Dow-DuPont stands as one of the few recent stock-for-stock mergers, a class of deal markedly on the decline © FT montage
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The proportion of merger and acquisition activity involving all-share deals has dropped to a record low this year, as access to cheap cash and doubts over US equity market valuations complicate what can already be a fraught option for dealmakers.
The collapse of merger talks between the telecoms groups Sprint and T-Mobile US last month was one more demonstration of the difficulty of agreeing terms for such share swaps — and bankers say cash will continue to be king for companies that put themselves up for sale.
Stock-for-stock deals involving US companies accounted for just 10.6 per cent of transactions by dollar value in the year to December 1, according to data from Dealogic. That puts 2017 on track to be the weakest year for such deals since Dealogic began collecting data in 1995.
The average for the past 22 years has been 18.5 per cent, and in 2016, 23.9 per cent of deals by dollar value were consummated using all stock.
“We are currently in a period where companies have plenty of cash on their balance sheets and access to a lot more on historically favourable terms,” said Frank Aquila, a deals lawyer at Sullivan & Cromwell.
Measured by number of deals, the proportion of all-share transactions this year has been 11.4 per cent, down from 13.9 per cent in 2016.
The fall in all-share transactions by dollar value is especially pronounced due to the absence of megadeals, showing how cash is cheaply available even in large quantities. The few recent significant stock-for-stock mergers include the combinations of Praxair and Linde, Dow and DuPont and Dynegy and Vistra Energy.
In the late 1990s during the dotcom boom, all-share deals accounted for well over half of all M&A activity.
However, after merger accounting rules were changed in the early 2000s to end the use of a complex financial engineering trick that made all-share deals more attractive, the proportion of stock-to-stock M&A stabilised at around 20 per cent.
This year’s dramatic drop stands out.
According to Michael Carr, co-head of global M&A at Goldman Sachs, the tricky discussions around both valuation and corporate governance make completing an all-stock deal “like a bullet hitting another bullet”.
The share price of a buyer making an all or partial stock offer could dramatically fall during a takeover process, meaning that the actual final bid could be significantly lower than the original proposal — even before worries about the longer term prospects for the acquirer’s stock.
For the selling company, an all-stock deal is twice the work. It has to determine both what it is worth and also the quality of the shares it is accepting.
So-called fairness opinions that bankers issue in stock deals specifically opine on the appropriate exchange ratio — the amount of stock per share the acquiring company offers the seller — not the explicit dollar value of the seller.
It is like a bullet hitting another bullet
“What is normally a discussion for a board that is focused on premium then becomes a discussion on the valuation of the acquirer stock. It becomes harder to sell a transaction to a board and shareholders that has more variables”, explains Johannes Groeller of PJT Partners.
The exchange ratio is typically triangulated based on how much each side is contributing in revenue, profits, and growth.
For this reason, the target shareholders may even be offered a price that implies a discount to their prevailing market value. When Towers Watson announced its $18bn combination with Willis in 2015, the exchange ratio implied a value on Towers Watson’s shares below their trading price. After a shareholder revolt, the terms were sweetened for Towers Watson shareholders.
“The exchange ratio can be very hard to peg. One stock may have momentum, another may not. You really have to be careful to set the exchange ratio when the stocks are aligned, even if you have determined this is strategically the greatest merger ever seen,” says Mr Carr.
Particularly in so-called merger of equals deals, the opportunity for value creation comes from realising synergies over time. Avoiding the excessive debt that can be needed in a cash buyout is thought to be an advantage.
The Sprint-T-Mobile tie up would have created a mobile phone colossus with a combined enterprise value of $135bn. Despite an estimated $30bn to $40bn of synergy value, the companies said in early November that they were “unable to find mutually agreeable terms”.
A person close to the talks said the various options on the table implied near-identical ownership splits, within one percentage point of each other. But after T-Mobile stock’s sharp rally in recent years, its market value of almost $50bn was nearly twice that of Sprint’s. Both companies had dominant shareholders — SoftBank at Sprint and Deutsche Telekom at T-Mobile — who also had strong views on how the new company should be managed that doomed discussions for now.
Sellers are set to continue to prefer cash, particularly in hostile situations, bankers say, as target companies try to avoid the risk of taking equity, particularly after a prolonged bull market that has led to elevated valuations.
“If you believe the market will correct, it’s risky to take on somebody else’s paper at current market valuation,” said one senior M&A banker in New York. “Unless you really believe in the strategic value of the deal going forward most boards would turn a large stock offer down. Obviously there are exceptions, but cash is nearly always king.”
Mr Aquila at Sullivan & Cromwell, who has worked hundreds of both stock as well as cash deals, said that in a hostile situation, with market valuations at record high levels, “the seller is unlikely to want to take the buyer’s stock because there’s a risk that paper value could drop at any time”.
However, he added that there if the seller truly believed in the benefits of a merger, agreeing to be acquired with stock was actually an incentive. “Even if there’s a market correction the two companies would buffer the fall in share price thanks to the synergies generated by the merger.”
This post originally appeared on Financial Times