- The Arvida deal and now cancelled Warehouse takeover approach gave rise to an expectation of more M&A (merger and acquisition) activity. A lift in capital market activity could be prompted by expectations of lower interest rates linked to weakening activity in the current economic cycle.
- The state of the current economic cycle reflects an established cross-sector pattern of weakening activity alongside falling interest rates, higher unemployment, and lower corporate margins.
- Expectations strongly suggest that private equity could be heavily involved in the incoming acceleration of M&A activity.
Lower funding costs improve deal dynamics
The rotation from more defensive stocks started in New Zealand when our Reserve Bank found the dovish switch in the signal box. Globally, the Federal Reserve also timed their rate cut conversation in line with lower inflation data. Typically, quality cyclical stocks get their valuations cut beyond a reasonable expectation of mid-cycle earnings. It’s as if the world collectively decides that economic growth will never return, and a buyers’ strike occurs across the consumer, housing, transport and industrial sectors. Investors only want to own technology and utility stocks until they, on average, become priced to perfection.
Of course, disruption, through new technology, regulation and demographics might mean that cyclical stocks miss out on the next economic cycle. Many companies may not survive to see a recovery in earnings, while more highly leveraged companies might become unable to service debt and fail to see through the business cycle. It’s sometimes a narrow margin picking winners from the value pile of companies. And so, with the recent news on likely cuts to interest rates, there was possibly a sigh of relief in some corporate treasury operations where a susceptibility to being caught in a banking covenant downward spiral or predatory bid was perhaps the biggest worry.
The deal makers are always sharpening their pencils. It’s a fine line as to when to launch a bid. Wait for the starting gun on an interest rate cycle and you may miss the bottom. Pre-empt the economic cycle, and you could be fighting both a downturn in demand and higher rates for longer.
The velocity of money has fallen sharply in capital markets over the last twelve months, just ask the investment bankers. Like New Zealand’s hydro lakes, it’s been a dry period. As noted by Harbour’s Shane Solly this January, the deal makers have been working on many transactions in the last six months. The Arvida deal was first mooted in December 2023 and, while the economic news in the housing market deteriorated, fundamental demand for aged care facilities hasn’t folded. Results from the likes of Summerset have continued to indicate that the broad sweep of demographic demand is solid, while development margins are available for good operators. The Arvida bid, at $1.24 bn, seems a big number, however it remains a shade under net tangible assets, and Arvida has a decent pipeline of development. At a 68% premium to the share price at the time, the $1.70 bid price is supported by the Board. Sadly, it seems odds-on we lose another listed company.
But M&A can be a stuttering affair, with proposals and counter bids, and then failed transactions. The collapse of the Warehouse Group proposed transaction involving founder Sir Stephen Tindall (the Tindall Foundation) and private equity firm, Adamantem Capital, is typical of incomplete and conditional proposals. The Warehouse has seen so many earnings downgrades and management recycling that it’s been hard for analysts to keep up. In part, that reflects the very real collapse in the New Zealand consumer in the last twelve months, and also perhaps both competition and a change in buying habits. While the proposed swivel to compete with supermarkets might be a business strategy best conducted away from the spotlight provided by public markets it is also a bold strategy, and perhaps a step too far for private equity investors.
What next?
The share price rally in the transport sector, eg Mainfreight and Freightways, likely says more about interest rate expectations, than M&A. Both probably became far too cheap. In other sectors, it’s hard to say whether a fall in rates will be enough to solve either demand or capital issues. The listed property sector is possibly most interesting, with depressed listed multiples, among increasing evidence of private sales at or near NTA. We suspect private equity is circling both individual properties and perhaps entities, albeit investors are still concerned about rising vacancy rates in some corners of the industry.
Amongst all this excitement about rates falling, nothing seems new in this cycle. The tension between falling interest rates, weakening activity, higher unemployment and lower corporate margins is seen time and time again across different sectors. That tension often plays out with a jump in equity prices then some volatility as difference forces come into play, before settling into a better environment overall as inflation stays well-behaved, investors gain confidence, and companies return to stronger profits. Although no two cycles are exactly the same, this one, for now at least, is playing out similarly to prior rate cut cycles.
Through all that, the M&A cycle seems likely to accelerate. We can’t help but think that this cycle may see private equity investors accelerate acquisitions and consider selling down holdings perhaps back to the listed equity market.
Through all this rotation we also think that the companies that continue to bank high quality capital reinvestment strategies may also see opportunities. Growth companies can be equally acquisitive, benefiting from falling rates. Infratil’s recent capital raising provides an example of investing in more of what you know works. Picking the next M&A target might be a less likely strategy for developing wealth.
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