BizAnalyst Network

How to handle the MA boom

How to handle the M&A boom
By Mohamed El-Erian

The boom in mergers and acquisitions has underscored the disparity between rising market values and serious economic concerns, writes Harvard Management Company President Mohamed El-Erian in this Financial Times commentary. Meanwhile, equity investors are enjoying benefits as investors looking for markets to "revert to the mean" have been stymied.

The mergers and acquisitions boom rolls on, slowly but surely changing the financial and corporate landscape. Spurred on by a record surge in private equity flows and enormously accommodating debt markets, the momentum of this shift is showing little sign of fading.
The impact is being felt across markets, particularly in the US where several indices have reached record levels.

But the M&A boom has helped to accentuate the contrast between buoyant market valuations and concerns about a US economy facing headwinds on account of a difficult housing market, a subprime mortgage debacle, high energy prices and large consumer debt.

The joy of equity investors, especially leveraged ones, also contrasts vividly with the frustration of others. Investors betting on continued historical aberrations in market trends have continued to benefit so far. In contrast, those looking for markets to "revert to the mean" have been left frustrated.

The latter have continued to observe stark historical inconsistencies in market valuations, volatilities, correlations and liquidity. Yet their attempt to exploit these inconsistencies has been repeatedly disturbed by yet greater market aberrations. The "Theory of Second Best", which dates back to the 1956 work of two economists Kelvin Lancaster and Richard Lipsey, provides a useful framework for thinking about all this.

Essentially, this theory looks at what happens when, in certain circumstances, one of the optimal conditions of a model is not fully met. Intuitively, when this happens, it might be supposed that the second-best solution involves continuing to meet the other optimal conditions of the model. The Theory of Second Best cautions against this. Instead, it suggests that a better outcome may involve deviating from these conditions.

When applied to today's financial markets, the second best theory illustrates one of the ways in which investors have had to adjust their approach to take into account the manner in which emerging economies are allocating their large and increasing reserves.

These economies' large "non-commercial" purchases of US fixed income products have introduced and sustained significant pricing distortions. And, as the Theory of Second Best suggests, the next-best solution for investors has implied betting on additional historical anomalies in other markets.

How has this worked? Large foreign purchases of US bonds have led to an unusual compression in bond yields and credit spreads. The resulting misalignment versus the equity risk premium has encouraged increasingly large leveraged buy-out activities which, in turn, attract even more capital to private equity.

No wonder M&A activity has surged. And, as the corporate landscape changes, companies with large cash holdings have been forced in, with some playing defence and others offence.

How long can this go on? For a while; but not forever. In the short term, the phenomenon has significant momentum that can only be derailed by a series of economic and technical dislocations. A single dislocation will not suffice as illustrated by the temporary setbacks of May-June 2006 and February 2007.

Over the longer term, valuations will be excessively divorced from the underlying economic realities, especially if the US economic slowdown intensifies. In addition, the risk of regulatory and political backlash will rise. Finally, the distortion that lies at the heart of it all – the non-commercial allocation of sovereign wealth funds – will slowly fade as emerging economies face pressure to increase the rate of return on their reserves and to allocate more funds to domestic uses.

Therefore, the basic challenge for investors is an outlook that is inherently fluid and potentially dualistic. The solution may well have three principal components: a strategic asset allocation that emphasises secular themes and a long-term destination; portfolio overlays that recognise the reality of an historically unusual journey; and a risk management process that is sensitive to the nature and evolution of the underlying market distortions.

Mohamed El-Erian is president and chief executive of Harvard Management Company.

mergers, acquisitions, M&A, investment banking, private equity

Labels: acquisitions, investment banking, MA, mergers, private equity

posted by Victor Lloyd Smith @ 5:31 PM