New Year's Eve: A dead year for deals

Global mergers and acquisitions volume fell to roughly $3 trillion in 2023, the lowest in a decade, and advisory fees fell with it. Investment bankers will remember it as a dismal year. Companies had not lost their appetite. The cost of capital had jumped, and that was enough.

From record to drought

The fall looks steeper against what came before. In 2021, with policy rates at zero and equity markets at record highs, global deal volume passed $5 trillion for the first time. Buyers could borrow cheaply, pay in richly valued shares, and assume that the exit multiple would be at least as generous as the entry multiple. Two years later every one of those assumptions has been reversed.

The turn came in 2022, when the Federal Reserve began the steepest run of rate rises in four decades. By July this year the federal funds rate stood at 5.25 to 5.50 per cent, and the European Central Bank had pushed its deposit rate to 4 per cent. Long-term yields followed, with the ten-year Treasury briefly touching 5 per cent in October. A financing structure priced for zero rates does not survive that.

No cheap debt, no buyouts

As benchmark rates rose, the leveraged buyout machine that drove private equity dealmaking stalled. Syndicated loan markets balked at underwriting buyouts worth billions, and private credit funds demanded punishing coupons. Sellers still hoped for old prices while buyers priced in higher rates, and the two sides rarely met. Without cheap leverage, financial engineering stops adding up.

The arithmetic is unforgiving. Most buyout loans float over a short-term benchmark, so when that benchmark climbs above 5 per cent and a lender adds a margin of several points on top, the all-in cost of debt reaches double digits. A company bought at a high multiple of earnings cannot service that much debt at those rates, so sponsors must either put in far more equity or pay a lower price. Sellers who remember the valuations of 2021 have mostly refused the lower price.

Banks had their own reason for caution. In 2022 they were left holding the loans they had promised to finance Elon Musk's purchase of Twitter and several large buyouts, unable to sell them to investors without heavy losses. Having been burned once, underwriters were in no hurry to commit to new jumbo financings this year.

The deals that did get done

The biggest transactions of the year show what still worked: large companies paying in shares or cash from their own balance sheets. Exxon Mobil agreed to buy Pioneer Natural Resources for $59.5 billion in October, and Chevron agreed to buy Hess for $53 billion less than two weeks later, both largely in stock. Pfizer bought Seagen for $43 billion, and Cisco agreed to buy Splunk for $28 billion. None of these depended on the leveraged loan market.

Regulation removed some deals entirely. Adobe and Figma abandoned their $20 billion merger this month in the face of objections from European and British competition authorities. Microsoft closed its purchase of Activision Blizzard only after restructuring the deal to satisfy Britain's Competition and Markets Authority, some twenty months after it was announced. American antitrust agencies have published tougher merger guidelines, and boards now build long regulatory delays into their planning.

Winners and losers of the freeze

Private equity firms are the most obvious losers. They cannot sell companies at the prices they hoped for, so they hold them longer, and the pension funds and endowments that invest in their funds receive less cash back than they planned. That in turn slows new fundraising. Investment banks suffered too: advisory and underwriting revenues fell, and Goldman Sachs began the year with one of its largest rounds of job cuts since the financial crisis.

Private credit funds have gained. As banks retreated, direct lenders financed many of the buyouts that did go ahead, taking fatter margins and tighter terms. Restructuring advisers have also been busier, since companies bought with cheap floating-rate debt now face higher interest bills. Cash-rich strategic buyers, such as the oil majors, have found fewer rivals in auctions.

A precedent from the 1980s

The last time a buyout boom broke on financing costs was at the end of the 1980s. The leveraged deals of that decade, culminating in the takeover of RJR Nabisco in 1988, relied on the junk bond market. When that market seized up and Drexel Burnham Lambert collapsed in 1990, buyout activity fell sharply and did not recover for several years. The lesson then was that deal volumes follow the availability of credit more closely than the needs of companies.

The case for a rebound

The strongest counterargument is that the pressure to deal is building. Private equity funds hold large sums of committed but uninvested capital that must be spent within the life of each fund, and they own companies they must eventually sell. Corporate managers still want scale, technology and access to new markets. Bond markets rallied hard in the last two months of the year, and the ten-year yield has fallen back below 4 per cent, easing the financing sums at the margin.

The Fed's own projections now show three quarter-point cuts next year, and futures markets price more. If those cuts arrive and equity markets stay firm, the gap between buyers and sellers should narrow. The initial public offering market reopened a little in September with the listing of Arm, which gives private equity another route to sell. The constraint is that even three cuts would leave short-term rates far above the levels at which the last boom was financed.

What to watch

The first signals will come from the leveraged loan market: new-issue volumes, the spreads lenders demand and whether banks again commit to underwrite large buyouts. Filings for public listings and the pace of sales between private equity firms would show whether sponsors are willing to accept lower prices. Antitrust rulings on large pending deals will determine how much of the strategic pipeline can close.

Much of the M&A boom turned out to depend on zero interest rates. Until funding costs fall meaningfully, deal volumes will probably stay depressed and investment banks will keep their advisory teams lean. The likely shape of the coming year is a modest recovery led by stock-funded corporate mergers, with leveraged buyouts lagging until the Fed has cut several times and sellers accept that the prices of 2021 are not coming back.