Merger and acquisition activity is a leading indicator of business attitudes. When the economy is coming out of a recession, healthy companies are looking to acquire less healthy companies that are selling at relatively low prices because of the stage in the business cycle.
As economic growth picks up steam, M&A activity increases as corporations look to increase productive capacity or look to expand into different markets. This kind of acquisition business tends to re-enforce economic growth and contributes to optimism about the future.
At a later stage, of course, the M&A business can overheat as the company prices become overvalued and as CEO hubris takes over.
In the United States, M&A activity has been pretty sparse during the early years of the current recovery. Healthy corporations were sitting on tons of money but they just did not seem to commit to many transactions because of the uncertain atmosphere that existed around the economic policies of the Obama administration. As a consequence, corporations flush with cash used those funds to raise dividend payments to their shareholders or buy back their stock. Those corporations that did not have as much money around could borrow from the ample pools of funds around at very, very low interest rates and do the same thing.
It was also apparent that the acquisitions that took place contributed very little to economic activity. That is, the combinations that grew out of the transactions that occurred failed to produce much physical investment that would spur on the economy.
Finally, last year, M&A activity seemed to pick up and this spilled over into this year. In fact, some analysts are predicting that M&A transactions will double in value this year over last year and this will put the total near the level hit in 2007, which was part of the boom years of the early 2000s.
What kinds of transactions are driving this increase in activity?
Mohamed El-Erian argues in the Financial Times claims that "Very few deals have been driven by ambitious and realistic expansion plans, rather they are motivated by the desire to squash competition, especially that coming from smaller companies that do not benefit as much from cheap financing and ample cash, or by 'inversions' that allow companies to reduce tax liabilities through a change in legal domicile."
In essence, Mr. El-Erian is saying that the acquisitions that have taken place have primarily stayed within the financial circuit of the economy. That is, the deals have produced very little that contributed to the economic activity that would benefit the society as a whole.
The smaller companies are just absorbed and do not contribute much to the growth in revenue or to increases in productivity that help improve economic growth. But, let's look a bit more at the other reason Mr. El-Erian gives. The word 'inversion' has gotten a lot of press recently.
Inversions have to do with an American company buying a company located in another country and then locating the headquarters of the combined companies in the foreign country. The reason for re-locating the headquarters in the foreign country is taxes. The United States has one of the highest tax rates on corporations in the developed world. These American companies argue that they cannot be competitive in a global environment if they continue to be headquartered in the United States.
El-Erian and others have argued that because many companies have acted on this incentive, M&A activity has increased to the level achieved in the first seven months of 2014.
The question is whether or not M&A activity will continue at this level in the future. Sarah Gordon argues in the Financial Times that it will not.
Her argument is that the actions of the Obama administration to restrain inversions are already having an impact on the M&A business. One of the reasons that it is having an impact is that the Obama administration is not concentrating on the economic incentives of the high taxes, but is using name-calling as its weapon. It has referred to American companies that move their headquarters off-shore as "unpatriotic." And, the reason for using this tactic seems to be political in nature.
The case Ms. Gordon cites is the Walgreen Co. (WAG) acquisition of Alliance Boots, a UK pharmacy. Walgreens originally intended to move its headquarters to Europe "and save billions of dollars in US tax…"
However, "Walgreens recognized the growing political opposition to such tax-fueled transactions. The company said it was mindful of the public reaction to a potential inversion deal, given that it was an 'iconic' American consumer retail company…." In other words, Walgreens did not want to become the poster-child of the greedy and unpatriotic American company.
Both political parties, Republican as well as Democratic, realize that tax reform is needed. Up until now, people have believed that they could not achieve any agreement on what the tax reform is to look like before the November congressional elections.
Now, however, Ms. Gordon argues that "Bankers and other advisers are still clinging to the hope that companies less in the public spotlight than Walgreens will be tempted by inversion deals, But, even if Republicans and Democrats find it hard to agree on how to tighten the rules, there is a growing sense on Wall Street that legislation is in the cards."
The result is that M&A activity will decline.
"Tax inversions have been a significant driver of the surge in M&A activity this year, with many of the largest transactions initiated by US companies seeking to deploy trapped off-shore cash." Furthermore, "Deal fever was being stoked not just by the need for US companies to put off-shore cash piles to work but also by the absurdly generous market borrowing terms available."
But, Ms. Gordon believes that this activity was reaching the bubble stage as proceeds were generally staying within the financial circuits of the economy and that M&A totals were reaching for the boom level numbers of 2007, "the peak of the last M&A bubble."
But, there is a cost to achieving a slowdown in this way. It was mentioned above that M&A activity had been low during the early stages of the current recovery due to the uncertainty of the economic policies of the Obama administration. Tamping down the rising optimism connected with recent increases in M&A activity using name calling as a substitute for actual revisions in the tax rules will not do anything to help the "animal spirits" of the business community. In fact, it might even depress them.
And, if transactions just benefiting the financial circuit are harmed, it is highly unlikely that businesses will act very optimistically when it comes to physical investment that might help spur on economic growth and employment.
The longer-term impact of this would be to reduce economic growth in the last two years of the Obama administration to even lower levels than now expected. This is certainly not a "normal" economic recovery by any means.
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