While 2014 has seen a strengthening of M&A activity, fuelled by favourable economic signals at the start of the year, autumn has brought with it significant changes, particularly in the way that transactions are financed.
Michael Dakin, a partner at Clifford Chance, says: “2014 has been a year of two distinct halves. During the first half of the year, the high-yield [bond] market seemed unstoppable in its appeal as a means of financing M&A. While during the second half, with negative macro-economic signals from the eurozone in particular, we saw a shift in this trend, with bank financing becoming the method of choice.
“This is not an alarming or unexpected change, but simply a cyclical development. Consequently, we would expect to see the return of the high-yield market shortly, probably early in 2015.”
One question is whether acquirers need to seek finance for M&A, given record cash reserves. According to Deloitte, $3.53 trillion was held by the top 1,000 public, non-financial companies at end 2013. However, 81 per cent of this was held by only 32 per cent of companies, many of which are more conservative in their spending habits than their less cash-rich peers. Consequently, while some corporates are holding large cash balances, these are not typically the most active in M&A.
Although bank financing has increased, this has pros and cons compared with the high-yield capital markets. For example, while bank financing offers greater certainty, ease and lower costs, the high-yield market is more flexible and typically involves a more favourable covenant package. Borrowers can raise a larger amount of debt as they are accessing a different investor base, leading to higher leverage ratios.
Sriram Prakash, head of M&A Insight at Deloitte LLP, emphasises: “There is an abundance of capital in the market. In the UK, for the first time in five years, the flow of credit from banks to private non-financial corporations has turned positive. In addition, there has been a rapid growth in alternative lenders, who are providing more flexible debt structures and increased speed of execution. These factors make it a good time to seek external financing from multiple sources for capital expenditure or M&A.
LEVERAGED LOAN MARKET
“The rise of the leveraged loan market is resulting in higher liquidity levels. In the past, leveraged loans were dominated by private equity borrowers. However, in recent years, the small and medium-sized enterprise and corporate sectors have been borrowing using such loans.”
Leveraged loans are not only offered by banks, but also alternative lenders such as large asset managers, hedge funds and emerging investment managers. The most recent Deloitte Alternative Lender Deal Tracker survey shows that in the second quarter of 2014, 59 per cent of the funding deals related to M&A activities. The UK remains the largest market for alternative lenders, followed by France and Germany.
Acquirers are also looking ahead to the next stages in the financing cycle through the use of bridge financing. “Although bank lending is the current preferred means of financing M&A, there is still the potential for some opportunistic deals, such as synthetic bridges to give access to the high-yield market,” says Mr Dakin.
For large, competitive or time-sensitive transactions in particular, it can be a practical option, as in the case of the $61-billion bridging loan taken on by Verizon to buy Vodafone out of their US joint venture in 2013. Bridging loans can be replaced with capital market borrowings depending on market conditions at that time or funded with cash.
While bridging finance provides a potentially valuable means of harnessing the ebb and flow of alternative financing sources, shadow banking is also adding dynamism to the M&A markets.
Mr Dakin says: “Shadow banking, such as private debt, is having an impact on M&A financing, as the buyout of telecoms firm Daisy by its chief executive, backed by private equity, demonstrates.”
Given the finite and potentially declining number of high-quality financial assets in which to invest, and large pools of debt capital, investor interest in M&A is likely to grow, with innovative forms of financing for these transactions.
Mr Prakash concludes: “The current conditions of low valuations, inexpensive debt and ample cash reserves all provide an environment conducive for deal-making. Success will depend on having a long-term outlook and demonstrating a compelling growth story to the markets.”