The current “pay the shareholder” regime, which began in earnest in early 2014, is a tremendous cyclical opportunity for hedge fund managers.
The term “pay the shareholder” refers to the period of a market cycle in which management teams reward shareholders through increased dividends, share buybacks and corporate transactions such as mergers, acquisitions, spinoffs, asset sales and non-distressed restructurings. Accretive transactions such as these typically accelerate several years after the bottom of a bear market when management teams regain confidence in the economy and corporate balance sheets. Now that we are a year and a half into this cycle, there have been at least two major similarities with the last cycle:
1) Share buybacks and dividends have increased significantly as companies pass on the benefits of cheap credit to shareholders, sometimes at the expense of debt holders and capital investment; and
2) Announced merger and acquisition volume has picked up dramatically — and like last year is expected to eclipse $4 trillion globally.
Furthermore, several significant positive differences in the two cycles have arguably created greater opportunity for both strategic acquirers and event-driven hedge fund managers:
1) More pent-up demand for consolidation. The last cycle of 2005-2006 followed a four-year dearth of deal activity (2001-2004), while this cycle took 6.5 years (summer 2007-end of 2013) to get moving due to the eurozone crisis, slower than expected economic growth, political gridlock and the U.S. debt downgrade. Strategic deals typically make sense regardless of the calendar year, but only take place in high volume during the right part of the cycle. The longer the dormant period, the greater the volume of potential deals in the pipeline.
2) There is little to no private equity sponsor or leveraged buyout competition. This is arguably the biggest positive difference in this cycle vs. the last. According to Bloomberg data, the volume of LBO deals as a percentage of total announced deal volume peaked at 7.6% in 2006 and dropped only slightly to 6.9% in 2007. Additionally, all 10 of the biggest LBO deals of all time were completed from 2006 through the summer of 2007. In comparison, despite total announced deal volume surging past $4 trillion last year and tracking similarly this year, the LBO percentage dropped to 0.9% last year and is an anemic 0.4% currently.
What phenomenon explains this massive drop? Have the barbarians at the gate suddenly gone meek? Have private equity firms been unable to raise capital? On the contrary — they have been raising money hand over fist. The main explanatory variable for this decline has been simple and transparent — regulatory reform of the banking system has made it prohibitively expensive for private equity firms to raise the leverage necessary to compete with strategic acquirers. The cost of capital incurred by banks that finance LBOs is now capped at levels not sufficient for LBO sponsors to compete with strategic acquirers that can borrow cheaply, are cash rich, and can use stock as currency without impairing balance sheets and eating into cash. Additionally, LBO deals offer none of the strategic benefits that accrue to strategic acquirers, including reduced operating expenses as a percent of total sales, better pricing, product integration and a reduced tax burden.
Without the LBO competition, strategic acquirers aren't being forced to overpay for transactions. In many cases we are seeing share prices appreciate post-deal announcements, which is a significant departure from the last cycle. For event-driven managers, the benefits are tangible as well. Managers who focus on merger arbitrage or anticipatory take-out strategies are more comfortable pursuing strategic deals, as opposed to LBOs, for one simple reason — strategic deals typically have a higher probability of completion due to lower financing risk and the accretive nature of such transactions. LBO financing has historically been more susceptible to the whims of credit markets and thus more fragile. Additionally, strategic synergies can be realized in several quarters or years whereas returns on an LBO deal are often only realized by a distant-future sale or IPO. In the current cycle event-driven managers can pursue announced transactions with more confidence, and can thus generate more consistent, attractive returns.
3) Transactions in this cycle have been predominantly financed with debt and cash, as opposed to the last cycle where transactions were primarily equity-financed. Typically the cost of equity is higher than the cost of debt or cash. Thus, debt and cash financed deals end up being more accretive to shareholders than equity-financed ones. The main reasons for this difference are corporate balance sheets with massive cash hoards, modestly lower corporate leverage levels and significantly lower interest rates, which produce lower costs of debt financing available to strategic acquirers. A skeptic might say this advantage can change quickly if interest rates rise dramatically, credit tightens, corporate leverage levels get too high or cash balances plummet. However if one of these issues comes to pass in the near term, management teams can use their equity as currency to pursue accretive strategic deals as they did far more frequently in the past.
4) Activist managers have more influence. This difference benefits all shareholders for a number of secular reasons: long-term equity performance has improved in the majority of activist situations, particularly those focused on operational improvements vs. pure financial engineering; long-term shareholders and shareholder proxy firms have more experience with activist investors; and Dodd-Frank regulations now prohibit management teams from ignoring activist's restructuring ideas.
The only major negative difference between this cycle and last is the specter of regulatory intervention. Unfortunately, regulators have increasingly intervened in announced transactions deemed non-beneficial to consumers (anti-competitive), harmful to the U.S. Treasury's tax collection capability (inversions, for example), or that violate newly conceived notions of longstanding regulations (such as recent creative interpretations of net neutrality rules).
The intervention wave began with the near-rejection of the American Airlines/US Airways merger in the fall of 2013, continued with the Federal Communications Commission's rejection of the Sprint/T-Mobile acquisition in the summer of 2014, escalated further with the immolation of the AbbVie/Shire acquisition in October 2014 and recently hit a crescendo with the joint FCC-Department of Justice rejection of the Comcast/Time Warner Cable deal in April 2015.
While regulatory fervor has shown no sign of abating, ultimately we believe the lack of LBO competition, latitude for strategic acquirers to obtain financing and other aforementioned factors far outweigh regulatory challenges. We predict this “pay the shareholder” cycle will continue at least into 2016, creating a fertile environment for strategic acquirers and event-driven strategies.
Troy Gayeski is a partner and senior portfolio manager at SkyBridge Capital, a global alternative investment firm with more than $13 billion in assets under management and advisement.
