Is This the Start of the Next M&A Boom?

NEW YORK ( TheStreet) -- M&A is all the buzz with companies, like investors, looking to score a deal on depressed valuations. Buyouts have come with rich premiums, benefiting smart investors who can identify takeover targets now.

About $66 billion in transactions have been announced in the U.S. this year, a decline of 63% from the same period last year. But this year's deals carry a much higher premium. Acquirers, on average, are offering to pay 48% more than companies' stock-market values this year versus 21% at the start of 2011.

Among the biggest deals, commodities giants Xstrata and Glencore announced a $90 billion merger deal in the past week, although that has seen shareholder pushback already. On Thursday, Oracle ( ORCL) announced a $1.9-billion buy of cloud-computing company Taleo ( TLEO).

Those premiums are coming on the heels of low valuations and a need for corporations to drive growth. Currently, the S&P 500 is trading at about 14 times earnings, which is below the five-year average of 16 times. With many quality companies trading at a steep discount to historical valuations, cash-rich acquirers are in a position to pay a nice premium for these companies and still consider it a deal.

With economic growth expected to hover just above 2% in the U.S. for the next few years, organic growth will be hard to come by. Buying smaller rivals is one strategy that many companies will use to drive growth. The trend toward consolidation in a number of industries, including biotech, chemicals and mining, to name a few, will be a key driver of M&A in 2012.

The Great Recession forced many companies to get their financial house in order. As a result, corporate balance sheets are the strongest they've been in a long time. Cash balances for the S&P 500 have increased by 49% since 2007 to $287 billion and net debt per share has declined by 56% over the same time period.

Corporations aren't the only ones with cash in their coffers. Private-equity firms too have amassed a significant amount of cash over the last five years. According to President and CEO Magazine, private-equity firms have more than $500 billion in capital available for deployment.

Cash is always an important component used to acquire businesses, but another encouraging sign that the deal market is open for business this year is the improvement in the debt financing markets. Deal action was depressed in the past few years when financing dried up. While the market isn't back to its pre-recession levels that allowed for highly levered deals, it would be available for quality deals. This is most important for private-equity investors.

That said, cash is expected to be the primary source of capital as far as deal financing goes in 2012, with access to debt markets giving buyers optionality. David Lonsdale, president and managing director at Allegiance Capital Corporation says that banks "are lending more aggressively, however I still think you're going to see a lot of equity in deals. It'll probably be about 30% to 40% equity and the remainder debt."

That level of equity or cash investment by acquirers is higher than the standard of 20% to 25% a few years ago, making healthy companies with good cash flow characteristics likely targets. Otherwise the required return on investment could take longer to realize than the buyer would like. That is especially the case for private equity firms that don't have the synergies corporations do that justify the equity investment.

Valuations of M&A transactions are expected to continue to expand though may not reach the levels seen in 2007. Private equity transactions that were highly levered helped contribute to the peak multiples of 2007 explains Ilan Kaufthal, Chairman of Eastwind Advisors.

Its clear strategic acquirers are willing to pay big premiums for companies that can help expand market share or provide entry into a new and important market. Eastman Chemical ( EMN) offered to pay nearly a 50% premium for specialty plastics and chemicals maker Solutia ( SOA) to expand their presence in emerging markets.

Year-to-date the mining, diversified financials, oil and gas, and biotech sectors are winning the M&A game with the most deals announced. That is largely in-line with what a survey of finance professionals by Bloomberg found -- the survey sees energy/power, basic materials and financials leading the way in 2012. Investing in potential take-over targets in these industries could help you to capitalize on the M&A boom.

-- Written by Lindsey Bell in New York.

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