The Credit Opportunity in M&A

In an environment of tight spreads and low volatility, we believe the reemergence of mergers and acquisitions can be a source of idiosyncratic alpha in credit markets.

The path of interest rates may be uncertain, but there is broad consensus that it is heading downward. Credit spreads are tight and volatility is low because economic growth has proven resilient and corporate balance sheets are generally robust.

As we have been writing recently, against this backdrop shifting supply-and-demand dynamics are more likely to move bond markets than fundamentals. That’s one reason why we shined a spotlight on asset-backed securities a few weeks ago, where strong technical crosscurrents have been generating attractive value.

This week, we turn our attention to mergers and acquisitions (M&A). M&A is often assumed to involve risky leverage that is unappealing to credit investors. We think the reality is more complex, especially in today’s environment, which is characterized by corporate strategic transactions as opposed to highly levered buyouts.

In our view, this reemerging source of technical volatility and fundamental realignment could provide opportunity in today’s quiet credit market.

Turn in the Tide

M&A was almost dormant in 2023: In the U.S., as a proportion of the market value of the benchmark equity indices, it fell to its lowest level in 20 years, according to McKinsey.

The scarcity and rising cost of debt played a part, particularly for private equity-sponsored companies. Larger corporations did not want to frighten shareholders during a year of recession forecasts and rising rates, and were wary of the tightening regulatory and antitrust environment.

Some of those constraints are now lifting. Now that rates appear to have peaked, many company management teams are looking at coupons on a 15- rather than a five-year view and concluding that they are not prohibitively high—particularly given their strong balance sheets. Recession concerns have abated. And some companies are concerned that, if they do not start talking to potential partners now, they may be left on the sidelines should the regulatory backdrop become more favorable after November’s U.S. elections.

In addition, high share prices now give acquirers valuable currency with which to shop for potential targets. The sluggish global economy makes organic growth challenging, and further efficiency gains may also be difficult: Strong balance sheets reflect past efforts to cut costs, be conservative with investments and preserve margins. As a result, we believe M&A may be the only way for many businesses to meaningfully grow market share and enhance their bottom lines.

We are seeing this turn in the tide in credit markets, which saw record supply of investment-grade new issuance during January and February totaling $356 billion; according to S&P Leveraged Commentary & Data, around 15% of that was related to M&A.

Deal Financing

Credit investors are not traditionally supposed to be fans of M&A, and it’s true we are wary of leveraging M&A, where debt is loaded onto balance sheets to buy competitors.

But the reality is more complex than that. As active credit managers, we consider the dynamics that are driving consolidation in a particular sector, together with the way individual acquisitions have been financed and subsequent deleveraging plans, to come to a view on what an individual transaction means for creditworthiness.

We see four basic dynamics behind most M&A transactions: buying growth, cutting costs or achieving scale, responding to regulatory change, and responding to industry disruption.

Opportunities for companies to become stronger together—more profitable and more cash flow-generative—are often more evident when cost-cutting is the prominent M&A dynamic. We see that driver at work in recent deals in the Metals & Mining, Chemicals, Energy and Retail sectors.

Responding to regulatory change or industry disruption poses more risk, in our view, as it reflects companies struggling with underlying sectoral challenges. We see these dynamics at work in Financials (such as U.S. regional bank consolidation) and in Cable & Media (where the “streaming wars” are forcing companies’ hands).

Deleveraging Plans

Buying growth—which we regard as the most prevalent motivation for current M&A and a key driver in the Food & Beverage, Consumer Products, Retail, Energy, Technology and Health Care sectors—can heighten credit risk if it requires major debt issuance or even elicits a rating downgrade.

However, because acquirers’ share prices are high, a relatively high proportion of recent deals have been majority equity-financed, especially but not exclusively in Technology and Energy. In our view, this enables credit investors to focus on the potential for the growth strategy to enhance cash flow rather than the risk of excess leverage.

Moreover, even a transaction that involves substantial new debt can be attractive. Adding some M&A debt to a company’s balance sheet can result in higher coupons on newly issued bonds or a drop in the valuations of outstanding paper, and that sometimes opens an attractive entry point into the credit of high-quality businesses.

In these cases, our role as an active manager is to assess the cogency and practicality of the issuer’s plans for achieving synergies, raising cash flow and ultimately deleveraging—as well as identifying any risks to the execution of those plans. Does paying down the debt assumed to buy their target business involve selling another business division into the private equity market, for example? As we saw in 2015 and during the Global Financial Crisis, that market can disappear very quickly, or ask for steep discounts, raising the risk and fundamentally changing the way we perceive the credit.

Differentiate Portfolios

In short, we are seeing a comeback for M&A that we think is likely to continue through 2024.

Each transaction complicates and changes the credit fundamentals for both acquirer and target, and many result in a jolt to the supply-and-demand balance in the acquirer’s debt.

In an environment of tight spreads, low volatility and broad consensus in credit markets, we believe this reemerging dynamic can offer a way to differentiate portfolios and seek potential outperformance.