Mergers and acquisitions: Are monster deals back?

Suddenly chief executives are on the takeover trail again. Stephen Foley finds out why

The world's chief executives have rediscovered their animal spirits. It is not just Irene Rosenfeld, combative boss at Kraft Foods, who has reached for the corporate chequebook in recent weeks in her pursuit of Cadbury. Bob Iger at Disney signed off on the $4bn (£2.4bn) purchase of Marvel Entertainment, home to the Incredible Hulk, Spiderman and a host of other cartoon heroes, just seven days earlier. On both sides of the Atlantic, it seems the floodgates are open: T-Mobile UK and Orange are merging; a private equity consortium is taking control of Skype, the phone company currently owned by eBay; the $5.5bn takeover of BJ Services by Baker Hughes is the largest oil services industry deal in more than a decade. Mergers and acquisition activity was almost wiped out by the credit crisis and the economic chaos in its wake – but it's back. In a big way.

The deals announced so far are just the tip of an iceberg, says Paul Parker, the head of global M&A at Barclays Capital. He can see behind the headlines, to the growing pipeline of deals in the works at his investment bank and beyond, to the growing willingness of chief executives to contemplate ambitious deals.

"This has been a sharper, deeper and more painful cycle than others," Mr Parker said, "but it is all very consistent with the troughs of the early Nineties and the 2002-03 period: M&A follows GDP and, as GDP turns, so does M&A."

To understand the sudden turnabout, one has to look to the psychology of the C-suite, the chief executive's office. The average tenure of a corporate boss is short – shorter, certainly, than a single economic cycle. That concentrates minds. M&A offers them an opportunity to reshape their companies at a stroke, an off-the-shelf legacy.

The big deal is what Mr Parker calls an "inorganic catalyst" for growth. "History is on the side of those who buy at the trough. Now there is a broad sentiment that the glass is more full than empty, and chief executives have to make a call. We have always had deals where the synergies are so great that they overwhelm the lack of visibility on earnings, but now things have stabilised and there is some visibility, chief executives can say to their boards that valuations make sense and that they don't want to let an opportunity get away."

Merger and acquisition activity fell 42 per cent in the US in the first half of this year, compared with an already depressed 2008. The drop-off was even worse in Europe and Asia, according to Bloomberg data. Such deals as there were fell into Mr Parker's category of overwhelming synergies, such as Pfizer's takeover of Wyeth or Pepsi's buyout of its two top bottlers in early August.

Now we are in the brief window of hard work between the end of the summer vacations and the Thanksgiving break that opens the winter holiday season, and the deals so far are almost as conservative. None foresees a return to the debt-fuelled M&A boom and sky-high valuations of the middle of this decade, characterised by multibillion-dollar leveraged buyouts from private equity giants such as Blackstone and KKR.

The absence of super-cheap debt for private equity firms has opened the door for industry buyers. In 2007, private equity was likely to have been able to pay more for Cadbury than any trade buyer. Now the talk of counter-bidders against Kraft is focusing on industrial rivals such as Hershey and Nestlé. This is reassuring stuff for those who want sustainable M&A, rather than an irresponsible bubble.

Peter Hahn, a former managing director at Citigroup who now lectures on corporate finance at London's Cass Business School, says the Cadbury deal is "hardly a deal too far". And he added: "On the basis of what's been proposed by Kraft, this is a relatively conservative deal, with a large equity component to buy a company that is highly cash generative. So far, executives are dipping their toes or their feet in the water. Nobody's taking big dives."

Debt financing for acquisitions is now more available than it was a year ago, after the relentless tightening credit conditions that culminated in the debt market shutdown after the collapse of Lehman Brothers. Investment-grade companies in the US have sold $810bn of bonds this year, 33 per cent up on the same period in 2008. In Europe, the increase is 38 per cent.

That gives chief executives access to more cash to pursue their targets, but bankers say conservatism will not be quickly thrown out of the window. But Mr Parker of Barclays says that "we will not emerge to another cycle where as much of the consideration is in cash". After seeing what happened in the recession, with corporate bankruptcies rocketing, debt holders have rather decided they would like to be sure of being paid back. Company chief executives, meanwhile, are more focused on keeping their corporate credit rating secure and therefore prefer to buy rivals using their own paper, rather than borrowed money. The rebound in the stock market means that shares are a more valuable currency, too.

And there is another factor favouring trade over the financial buyers in the world of private equity. It is a political factor, as Mr Hahn of the Cass Business School points out. The Kraft bid for Cadbury is being funded in part by Citigroup, the financial giant which came to the brink of collapse last year and now has the US government among its largest shareholders. Bailed-out banks are under pressure to make sure that real business can get access to loans in order to hoist the economy out of recession: in this context, a loan to Kraft is a "good" loan, says Mr Hahn, in a way that lending to a private equity bidder would be a "bad" loan, from a political point of view.

Analysts have cheered the strategic logic of the Kraft bid for Cadbury, in the same way that they have cheered the commercial sense of bringing Spiderman into Disney's web, or bolting together two of the UK's weaker phone companies. These are the deals that characterise the new boom in M&A. Industrial logic, not financial trickery.