At the beginning of the third quarter of 2007, merger & acquisition activity in Canada shifted gears dramatically. After a record breaking second quarter, the number and total value of announced transactions suddenly plunged, and deals that were in the pipeline were put on hold. Most noticeable was the virtual disappearance of “mega-deals” fuelled by private equity.
The slowdown was all the more dramatic because of what had preceded it. For the past several years, M&A activity in Canada had been growing at a blistering pace. Takeover activity had been strong across many sectors of the Canadian economy, and volumes and the dollar value of transactions set new records year after year. In 2006, for example, announced transactions neared the 2,000 mark, more than twice the number seen two years earlier. The value of transactions also grew significantly, reaching $257 billion.
All indications showed that the record breaking would continue in 2007. The first two quarters of the year again registered volumes that presaged new highs, and the dollar value also surged ahead, powered by such blockbuster deals as the buyout of BCE by the Ontario Teachers’ Pension Plan and its private equity partners as well as the acquisition of mining giant Alcan by Rio Tinto. The fundamentals that had driven this pattern over the past few years remained in place: strong balance sheets, low interest rates, resource demand from countries like India and China and, finally, the anticipated changes to the tax structure of income trusts.
The sudden decline in activity has been traced back to the crisis in sub-prime lending in the United States. Concern over the ability of many new homeowners to meet their obligations dovetailed with a slowdown in house prices in key American markets in the middle of the year. While the sub-prime market itself is not directly linked with leveraged financing in the corporate world, investors became jittery over the quality of debt that had been repackaged and sold onwards by the initial lender. Their anxiety turned into a generalized concern about the correct evaluation of risk, as lenders backed away from the credit markets. Even though interest rates have remained reasonably steady, thanks largely to central bank intervention, the risk-adjusted cost of borrowing has been re-evaluated upwards.
A New Reality for Private Equity
The impact on private equity has been sharp and swift. As credit markets began to dry up, private equity investors found it much more difficult to access the kind of money they had used to fund their buyouts in the past few years. With banks unable to move large loans into the institutional market for want of buyers, private equity clients were effectively frozen out of the M&A sector. This development was not limited to Canada. In the United States, Europe and Asia, multi-billion dollar transactions fuelled by private equity peaked in the second quarter of 2007 and then suddenly plummeted.
For the past few years, private equity has been a major player in M&A activity in Canada. There are many reasons for this, but one of the most significant is that large institutional investors, such as pension funds, seek out private equity partners with whom they can complete transactions. This is driven by the need to generate compelling returns, which becomes increasingly difficult to do as the funds become larger and larger.
Inevitably, the question that arises is whether this is a short-term pause or a more lasting reconfiguration of the M&A landscape. After only a few months, it is simply too early to tell whether the momentum of several years has been lost.
However, there is no reason to believe that the role of private equity and institutional investors will change over the long term, since the search for higher returns will continue. This is a trend that has long been established in the United States and has gained ground in Canada as well. Yet private equity may not benefit from the easy credit it enjoyed for so long in the first half of this decade. There has been exceptional liquidity in the world economy since September 11, 2001; a result of monetary easing by the U.S. Federal Reserve and the huge appetite for U.S. financial instruments on the part of China. This liquidity may decline, with a possible tightening of U.S. monetary policy and a generalized increase in the perception of market risk. As a result, private equity investors, while still able to leverage funds for takeovers, may end up paying a higher borrowing cost than before and therefore tread more cautiously when contemplating buyouts.
The M&A Market is Still Alive and Kicking
These developments do not mean that mergers and acquisitions have suddenly disappeared from the Canadian business landscape. While the volume of transactions has dropped markedly from the first half of 2007, it is still at a level comparable to that seen in 2006, which in itself was a record-breaking year. Smaller-sized deals are now the norm, and these still attract private equity players – backed by lenders who might be more nervous about getting involved in the kinds of large deals seen in the early part of the year.
Over the long term, Canada is likely to be favoured by investors looking for safe but healthy returns, especially in the resource sector. Canada’s security regulations make the country “bidder-friendly” and it is one of the most politically stable jurisdictions in the world. As well, the strength of the Canadian dollar, which is at a 30-year high against the American dollar and has been one of the best-performing major currencies in the world in the last year, will whet the appetite of Canadian firms and investors to seek out new opportunities abroad.
The most significant change, then, that has come about as a result of tightening credit is a shift in the dynamics within the M&A sector. Previously, industry players were often shut out of a bid by private equity investors, who benefited from not having to meet the same kinds of regulatory requirements and from having large pools of cash with which to bid. With private equity now facing a credit crunch, corporate buyers find that their offers, which may involve offering their own stock with or without a cash component, are more attractive than before and they are in a position to compete more effectively for strategic assets. The need to achieve greater economies of scale will always be a major preoccupation of companies as globalization continues, and will not be affected by the borrowing climate for private equity. Whatever the impact of the recent slowdown, and the resulting adjustment, the M&A sector will continue to be vibrant.