The number of M&A deals in the U.S. could be increasing since small cap stocks are inexpensive and companies have free cash flow, equity analysts say.
Deal activity could rise even though mergers and acquisitions are typically cyclical and the weaker market returns have resulted in a lower number of deals in 2022, wrote Jill Carey Hall and Nicolas Woods, equity and quant strategists at Bank of America Securities, in a recent report.
When small cap stocks are cheap, the number of deals has historically risen, Hall and Woods wrote.
“Several factors are supportive of a pick-up in US M&A,” the report said. “Deal activity has been highest when small caps are cheap vs. large caps (very true today); disruption is also a driver (extreme bifurcation between high and low-growth companies today) and both small and large cap corporates have ample cash on their balance sheets.”
Rising interest rates and tightening credit conditions are major headwinds for companies looking to acquire smaller businesses, but when the economy improves, it “should open the door to more deals,” Hall and Woods said.
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Why Dealflow Could Rise
Broad M&A pickup could occur because the number of healthcare deals are on pace for a record year since 1997 and has been led by the biotech sector while tech deals are tracking the highest since 2016 and have been led by software mergers, the report said.
“Overall, across U.S. M&A, we've seen more take-privates this year, which could offset some of the recent rise in the number of public companies off two-decade lows,” they wrote.
The number of M&A deals year-to-date has fallen below 2021’s levels with the financial sector being the largest laggard since the number of deals in the sector has been the lowest since 2011.
The number of deals started off strong in 2022, but the pace began slowing down since the spring. The number of deals year-to-date total 150, which would fall below last year’s total annualized.
The deals in 2022 have been larger and “on track to exceed last year's levels and near 2019 levels,” Hall and Woods said. Even the mega-cap space has started to see deals after a lull for the past two years.
“... we have seen a few mega cap deals this year, while the number of small cap deals is tracking below last year's levels (based on market cap size of targets),” they wrote.
The levels of free cash flow have been a boon for companies seeking to acquire strategic targets. The majority of deals closed with no debt financing.
“Deals mostly cash amid lots of cash on balance sheets - 80% of deals year-to-date have been cash deals, a record high in our data history since 1994. Cash deals have been a rising share of deals over time, in tandem with rising cash levels on corporate balance sheets.”
Equity Markets Recovering
The M&A market is contingent on equity markets “calming down and starting to recover,” Thomas Hayes, chairman of Great Hill Capital in New York, told TheStreet.
“The rate of change in interest rates have been abrupt and unsettling for markets, but now we are closer to the end point and the market is starting to come to terms with that,” he said.
The earnings of companies in the third quarter have been better than expected, which helps both acquirers and targets.
“If the trend is persistent with the equity markets moving higher, we can see some decent investment banking M&A or some debt and equity deals may be able to get done before year end,” Hayes said. “We do need earnings to continue to beat expectations and on that basis all the institutional managers who are offside in too much cash will have to buy equities into the end of the year.”
Rising valuations of public companies will also be a tailwind, Hayes said.
“The more equities move up, the more cash has to come off the sidelines to chase that performance into the end of year because they don't want to underperform equity benchmarks,” he said.
The market has already priced in the Federal Reserve’s plans for the next two meetings - the central bank has signaled it plans to hike rates again in November and December.
“The rate of change is finally going to slow, causing stability in the market for equities and M&A,” he said.
The market will finish 2022 with a tick up on M&A and equities are higher, Hayes said.
M&A activity is impacted by company valuations, rising interest rates and excess cash flow on balance sheets, Art Hogan, chief market strategist B Riley Financial, told TheStreet.
“Acquirers now have a good buffet of companies to look at now for valuations,” he said.
Companies with free cash flow on their balance sheets will make accretive acquisitions or bolt-ons or buybacks of their stock, Hogan said.
“That sets the table nicely for a pretty active M&A season,” he said.
Buying a company that is a disruptor is more efficient for companies who want to add tech or software as a service, Hogan said.
“Interest rates are driving valuations, which make them more attractive - if you have a pile of cash, you most likely won't have to do a raise,” he said.
Adobe’s recent $20 billion acquisition for Figma, a digital design startup, was an acquisition that the executives at the giant software maker saw “could bite into their business,” Hogan said. It was Adobe’s largest deal since the company purchased Frame.io, a cloud video software company, for $1.28 billion in 2021.
“They weren't waiting for the bottom of the market and instead of buying back stock, they did an accretive acquisition,” he said. “It was the perfect time for buying a disruptor.”
The bar is a bit higher now for companies to use debt to finance M&A, Steve Sosnick, chief strategist of Interactive Brokers, a brokerage based in Greenwich, Conn., told TheStreet.
“The bottom line is it's easier to borrow money to do deals when interest rates are low and there is a lot of liquidity in the place,” he said.
As interest rates go up, the cost of servicing debt moves up meaningfully and it “ puts a lid on what you can pay,” Sosnick said.
“Over the last six months, high yield bond rates moved up by 2%," he said. "The acquirer is already paying a premium and higher debt cost limits the premium they can pay.”
Since M&A activity is cyclical, there will be opportunities for “astute acquirers to find companies trading at low valuations,” Sosnick said.
“Right now it is a trickier part of the cycle - when things are volatile sometimes it is harder for strategic acquirers to have the stomach to make moves,” he said.
