M&A Activity Fearless Against Fed's Looming Interest Rate Hikes

Mergers and acquisitions activity has taken Wall Street by the horns in the first half of 2014, and if the latest activity is any indication, M&A is striking a significant comeback.

According to Intralinks’s Deal Flow Indicator, in the first quarter of the year, the number of announced deals was 2% higher than in the same period in the previous year, while the values of those deals shot up a staggering 39% to $625.3 billion.

While first-quarter data paint a rosy picture for M&A activity through the remainder of the year, the big question facing dealmakers is whether to buy at a more frenzied pace as the Fed continues to hint at a pickup in interest rates starting in 2015.

“It’s an interesting question and multifaceted. It’s actually a little complicated. The answer isn’t just black and white, yes or no,” Matt Porzio, vice president of product marketing at Intralinks, said.

The Fed’s use of near-zero short-term rates and its massive bond-buying program, put into place in response to the 2008 financial crisis to keep the economy from falling into a deeper recession, has helped boost U.S. equity markets to record high after record high. In a similar way, that extra liquidity in the market has also made M&A a little bit easier thanks to lower interest rates, easier debt financing, and other factors.

While M&A activity, in terms of number of deals, is still well off the highs of the 2006 to 2008 timeframe, Porzio said deal valuation is a better gauge to look at when trying to determine the health and longevity of the M&A market.

“What we’re seeing is fewer deals in the market, but higher quality, fully-valued deals and larger average deal sizes. Those are getting done with cheap financing, debt and cash – stockpiled by private equity and corporates,” he said.

He added that because private equity firms are one of the largest players in the current M&A market environment, once rates begin to steadily creep higher they could be the first ones to also step out of the deal-making arena. And that’s where he said investors will begin to see corporate actors take on a more prominent role.

“Corporate confidence is rising and they have long-term inorganic plans for growth,” Porzio said. “That will continue to happen. They’ll step in and make up for the lack of private equity if rates climb (pushing, PE out of the equation).”

To that point, Jim D’Aquila, managing director of Imperial Capital, said by the time interest rates are on the rebound, he doesn’t see M&A substantially affected until after short-term rates rise to the 1-2% level from the current near-zero rate.

“What’s regulating things now is more so debt/equity ratios than debt/coverage ratios,” he said. “I don’t think (raising rates) will affect prices because so much equity still has to be put to work. As you go above the 1-2% range, that starts to push on prices rather than volume.”

To an even more basic point, Porzio and Joe Rodgers, co-head for capital advisory for KPMG Corporate Finance LLC, believe higher interest rates have long been priced into the M&A deal market.

“The general consensus is if the Fed’s going to do anything with rates, it’s going to be moderate. Most people think the Fed will leave rates alone until 2015.”

He said unless rates spike, M&A activity is likely to remain around current levels, and he said two things are likely to continue driving it: Optimism from consumers about the economy, and the more competitive structure of the deals that now that have more flexibility.

M&A To Heat Up ‘Across the Board’

Pfizer’s (NYSE:PFE) attempted $119 billion takeover of British rival AstraZeneca (NYSE:AZN) dominated headlines in May as M&A in the health care and technology sectors took control of deal coverage in the first half of the year.

Looking into the next six months and start of the new year, though, will the buying hold steady in those two arenas, or bleed into other spaces?

“I think as corporations sitting with record amounts of cash believe the economy is improving…and I think we’re still seeing M&A pick up across the board," Rodgers  said.

He added the place to watch are deals coming out of the middle market where in the low-rate environment of today, investors are looking to get the best yields.

“That’s an attractive place to be because there’s money in the space; ultimately you’re in a secured position but generating a decent yield.”

Rodgers’s caveat to that is when rates do begin to climb, there will be some middle-market investors who begin to rethink their positions and consequently there could be a slight pullback from that area as those investors look to reallocate money into the fixed income market.

D’Aquila, on the other hand, says he’s looking to the food products retail space for a pickup in deal making buzz…and he said he always loves a good food fight.

“Food remains an attractive area,” he said. “It’s harder to push prices to weakened consumers, so you need to have more scale. With some of the weather patterns and feed issues, there’s a supply problem for some companies, so they’re buying up other companies to secure product.”

He points to the bidding war in the food retail space for Hillshire Brands (NYSE:HSH). In the last couple of weeks, Hillshire went from its own quiet deal to acquire Pinnacle Foods (NYSE:PF) for $6.6 billion – to being thrown in the center of an all-out food fight wherein Pilgrim’s Pride (NASDAQ:PPC) offered $45 per share to acquire the maker of Ballpark franks and Jimmy Dean sausage. Just days later, Tyson Foods (NYSE:TSN) joined the escalating battle, offering a takeover priced at $50 per share, before Pilgrim's countered again Tuesday with a $55 per share offer.

D’Aquila said he anticipates more action in the food retail space, but is also keeping an eye on retail and tech. He said he sees more consolidation in consumer tech surrounding apps, streaming services, and the shared economy sectors. In that space, he said, activity like that is just the tip of the iceberg.

Porzio pointed to the recent Beats acquisition by Apple (NADAQ:AAPL) as a sign there’s still loose cash looking to be invested. He said at the end of the day, investors have to buy growth, and private equity has to put money to work.

“From a sector perspective, tech, media, and telecom have been firing on all cylinders,” he said. “Cash is still king, especially with buyers like Apple who can put it to work. With that money on the sidelines…in the short, mid-term, the rate environment has minimal effect in those hot sectors.”

Porizo added the places that could feel a squeeze in M&A activity would likely be those where the deals are contingent on financing and as rates rise, buyers become less willing to drop more cash to make the deal happen.

“I’m also waiting for retail at some point,” D’Aquila added. “I think we need some retailers to put up solid quarters at some point. We’re seeing the opposite right now.”

He added, though, that after last year’s particularly harsh winter stunted the slowly growing U.S. economy, retailers are beginning to come back, and consumers are showing signs of life, which could eventually help spur more dealmaking in that industry as well. He pointed to Lowe’s (NYSE:LOW) and Home Depot (NYSE:HD) – both home improvement stores that recently put up what he calls “decent” numbers in the most recent quarter.

“When confidence is just building, it’s very fragile and doesn’t make much to make it unfragile,” he warned. “But I feel people are more upbeat, both the consumer and executives.”