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.

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.

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.