We have seen numerous debt-funded merger and acquisition (M&A) transactions in recent years that have generally added leverage, which is usually meant to be temporary. Companies often define paths to delever in the years following these transactions, thus resulting in muted reactions from the rating agencies. Nonetheless, total debt has seen significant growth, particularly in the lower end of the investment-grade market.
This week’s chart highlights the pre- and post-M&A leverage in the periods before and after the financial crisis. Note that for both periods, companies have generally added the same amount of leverage for M&A (1.4x). During this cycle, however, businesses adding leverage for M&A were at a fundamentally weaker starting point than the pre-crisis period. Starting leverage was about 0.7x higher than pre-crisis.
Post-crisis transactions were largely in the consumer non-cyclical sector, which has more stable cash flows during softer macroeconomic periods. As a result, although post-M&A leverage has risen to somewhat high levels, the rating agencies have been more lenient in allowing companies to shrink their balance sheets over a year or two. This is particularly the case when cash flow generation, conservative financial policy and/or scale are prevalent. Transactions that have fit this mold include Anheuser-Busch/SABMiller and Kraft/Heinz (both deals over $100 billion), as well as other large healthcare and pharmaceutical transactions.
Spreads of companies in the post-crisis period have slightly underperformed the investment- grade index in the two years following the M&A announcement, while the pre-crisis companies outperformed. This likely speaks to the lower leverage starting point in pre-crisis names and investors viewing the transactions more positively. The rise in leveraging M&A also explains some of the decline in quality of the Bloomberg Barclays Corporate Index from the pre-crisis period and the growth in the BBB-rated paper to about 50% of the index.
Companies involved in leveraging M&A transactions that exhibit strong cash flow and a financial policy demonstrating a willingness to delever could see improved credit metrics in relatively short order, or at least maintain the financial flexibility to weather a modest economic downturn. Broadly speaking, given the weaker fundamental starting point for companies pursuing debt-funded M&A, should these companies face unexpected headwinds and the rating agencies decide to tighten the leash on the window to delever, spreads could be pressured, as we have begun to see in the food and beverage space.
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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