M&A Binge Far From Over

Cash from unclosed deals will help maintain the upside, and rate jitters won't curtail the dealmaking.
Author:
Publish date:

Updated from 7:00 a.m. EDT

Contrary to fears circulating last week, it's premature to bemoan the end of the buyout boom because of rising interest rates. But even in the unlikely event that private equity and M&A activity does nosedive, the deals already announced but not yet closed are likely to provide a second-stage liquidity boost to the stock market later this year.

Case in point: Private equity firms Kohlberg Kravis Roberts and Texas Pacific Group offered to pay $32 billion in cash for

TXU

(TXU)

on Feb. 26. TXU's stock jumped 13.2% that day, but the utility's shareholders won't get the cash until sometime in the fourth quarter, when the deal is expected to close.

The same thing is true for all of the cash deals to be settled among the year's $800 billion U.S. deal tally thus far, according to data from Thomson Financial. This includes $300 billion in private equity deals, which are inherently all-cash.

Among strategic deals this year, 75% are all cash. The stock market is likely to benefit from a lot of that cash flowing back into the market long after the headlines heralding the deals fade.

"When shareholders get cash for their stock, they typically redeploy that into investments, including stock," says Tobias Levkovich, chief U.S. equity strategist at Citigroup. "The timing is important: The deal is announced, it gets done, then shareholders get the cash, and then they decide where to reinvest it. That doesn't happen simultaneously."

The typical merger takes an average of 131 days to complete, or just over four months, says Rich Peterson, an analyst at Thomson Financial. Deals can take longer to complete if there's a bidding war or regulatory hurdles to overcome, as is the case in the TXU deal.

Then there's the case of

News Corp's

(NWS) - Get Report

$5 billion cash offer to buy

Dow Jones

(DJ)

. The news and Dow Jones' stock pop happened on May 1.

But the deal is still up in the air amid slow-moving negotiations between Rupert Murdoch and the Bancroft family, which owns a controlling stake in the financial news publisher. If the combination ultimately happens, a closing is unlikely to take place until late autumn at the earliest.

Even without such holdups, the $25 billion cash to fund

Alltel's

(AT) - Get Report

buyout by Texas Pacific Group and Goldman Sachs Capital Partners, announced May 21, isn't expected to fill shareholder wallets until sometime this fall.

The $800 billion of deals announced thus far this year is almost akin to a multi-billion-dollar call option on the stock market. The liquidity to come makes up for the chronic lack of retail investor interest in U.S. stocks.

It also melds with the shrinking supply of shares from company buyback programs to add up to a sturdy safety net for stocks.

Furthermore, the deal-driven cash bonanza will likely spill over into 2008, just as last year's deals continue to fuel stocks nearly halfway through 2007. Of 2006's $1.4 trillion in U.S.-based deals, 17%, or $244.7 billion worth, are still not yet completed, according to Thomson.

Monday morning brought news that

IBM

(IBM) - Get Report

will acquire Sweden's Telelogic in a transaction worth roughly $745 million, while

Back Yard Burgers

(BYBI)

agreed to be taken private equity in an arrangement worth around $38 million.

Which brings us back to the misguided notion that last week's rising Treasury yields dry up deal flow, especially leveraged buyouts.

Anxiety that deal activity will shrivel arises from fears of the end of low-cost debt financing, which has facilitated buyouts at attractive premiums. Amid record low default rates, the risk premiums -- or spread between corporate bonds and comparable Treasuries -- recently reached record low levels.

This is true for both the investment-grade and speculative-grade, or junk, bond markets, where most LBO bond deals are at least partially financed. Deals are also financed in the leveraged loan market, where demand has been rampant and spreads have also been low.

"The difference of 0.25% or 0.5% in the cost of debt won't derail an LBO," says Brian Hessel, managing partner at Stonegate Capital Management, which specializes in high-yield bond portfolios for institutional investors. "When the financing cost moves up by 3% or so, that would be meaningful. That would be a machine shutting down."

The average spread on high-yield bonds widened only 6 basis points last week, according to Merrill Lynch, vs. 18 basis point for the 30-year Treasury bond and 13 basis points for the 10-year note.

These high-yield spreads remain near record-tight levels and about 100 basis points lower than they were one year ago. The average risk premium in the leveraged loan market rose by only 1 basis point last week. This indicates no panic selling in risky debt markets and shows that investors retain their confidence in corporate health.

A Treasury selloff based on a reassessment of stronger economic growth such as last week's does not cause a high-yield bond market collapse, because the stronger growth feeds into stronger earnings, which supports high-yield bonds and stocks, write Merrill Lynch high-yield bond strategists Chris Garman and Oleg Melentyev. An inflation-driven bond selloff, on the other hand, is "dead weight," says Melentyev, because there's no upside for earnings.

Indeed, investors are not running away from the risky asset class at all; they're seeking out high-yield bonds. Junk-bond funds reported an eighth straight week of inflows, according to Merrill Lynch.

On the demand side, appetite for new deals in the high-yield bond market remains strong, says Hessel. New offerings have not suffered after being priced. The worst Hessel could say about new deals is that they've traded at their offering price instead of popping higher.

On top of all that, buyout firms still have huge amounts of cash to put to work. Last year, private equity firms raised more than $156 billion in new money from institutional investors, according to Thomson. Fund-raising this year is sure to have eclipsed last year's flows given the already $300 billion of new deals in the U.S. announced thus far, notes Peterson.

So even if fear mounts about inflation enough that financing costs for buyouts rise more meaningfully, companies and firms will more likely rush to get deals done before the rug is pulled out from under them rather than stop rainmaking altogether.

That should keep the equities' side of Wall Street mostly sunny, even if there are some lingering clouds from last week's storm.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

here

to send her an email.