AlphaRank Merger Monitor -The Oil That Greases the Deal Machine

July 30, 2024 — Just as motor oil lubricates an internal combustion engine, allowing a car to operate at its peak efficiency, interest rates grease the M&A machine, facilitating mergers and acquisitions as companies seek profit growth and expansion into new markets.

However, the level of interest rates is not the only factor that enables merger transactions. Additional considerations, such as the recent direction of interest rates, forecast direction of interest rates, equity market performance, and new issuance in both the equity and credit markets, help spur dealmakers’ handshakes.

Currently, 79% of outstanding U.S. public mergers contain a cash component to the consideration paid (and conversely, just 21% are all-share deals). The risk-free rate, as measured by both the fed funds rate and Treasury bond rates, influences the level of financing rates for cash-funded merger transactions. Given the prevalence of cash considerations in the deal universe, recent moves in the yield curve have a pronounced effect on overall deal activity.

The federal funds rate, the benchmark interest rate controlled by the Federal Open Market Committee (FOMC) of the Federal Reserve, is the interest rate at which depository institutions such as banks lend reserve balances to each other overnight on an uncollateralized basis. Market prognosticators generally view the fed funds rate as the most important benchmark rate and the key determinant of “financial gravity”, or the level at which all other risk assets are priced relative.

Another key benchmark rate is the Secured Overnight Financing Rate (SOFR), the interest rate charged for dollar-denominated loans and derivatives, reflecting the cost of borrowing cash overnight collateralized by U.S. Treasury securities.

SOFR, which serves as the base rate for private credit and leveraged loans fueling the private equity buyout industry, is correlated with the fed funds rate. As the Federal Reserve begins to ease monetary policy by lowering the fed funds rate, SOFR will follow, reducing the rate at which leveraged buyout loans are offered.

The FOMC’s dual mandate includes maximum employment and stable prices. To maintain price stability, the Fed seeks to keep inflation at a moderate and predictable rate. Consequently, as the rate of inflation falls, the Fed has the mandate to reduce its policy rate.

While central bankers have had a challenging time reining in inflation over the past few years, they have experienced some recent success. For example, June’s personal consumption expenditures (PCE) price index, the Fed’s preferred inflation measure, rose 2.5% year-over-year, down from 2.6% in May. The Committee seeks to achieve an inflation rate of 2.0% over the longer run, and the recent PCE index reading indicates they are getting there.

Ergo, the market believes recent inflation prints are setting the Fed up for its much-anticipated rate-cutting cycle.

Source: CME

Currently, the market is pricing in an 88% chance of a 25 bps rate cut in September, with two or three cuts expected by year end.

Source: Bloomberg

As the Fed reduces its policy rate, we expect that SOFR, the rate at which leveraged buyout loans are funded, will fall in tandem. Low interest rates are like catnip for private equity funds, and the lower rates are, the better.

Consequently, as increased confidence in rate cuts begins greasing the deal-making wheel, we have observed a material uptick in buyouts from financial sponsors.

In July, there were twenty public mergers announced in North America worth an aggregate $65 billion. Of these, eight, or 40%, were acquisitions by financial sponsors:

• Bain Capital announced the $4.5 billion buyout of fintech company Envestnet
• KKR announced the $4.8 billion acquisition of edtech company Instructure
• Apollo announced the $1.9 billion LBO of gaming company Everi
• Sixth Street, along with Liberty Strategic Capital and J.C. Flowers, announced the $5.1 billion take-private of insurance roll-up Enstar Group
• Standard General struck a $4.6 billion buyout of casino company Bally’s
• Platinum Equity looked north for its recently announced acquisition of Canadian aerospace manufacturer Héroux-Devtek for $1.4 billion
• European private equity firm Astorg announced the $388 million deal for TSX-listed Hamilton Thorne
• Fairfax Financial announced a $1.7 billion transaction to take mattress retailer Sleep Country Canada private

In comparison, throughout 2023, only 22% of all M&A transactions featured financial sponsors as buyers.

Private equity buyouts are alive and well, and we have the Fed, along with the recent decline in inflation, to thank. While we have not seen the massive, league-table-busting leveraged buyouts of yesteryear, the steady drumbeat of LBO announcements this month indicates that private equity chieftains are ready and willing to put money to work.

As interest rates decline as forecast, we believe that private equity activity will increase from already notable levels.

The increased prevalence of private equity buyouts is music to the ear of arbitrageurs. Our 2023 memo, Putting Private Equity’s Credibility To The Test, took a look at the closing rate of private equity deals compared to strategic mergers. We noted:

“Over the past decade, there have been 358 private equity buyouts of U.S. public companies, compared to 1,613 total U.S. public M&A transactions… Of these deals, 95.3% of U.S. private equity transactions have closed successfully compared to 94.3% for all U.S. public mergers and acquisitions. The 4.7% deal termination rate of private equity compares favourably to the 5.7% for the average M&A transaction.”

Given the reduced antitrust scrutiny that has historically accompanied private equity buyouts, along with the “forced buyer dynamic” that we discussed in the above-noted 2023 memo, PE deals are generally considered safer than the typical strategic merger because of their higher completion rates.

As the private equity industry warms up its trillion-dollar deal making machine, to be well-greased from the Fed’s expected rate cuts, merger arbitrage investors stand to be positively positioned to capitalize on the forthcoming opportunities.

The AlphaRank.com Merger Monitor below represents Accelerate’s proprietary analytics database on all announced liquid U.S. mergers. The AlphaRank Merger Arbitrage Effective Yield represents the average annualized returns of all outstanding merger arbitrage spreads and is typically viewed as an alternative to fixed income yield.

Each individual merger is assigned a risk rating:

• AA — a merger arbitrage rated ‘AA’ has the highest rating assigned by AlphaRank. The merger has the highest probability of closing.
• A — a merger arbitrage rated ‘A’ differs from the highest-rated mergers only by a small degree. The merger has a very high probability of closing.
• BBB — a merger arbitrage rated ‘BBB’ is of investment grade and has a high probability of closing.
• BB — a merger arbitrage rated ‘BB’ is somewhat speculative in nature and has a greater than 90% probability of closing.
• B — a merger arbitrage rated ‘B’ is speculative in nature and has a greater than 85% probability of closing.
• CCC — a merger arbitrage rated ‘CCC’ is very speculative in nature. The merger is subject to certain conditions that may not be satisfied.
• NR — a merger-rated NR is trading either at a premium to the implied consideration or a discount to the unaffected price.

The AlphaRank merger analytics database is utilized in running the Accelerate Arbitrage Fund (TSX: ARB), which may have positions in some of the securities mentioned.

* AlphaRank is exclusively produced by Accelerate Financial Technologies Inc. (“Accelerate”). Visit Alpharank.com for more information. Disclaimer: This research does not constitute investment, legal or tax advice. Data provided in this research should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this research is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Accelerate may have positions in securities mentioned. Past performance is not indicative of future results.