday on TheStreet.com.

Ford just completed $26 billion in fund raising, and no one really knows what it plans to do with all that money. It has also cut costs this year, but it has a less-loved roster of vehicles. The automaker is struggling for relevance in the marketplace, and it has a new man in charge. Former Boeing (BA Quote) CEO Alan Mulally took the reins at Ford in September. Ford's stock has fallen 8.9% year to date, while its benchmark bonds have returned about 25%.

With Delphi emerging from bankruptcy, the two struggling automakers in the big three, Ford and GM, stand slightly better off, having bided their time in the liquidity rainstorm. DaimlerChrysler(DCX Quote) completes the trio.

So as investors seem willing to give these companies and the overall market the benefit of the doubt, their finish line is 2007. All three must renegotiate their contracts with the United Autoworkers Union, and they really need to be different this time.

"This isn't the regular, standard we'll-give-you-a-little-and-take-a-lot,'" says Gregg Klein, fixed-income analyst at BNP Paribas. "This time the big three have to right the ship, or they're going to face bankruptcy."

The deadline for the UAW's contract is Sept. 30, 2007. The talks are likely to start in June or July, says Klein.

As many strategists and analysts start to turn out the lights in their office having caught the liquidity wave, they've raised their forecasts for 2007. But there are plenty of skeletons in the closet. The automakers' success in the markets and their ability to buy time may have been somewhat driven by fundamental improvements, but much of it was likely investors chasing yield. That impulse could disappear in a heartbeat -- just like it could for the entire stock market and other riskier asset classes. No one knows exactly how liquidity might dry up, but everyone worries about it, and everyone thinks he'll be first to get out. For the time being, though, no one denies that the wave makes for a pretty good trade.