How the Rallying Stock Market Could Revive M&A

The Dow Jones Industrial Average is soaring. Since breaking the record last Tuesday, it has continued on a tear with nine straight days of new highs.

In a seeming abandonment of past trepidation, investors are forging ahead despite the uncertainty surrounding the sequester and the European puzzle. The record performance could mean promising news for the overall economy, as the market has a record of predicting the direction of the economy.

If the strong performance continues, M&A activity could be headed for a revival, on the basis of active corporate acquirers, rising valuations, and cheap credit.

1) Increased Activity Among Corporate Development Offices
The most immediate beneficiaries of the rising stock market will be corporate development offices, since the rising stock prices seem to be built largely on their growing profits.

After slow growth in recent years, increased profits are a welcome reprieve. Corporate development offices may look to capitalize on the extra cash by acquisitions that immediately add to the bottom line. While the results of our Corporate Development Survey revealed that 43% of corporate acquisitions are driven by accretion or synergies, the recent rise in stock prices may also spur many companies to make acquisitions simply on the basis of multiple arbitrage.

As Carl Shapiro mentioned in his recent New York Times article, “…deals occur when corporate profits are high and the stock market is feeling bullish: corporate executives seem unable to resist going on a shopping spree when their stock is soaring and they have lots of cash on hand.”

In addition to corporations having more cash for acquisitions, they will also have more leverage in stock-for-stock acquisitions, particularly when acquiring private companies. This just adds more momentum to an already strategic driven 2013.

2) Valuations will Rise
As corporate development offices look for their new acquisitions, they may find prices a little higher than anticipated; comparable valuations are naturally rising as stock prices swell. While the larger valuations will initially appear mostly in larger deals and the upper-middle market, the upward pull of prices will quickly trickle down to the middle and lower-middle markets. Valuations will also rise from the competitive pressures of new strategic buyers joining an already competitive landscape.

The stock-dependent valuation drivers are simply wind on the back of the dry powder and cheap debt that were already expected to drive higher prices in 2013. As Axial Member John Slater of Focus recently explained, “One important driver for the valuation jump in the middle market is an increase in total leverage available from a range of 2.5 – 3.25x cash flow immediately following the 2007/08 recession to a 2012 range of 4-4.75x.  Companies with steady, highly predictable cash flow are seeing leverage multiples of up to 5x cash flow and even more for companies with EBITDA over $20 million.”

Discussing dry powder, he continued, “Since fund management fee income is directly proportional to committed funds plus investments, failure to use this money would have very negative consequences for many PE groups.  Thus many of these funds will find themselves under tremendous pressure to do deals, even if they find that doing so requires an increase in their valuation expectations.”

3) More Companies Coming to Market
While rising valuations and increased activity of corporations may provide significant challenges in sourcing and acquiring new deals, it should encourage a number of long-awaited sales and exits, which may balance some of the buy-side demand.

Over the past several years, many private equity firms have been hesitant to sell their portfolio companies because of the unfavorable environment. For any company acquired in 2005 or 2006, the normal 3-5 year investment period forecasted a sale in the nadir of M&A activity and economic stability. To avoid selling low, many firms opted to continue holding their investments beyond the traditional window.

However, the stock market’s rise over the early part of the year has created a favorable selling environment — the first ten days of March saw a 47% increase in deals coming to market over the same period a month ago, according to the data on Axial.

Additionally, private equity firms with public portfolio companies have already begun to exit some of their positions in the secondary market. For these companies, the rising stock market means better selling price, regardless of active corporations or comparables.

Ken Sweet recently reported in the WSJ, “…secondary offerings by companies who count private equity firms among their backers hit a record high, compared to similar periods for every prior year since 1999. As of Feb. 19, 41 companies sold a total of $17.2 billion in stock, more than triple the $5.1 billion raised by 22 companies for the same period last year.”

While there is a chance the stock market rally may cool, a continued surge could signal a revival for M&A activity. The combination of acquisitive corporate development offices, higher valuations, and a surge of exits could finally release the sluggish industry from the mud. Based on the early part of the year, 2013 is shaping up to be a strong year for mergers and acquisitions.

Thanks to harry_nl for the photo.