Why the Spike in M&A Activity?

Why are we seeing a spike in Merger & Acquisition activity, and what does it mean for the underlying economy?

Successful mature companies, especially larger companies, by definition, create large amounts of cash on their balance sheets. While a startup company struggles to fund their growth, a larger more mature company comes to a point where the cash problem flips from “how to get enough,” to “what to do with all this cash?”

If you are the CEO of a successful mature corporation, your most critical job is deciding what to do with the cash thrown off by a large profitable business. You don’t want to accumulate too much, because piles of liquid assets make your company a tempting “hostile takeover target.” Predatory suitors become tempted to buy you out, split up the pieces, and take the cash. Corporations are not intended to be “piggy banks” for the storage of cash, but investments that put cash to work for gain. If the CEO cannot figure out how to put cash to work for reasonable gain, someone will take it away who can.

There are generally only three, or maybe four things that a CEO will choose to do with this accumulating pile of cash:

1) Invest in the organic growth of the company: This is arguably the best use of cash. It is the reason companies initially sell stock and take on debt. The trouble is, as a company grows, it becomes increasingly challenging to manage all of the sprawling activities of a large company; which is to say that many attempts to select growth strategies result in wasted capital with insufficient return. It is mathematically easier to achieve a large rate of growth when a company is small, but becomes more difficult as the company becomes larger; creating a project that will add $10k to your balance sheet to grow from $100k into $110k is fundamentally a simpler task than creating a project that will return $100M to grow from $1B to $1.1B. The latter project is simply larger, with more moving parts, and thus more challenging to manage efficiently. CEOs are measured by their boards, industry analysts, and shareholders for their ability to create return on invested capital. It is not career enhancing to invest large amounts of capital in organic growth only to achieve little or no return. It takes real guts as the CEO of a large mature company to stick your neck out and invest large amounts of capital in an ambitious growth project. The larger the company, the riskier it is perceived to be to invest in organic growth.

2) Buy back stock: This is one of the most popular uses of cash. It is generally deemed “prudent” or at least “innocuous” by boards and market analysts, and therefore perceived as a “safe” move by a CEO. It has the effect, at least in the short term, of putting small upward pressure on the price of the stock, due to an improvement in the earnings per share of the stock. But EPS is not the only way stocks are valued, so in the end the upward pressure tends to evaporate with time, and the underlying market perception of the stock value due to PE ratio and other factors, takes hold. Buying back stock has become the CEOs way to “burn money” without attracting criticism. The announcement of stock buy-backs with accompanying positive “PR spin” has become a carefully finessed art. The problem with it becomes clearer when we remember why we sold stock in the first place: To fund the growth of the company. Buying your own stock back is akin to saying to the market: “You know that money we raised by selling shares in our company to you? Well, we’ve decided we cannot figure out any way to invest that money in the growth of our company that will return any better return than buying the ‘market,’ so we’ve decided to renege on that deal.” In short, it expresses a lack of confidence in the company, by the company’s own Board and CEO. This ought to be a signal to the market that perhaps this company has reached an inflection point in its growth which very likely portends flat or declining valuation in the long run. By admission and by definition, the company has become too large to be profitably managed, at least by the present executive management.

3) Invest in Mergers and Acquisitions: This is an extremely seductive use of cash for a large company. When a CEO is at the helm of a large company, it is a bit like being at the helm of an ocean-going super-tanker. The scale of things makes it difficult to see where you’re going. When one considers a strategic growth initiative, CEOs often have the experience that their internal divisions rarely achieve very satisfactory returns on investment for major strategic projects. This is largely a result of bureaucratic inefficiencies, internal group-think, and institutional aversion to even moderate risk-taking, all of which stifles true innovation. On the other hand, the executive staff may bring to the CEO an opportunity to invest in a smaller company who, partly by virtue of their earlier stage of growth, is achieving remarkable growth rates. The temptation is to believe that the larger company can fold that impressive rate of growth into its operations without destroying the success of the smaller piece. Such is rarely the case. The most common result is that in fairly short order the new acquisition begins to yield returns on investment more like the parent and less like the pre-acquisition smaller company. Bureaucracy and risk-aversion are aggressive contagions. Large companies tend to do what worked for them before with small tweaks, while smaller companies find it much easier to do what no one has done before. The vast majority of dramatic innovation comes from smaller companies, and a very few large companies who’ve learned the knack of managing innovation outside the shadow of their big-company bureaucracy. In most cases, the best outcome from an M&A is the reward to an experienced entrepreneur whose resulting exit-strategy may fund the growth of a new startup that will in turn create new market innovation.

4) Pay Shareholder Dividends: Some would argue that this is the proper use of all excess cash when a company has reached a size beyond which profitable growth becomes too difficult. It is understandably difficult for the leadership of a company to accept that the very size of their company has become an obstacle to further growth. Executives may not want to set ongoing market expectations of future dividends, and so prefer the other options in the short term while hoping that further growth will yet become possible. Dividends are generally associated with mature markets; while companies tend to want to see themselves as youthful and thriving.

In our present national economic climate, private-sector companies are piling up historic levels of cash. This has been largely a result of cost cutting reductions in labor, and fear of committing capital in the face of unprecedented market uncertainty. The already difficult risk an executive takes on when capital is committed, becomes untenable in the face of manic government interference through intractable regulation, and hyper-active, and even irresponsible fiscal and monetary policies.

That we see a spike in M&A activity at some point is absolutely predictable. While equity markets love the “action,” it can hardly be viewed as a sign of returning vigor to the underlying economy. If the market uncertainty remains at these unprecedented levels, the cash, while in a new “piggy bank,” is unlikely see much greater circulation in the broader economy. We’re just seeing consolidation of entrepreneurial companies into larger, and generally less efficient packages, while the well-compensated entrepreneur retires to the sideline to wait for a healthier climate before reentering the fray.