Why Do Mergers Come In Waves?

Companies have a marked tendency to all try to join together with other companies at the same time. In the late 1990s, the giddy heights of the dot com era were fed by merger mania. In the first few years of the the twenty-first century, however, mergers were decidedly out of style. Now that the private equity giants are on the prowl, aggressive combinations of otherwise staid companies are again the order of the day.

Any individual merger can probably be explained in terms of a fairly simplistic rationale, at least if the management of either firm involved did even the merest due diligence. Yet market forces seem unlikely to explain why a series of otherwise unconnected companies in various industries would all try to merge at the same time.

One facile explanation is that group psychology momentarily grips a number of powerful yet otherwise unimaginative souls who try to ride every bull market to personal riches. Just like most prospectors show up after the gold is gone, group psychology can explain why one isolated success could spark a trend that others try to carry forward. Yet this explanation fails at least one key test: the wave of mergers snowballs so quickly that no one knows whether or not the merger will be a success or not before they decide to copy it. This might indicate that followers are irrational as well as unimaginative, but this explanation seems overly pessimistic. More likely, the originators of all those mergers must believe they see some underlying trend that gives mergers a greater chance of success.

The trouble with providing explanations for mergers is that post hoc explanations are worthless for predicting the next trend. Many of the arguments in favor of mergers, such as vertical integration, tax benefits, greater efficiencies, and the like, have been well and widely known for years. The tax benefits of greater debt loads have been standard undergraduate economics fare for decades - and that completely ignores a legion of MBAs who are trained to identify just this sort of low-hanging fruit.

Current merger-mania seems to be driven by a wide availability of cheap capital. Excess liquidity chasing too few assets are driving up prices worldwide and mergers provide a sure way to utilize that cheap money. Yet the wave of cheap money significantly pre-dated the current merger mania, and individual companies are likely just as capable of accessing modern capital markets as are conglomerates.

To the extent that psychology is responsible for merger mania, there may be no one explanation of the phenomenon. Still, the hidden mechanism that determines the beginning of merger mad frenzies would be a rich prize indeed.

DaimlerChrysler Deleveraging as Private Equity Ramps Up

Reuters reports that DaimlerChrysler's CFO Bodo Uebber has announced that the company will significantly reduce its use of corporate debt. At a time when private equity group Cerberus is using enormous debt to leverage its commitments to Chrysler, DaimlerChrysler is moving in the exact opposite direction.

Just how much does DaimerChrysler plan to reduce its reliance on commercial paper? Almost completely. The company will not issue bonds "in the quarters ahead". Daimler AG, as the company will be known once the Chrysler sale is complete, is making a strange decision.

The price of corporate debt is quite low and doesn't appear to be rising in the near term. Companies that engage in leveraged buyouts, like Cerberus and KKR, are on a tear making investments in otherwise uninspiring companies based almost entirely on their observation that those companies are under-leveraged.

MBA students around the world have long learned how to calculate the appropriate balance between equity and debt that maximizes the profits of shareholders, yet companies have consistently been far more financially conservative than those calculations suggest they should be. Of course, their are other costs associated with taking on excessive debt that cannot be expressed in purely financial terms. Many wealthy individuals are uncomfortable with taking on significantly more risk by increasing the debt of their businesses.

Still, the rewards of leverage remain clearly visible in the new leveraged buyout firms that are remaking the business world. DaimlerChrysler is making a decision to reduce its risk profile at a time when much of the smart money is betting in the opposite direction. Only time will tell who is right.

Chrysler Buyout Saga Continues

Reuters reports that private equity firm Cerberus Capital Management LP is now DaimlerChrysler AG's preferred buyer for its Chrysler assets. This significant information, from people willing to talk to the Detroit News, suggests a shift in interest from the formerly preferred Magna International, a Canadian auto parts maker. The shift is significant because until recently, one of the primary differences between the competing bids was that Cerberus was willing to give the current management and employees a large ownership stake in the firm. Yet just on Thursday, Magna indicated that it was also willing to make similar concessions.

Since no official announcement has been made, this shift might be only the outward reflection of negotiations that occurred quite a while ago or even a complete fabrication designed to somehow influence the strength of the competing bids.

Nonetheless, one unmistakable view of the shift away from the traditional auto business buyer to a private equity concern is that DaimlerChrysler is responding to the continuing weakness of the American automakers. Private equity has recently taken on the role of buyer of last resort in the larger equity markets, snapping up companies that otherwise look sickly to industry insiders. If the Germans have come to the conclusion that management is sufficiently unable to right the ship at Chrysler, they must see the ability of private equity concerns to create additional value by dramatically increasing the leverage of Chrysler as a big plus.

The important thing to remember is that private equity concerns like Cerberus lack the industry specific knowledge of players like Magna have. They also tend to adopt a decidedly mid-term view, planning to sell the company in about five years. Running an organization the size of Chrysler is less akin to driving a lawnmower and more akin to driving a battleship in terms of its turning radius. It might take five years to turn the business around under the best of circumstances.

Last quarter Chrysler was the only major American automaker to keep its head above water. Ford and GM are in free fall and Toyota is seemingly unstoppable. Yet just a recently as 2005, Toyota recalled more vehicles than it sold. The American auto consumer is a fickle beast and winning today is no guarantee of winning tomorrow.

Excess Liquidity and the Leveraged Buyout Boom

The IHT reports that some of the private equity firms which depend on access to cheap credit with few strings are complaining about an excess of liquidity. While precise measures of liquidity are prone to error, it is clear that the amount of liquidity has been increasing rapidly. The Bank of England estimates that liquidity has doubled in the last four years.

The high price of oil, which shifts enormous resources away from the developed world to oil sheiks in the Middle East, has further exacerbated the liquidity troubles. And at least until now, China's trade surplus has gone largely uninvested. When China decides to mobilize its capital in the global markets, this will further spread liquidity.

Liquidity by itself is not a bad thing. Quite the reverse, many good investments in the past have gone unmade because of a lack of liquidity. But as the subprime mortgage market recently demonstrated, easy money leads to loose credit practices. The mortgage market is unique in its general low level of risk, but capital investments and leveraged buyouts can be very high risk. When cheap credit is extended largely without conditions, many more loans are extended than would be accepted otherwise.

Even the private equity firms themselves are concerned about the easy credit markets because competitors are encouraged to step in and bid up the price of acquisitions. These more expensive, more heavily leveraged investments then become much more risky and investors become less likely to profit.

Ironically, the Fed's chairman Ben Bernanke is currently receiving public pressure to lower interest rates in order to spur growth during a period of excess liquidity. In this environment, Bernanke is likely to leave interest rates alone for the seventh straight meeting. This will probably leave him looking indecisive and reduce his credibility in the short term, but the alternative is even worse. Bernanke can't give in to market pressures even if he will be praised in the short term.

Leveraged buyouts are fueling much of the mergers and acquisitions activity driving the stock market higher these days. The leverage is cheaper than ever thanks to excess liquidity. The liquidity would be fine in isolation, but unfortunately it is accompanied by loosened lending standards. Interest rates aren't likely to resolve the problem anytime soon, in spite of the housing bust. Hopefully the private equity gurus will have the intelligence to proceed cautiously. But don't hold your breath.

Private Equity Pursuing Music Giant EMI

Reuters reports that three American private equity firms, namely Fortress, Cerberus, and One Equity, are all interested in paying something in the vicinity of $6 billion for the British music group EMI. The entry of significant private equity dollars indicates a major shift from as recently as March, when EMI rejected a $4.2 billion bid from Warner Music.

EMI is one of the world's largest music companies but the industry has faced difficulties adjusting to the presence of digital distribution and the resulting ease of stealing its product. While Napster has been vanquished and reincarnated within just a few years as a legitimate distribution channel, the development of countless clones with technology designed to avoid legal challenges indicates the ultimate weakness of the business.

Downloading music illegally is getting easier all the time, and the potential to download higher value products like movies is increasing the returns to mounting this diminishing learning curve. The music industry's attempts at digital rights management, or DRM, have been a titanic failure. In addition to failing to prevent any reasonably dedicated teenager from getting a hold of music, the whole process has had the effect of creating an adversarial relationship with customers.

EMI has been underperforming its industry over the past few years and has actually lost money in the last quarter. Given the profitability of the rest of the industry, even as it struggles with change, this indicates EMI's management is not up to the task of answering the digital challenge.

All of this clearly begs the question: "Why is EMI suddenly worth so much money?" The better question is: "Why would private equity firms be willing to pay significantly more than music industry insiders for the company?" The answer seems to be that music industry insiders are focusing on the unique value proposition of the underlying business while private equity gurus are more concerned with the balance sheet.

The music business may not be what it once was, but significant revenues are a certainty for the foreseeable future. At the same time, the recent spate of private equity firms engaging in leveraged buyouts across numerous industries with widely different businesses and risk profiles seems to indicate that relative to the price of capital, most publicly traded companies are insufficiently leveraged. EMI is a giant business that has lost its way. The company is losing ground, but that actually makes it a more compelling takeover target.

By taking a company with essentially no debt and leveraging it to the maximum, the Americans plan to take value stored in the enterprise itself and cash out quickly. EMI is slowly sinking, but it isn't drowning. A quick turnaround could net substantial returns on resale in five years when the company has returned to profitability.

Experts know their area of expertise and not much more. Music industry insiders see a floundering giant, but private equity sees untapped potential. Only time will tell if the money that private equity can squeeze out of a leveraged buyout will outweigh the loses at EMI's main business.

The Private Equity Boom Continues

The IHT reports that private equity giant Kohlberg Kravis Roberts and an inside investor have outbid their competitors and secured Alliance Boots, Britain's largest drugstore, for $22.2 billion. This enormous price represents a 40% premium on the market price. The largest leveraged buyout ever in Britain, the purchase gives KKR control over 3100 stores.

KKR has been extremely busy this year, having spent $109 billion on three buyouts including $44 billion for TXU, a Texas power utility. Merger mania seems to have hit Wall Street in general and private equity in particular has been constantly in the news.

Analysts predict that the intense bidding over Alliance Boots, which saw KKR raise its bid three times, indicates that other British companies will soon be targeted. Retailers like Carrefour, a titan in Britain, are the subject of speculation.

The question many average investors are asking is: "What prompted this frenzy of activity?" The answer is much more complicated than any one factor, but perhaps the leading reason for the burst of activity is the surge in investment capital being put to aggressive use from major pensions and private universities. There is no global shortage of capital and savvy investors chasing alpha are becoming much more prominent.

Private equity represents the latest fad on Wall Street for creating out-sized returns. Giants like Goldman Sachs are rebuilding their operations around more aggressive use of capital in order to emulate the success of upstarts like KKR.

Private equity seems to have a particular advantage in companies under public scrutiny because executive compensation and other issues don't have to be reported like at most public corporations.

The boom shows no signs of slowing as the careful managers of private equity firms have yet to ridiculously overbid for worthless assets. But the increasing competition for companies like Alliance Boots demonstrates the declining returns that private equity will be able to squeeze out of the market.