Mergers and Acquisitions in 2024: Headwinds to Tailwinds?

As published in CFA Institute Enterprising Investor on February 12, 2024

Global M&A plunged to a decade low last year, with $2.9 trillion in deal value announced, a 17% decline from the prior year. Dealmakers remained mostly dormant as they grappled with higher inflation, rising interest rates, increased regulatory scrutiny and market uncertainty while potential sellers remained anchored to previous richer valuations.

Private equity buyers saw a notable decline in activity last year after accounting for nearly a quarter of all buyouts in the previous two years as tighter financing conditions and higher interest rates weighed on their ability to complete leveraged buyouts. In Canada, there were 441 completed transactions last year with most of the deals being bolt-ons to an existing company within a PE portfolio.

PE firms found a way to continue doing deals in a higher rate environment by purchasing a minority interest in companies thus allowing them to preserve capital by writing smaller checks while also allowing the target company shareholders to maintain interest in the company should the valuation recover.

There were some bright spots. Commodity and industrial sector companies saw a big pickup in activity as inflation benefited many of these businesses and companies looked to scale their operations to drive improved efficiencies. The energy sector led M&A activity with several mega merger deals announced in the back half of the year with deal activity in the US Permian shale region surpassing $100 billion. While technology sector M&A declined overall, two big deals—Activision Blizzard’s $69 billion acquisition by Microsoft Corp (NASDAQ: MSFT) and VMware’s $61 billion acquisition by Broadcom Inc (NASDAQ: AVGO)— closed successfully. The healthcare sector saw a significant pickup in activity with dozens of biotech and pharmaceutical merger deals announced as the industry’s largest drugmakers face a steep patent cliff over the next decade and are actively seeking to refresh and extend their patent drug portfolios.

Despite the challenges of 2023, the pick-up in the last quarter gave investors a glimpse of better days ahead. In 2024, dealmakers are battle hardened and have adapted to the new regime by employing more structured deals to balance risk. These include the use of earn-outs, contingent value rights, carve-outs, and spin-offs. An increased number of deals are also structured with all or part stock consideration as opposed to all cash. Typically, an acquirer structures a deal with all cash consideration when they have ample cash or access to financing and are willing to assume all the risk as they have high confidence in their ability to achieve synergies or strategic targets from the acquisition. With tighter financing conditions and especially for deals within capital-intensive industries, sharing the risk and reward with shareholders is becoming more common.

Last year’s headwinds may become this year’s tailwinds hence we enter 2024 optimistic about the outlook for M&A and merger arbitrage. As inflation cools, interest rate expectations trend lower and companies adapt to the post pandemic environment, investor confidence is returning. Despite the geopolitical and economic backdrop of uncertainty, savvy companies are seeking opportunities to drive future growth and acquire the technologies and capabilities needed to compete and avoid being disrupted.

On the deal side, indications across the board from investment banks, advisors and company insiders all suggest that the M&A pipeline is robust. Rising equity markets have given management and boards the confidence needed to make deals with a growing number of companies in active dialogue. Shareholder activism is also rising as frustrated shareholders seek to realize value in stocks trading at deep discounts to intrinsic value. As we head into proxy season, ineffective boards may become targets for replacement and increased shareholder dissent could bring an opportunistic acquirer to the table.

The investment opportunity with merger arbitrage is also attractive with merger arbitrage yields in excess of 10% for average North American merger deals. This is a material premium to historic levels and a significant spread over high-yield bonds. In a more hostile regulatory environment, arbitrage investors can now benefit from a better understanding of what deals are likely to be targeted by regulators. After a string of losses by the regulators their resources are stretched thin, limiting the number of deals they can actively target. With wide spreads, an improved playbook for assessing deal risk and the potential for more M&A activity to materialize, 2024 could shape up to be a strong year for merger arbitrage performance.