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It’s almost starting to feel like the 1980s again. Merger and acquisition (or M&A) activity has jumped dramatically in the past few months. And it’s not just the number of deals that is catching investors’ attention, but the size and (in some cases) aggressiveness of the proposed transactions. On this last point, there has been a dramatic return of unsolicited offers for companies and (in at least one case with Dell and Hewlett Packard) a second company stepping in to make a competitive bid for the same target company (3PAR). As the table below illustrates, the scope of M&A activity is fairly broad, covering commodities, pharmaceuticals, computers, banks and utilities.

Recent Acquisition Bids

Source: The Wall Street Journal, August 20, 2010

According to market observers, several factors are driving the renewed interest in M&A by corporations. The first is how inexpensive corporate borrowing has become for large companies with strong credit ratings. As yields on government bonds have declined to near record lows, there is a strong appetite among both individual and institutional investors for corporate debt, which has driven up prices and driven down yields on this type of borrowing.

A second factor is the overall outlook for the economy. Recently, a number of macroeconomic indicators have suggested that the current economic recovery is possibly slowing. Several organizations have revised downward their overall economic growth forecasts for the U.S. in the second half of this year. This leaves businesses with the challenge of finding new sources of both top line (i.e. revenue) and bottom line (i.e. earnings) growth. Acquiring other companies, whether to improve market share, extend product lines or add entirely new lines of business, is one means of achieving this goal. An additional enticement is likely that companies have become adept at pruning unnecessary costs during the recent Great Recession. Since a key factor for the successful integration of acquired companies (so that value is created beyond the acquisition premium paid) is eliminating redundant costs while exploiting new economies of scale, acquiring companies are likely confident their management teams are up to this task.

A third factor some argue is contributing to the upshot in M&A activity is the amount of cash available on the balance sheets of many corporations today. This cash is primarily the result of a strong recovery in operating earnings and net profit by companies since the second half of 2009, along with their remarkable efforts during the recent recession to cut costs, forego unnecessary capital spending and generally “hunker down” financially. As the chart below illustrates (using the companies in the S&P 500 Index), operating earnings and net earnings per share have made a remarkable recovery since the second quarter of 2009. On the other hand, dividends per share paid out to investors (an important use of the cash generated operations) have trended in the opposite direction, in part because some companies cut, suspended or froze dividend payments.

There is another point of view regarding the levels of cash on corporate balance sheets which may have an impact on just how far the recent pickup in M&A activity goes. As the chart below illustrates using data from the U.S. Federal Reserve on balance sheets for non-farm, non-financial corporations, while liquid assets (like cash) have been on the rise, so has the level of debt. The chart plots liquid assets as a percent of total assets (on a market value basis) and total financial liabilities as a percent of net worth (primarily shareholder equity, also on a market value basis). Since late 2008, liquid assets have increased from 5 to 7% of total assets, a seemingly small percentage increase but approximately $412 billion in absolute terms. However, paralleling this rise has been the growth in financial liabilities, which have grown from approximately 90 to 110% of net worth (or approximately $390 billion in absolute terms, roughly the same increase as liquid assets).

What the gross numbers of both the S&P 500 companies or all non-farm, non-financial businesses (as reported by the Fed) don’t reveal is that there are financially strong and weak, cash rich and poor, and under- and overleveraged individual companies in the mix of both groups. This implies that the recent trend in M&A is likely to continue and be driven primarily by the largest and most healthy corporations with excess cash, access to cheap borrowing and capacity to add debt—whether it is issued to finance a deal or assumed from the target company as part of a takeover deal.

The good news for investors is increased M&A activity can help sustain the market during a period of economic softness or a slowdown that we may face in the next several quarters. The risk for investors is whether the money spent on M&A activity will be done wisely and with a clear eye on creating shareholder value. If not, that money is probably better spent buying back shares or increasing dividend payouts.

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