The level of merger and acquisition activity has reached historical heights over the last several years. In 2017, M&A events numbered over 15,500 - a new record. In 2018, just over 14,850 - the second-highest year in history. Executives clearly have a massive appetite for acquisitions, but what does this flurry of activity mean for investors? Is it a good reason why the CEO of a company is going out of their way to acquire other businesses.
Warren Buffett (Trades, Portfolio) thinks the recent M&A boom has made it difficult to find value. In his 2017 letter to Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholders, he highlighted this trend and explained why he feels it is a problem.
Demand drives price
“In our search for new standalone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price. That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.”
There are only so many businesses in the market. If the level of merger activity exceeds normal levels, then logically that increased demand will drive up the price of any given acquisition. When executives with a lot of dry powder in their corporate treasuries end up competing for the limited pool of acquisition targets available, that naturally makes it difficult for people like Buffett who like to buy whole businesses at value prices. But it also makes it harder for retail investors looking to buy shares in those companies at a discount.
Why is this happening?
What has caused this boom? Buffett thinks it comes down to two factors: the institutional imperative and cheap debt. On the first point, the Oracle of Omaha has this to say:
“Why the purchasing frenzy? In part, it’s because the CEO job self-selects for 'can-do' types. If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life.
Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase. Subordinates will be cheering, envisioning enlarged domains and the compensation levels that typically increase with corporate size. Investment bankers, smelling huge fees, will be applauding as well. (Don’t ask the barber whether you need a haircut.) If the historical performance of the target falls short of validating its acquisition, large 'synergies' will be forecast. Spreadsheets never disappoint.”
In other words, M&A activity is in the interest of all the decision-makers. The company being bought out is getting a premium price, the executives of the buying company get to expand their kingdoms and the investment banks that supervise the process get their cut. Moreover, executives seek to compete with one another and may pursue acquisitions in order to beat our their peers. Buffett has referred to this agency problem in the past as the institutional imperative.
Low interest rates and the availability of easy capital has also contributed to the M&A boom. Buffett pointed out that Berkshire does not tend to finance acquisitions with debt, which is why it has not been as active as some other large companies:
“The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed. At Berkshire, in contrast, we evaluate acquisitions on an all-equity basis, knowing that our taste for overall debt is very low and that to assign a large portion of our debt to any individual business would generally be fallacious...We also never factor in, nor do we often find, synergies.
Our aversion to leverage has dampened our returns over the years. But Charlie [Munger] and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need. We held this view 50 years ago when we each ran an investment partnership, funded by a few friends and relatives who trusted us. We also hold it today after a million or so 'partners' have joined us at Berkshire.”
Berkshire tends to zig when others zag. Therefore, it is not at all surprising they have opted to sit on the sidelines as valuations continue to balloon. Those who seek value would do well to do likewise. Buffett concluded this section of his letter with the following aphorism:
“The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.”
Disclosure: The author owns no stocks mentioned.
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