Letter from… Robert Cole: M&A must prove it can make companies better, not just bigger

The corporate takeover business is pretty sick. But anyone who believes that M&A has passed into history is mistaken.

The volume of worldwide mergers and acquisitions dropped 35% in the first quarter of this year, against the same period in 2011, according to data from Thomson Reuters. Despite this, there were still 9,000 deals chronicled with a combined value of nearly $500 billion in the first quarter of 2012.

Given the scale of the financial shock that began in 2007 and has rumbled on ever since, it is hardly surprising that M&A has been at a low ebb. Bereft of confidence, companies have focused on defence. Who wants to do a big deal, to go on the attack, when difficult market conditions could leave ambitious protagonists exposed?

Some think that the strength of corporate balance sheets would have spurred M&A activity. A report this month by the Ernst & Young Item Club said that UK corporate balance sheets were bulging with £754 billion (about $1.22 trillion)—a sum equivalent to 50% of Britain’s GDP. Last month, ratings agency Moody’s said that the balance sheets of nonfinancial US companies were holding $1.244 trillion of cash. But these reserves, it seems, have been built up out of fear, not greed. The defensive walls of cash are unlikely to be dismantled lightly.

The M&A bounce back has also been hampered by pure financial market circumstances. When debt was freely available, debt-fuelled financial engineering spruced up the potential for equity returns. Debt brought risks, of course, but leverage also brought the prospect of returns that could be magnified and compensate for the financial and operational dangers of M&A.

Enhanced corporate governance standards are another factor. Investors have learned to wonder if mergers are executive ego trips. Managements, sobered by the recollection of deals that were sunk by fretful owners, will think twice or three times before going out on a limb. The ghost of the Prudential’s ambitious $35 billion plan to buy AIA looms large. The not-altogether-different failure of (the security giant) G4S’s £5 billion idea to buy ISS, a Danish competitor, gives pause for thought, too. A major reversal could end with boardroom heads rolling.

Deal prices, meanwhile, have fallen, but are hardly in the bargain basement. The average EBITDA exit multiple for global deals, according to Thomson Reuters data, is now 11.2, compared with 13.7 for the period 2006 to 2010. And sellers still expect to receive a sizable premium to the pre-deal value. Latest numbers show that the average premium in the first three months of 2012 was 32.8%. That is actually a little higher than the 2006-2010 average.

The time will come when companies are confident enough to spend this way again. But that point may come only when global economic recovery is patently under way. It may only come after companies have mined more prosaic seams of growth—notably from sensible capital expenditure investment into businesses that are already owned.

Would-be dealmakers may have to show that acquired assets will not just lead to expanded earnings per share, but also exceed the cost of capital invested in the business. Deals may no longer wash if value is to be created though cost cutting. Estimates of revenue synergies are notoriously slippery, but M&A-ers may struggle unless they can convincingly point to a long-term, recurring growth story.

Investors will also need to be convinced that an acquisition will bring them more than the compound returns that they earn from a steady stream of dividends. And compounded dividend income, as shown by studies such as those undertaken by the London Business School in association with investment bank Credit Suisse, delivers a great deal of return over the medium and long term.

M&A might be helped if share-for-share deals gained popularity. It would take a mighty cultural shift by boards, and asset managers, because cash deals are so much preferred at present. But cash deals lack balance – loading risk and reward on buyers. Share for share M&A, in contrast, spreads the risks and rewards companies that fit themselves together effectively. They may create more genuine value and a healthier M&A pipeline.

After the excesses and failures of the boom years, ambitious companies—and investment bankers whose advisory skills have been shown to be wanting—have much to prove. And M&A may remain subdued until protagonists can give adequate assurance that deals do not just make companies bigger, but also make them better.

Robert Cole is assistant editor of Reuters Breakingviews (, the comment and analysis arm of the global news network.