M&A update: tailwind for up-cycle

Alternative strategies can complement or substitute short-duration fixed income

Global merger and acquisition (M&A) activity reached over $2.1 trillion through the end of August, up 16% from the same time last year.¹ The recovery in deal-flow continues to show momentum in North American markets, with M&A transaction up 23% in the U.S. and 37% in Canada relative to the same period last year.

We continue to see signs of optimism materialize in M&A deal-flow with higher activity across a broad number of sectors and industries. American multinational food company Kellanova (NYSE: K), commonly known as Kellogg’s, announced a deal to be acquired by Mars Inc. during the month. The $36 billion transaction represents the largest merger announced this year and the first large-cap consumer deal in over a year.²

The return of mega-merger deals is a positive sign for markets and M&A activity as large acquirers are exhibiting confidence in the economy, consumers, and credit markets given the risk and complexity of financing and closing a deal of this size. High investor confidence, lower interest rates, and strong equity markets are a powerful combination primed to drive M&A activity higher.

Small-cap M&A activity remains robust in Canada and the U.S. with conditions ripe for activity to pick up. An interesting dynamic we continue to see is many small and mid-cap companies receiving opportunistic acquisition offers at a decent premium to their current market price but well below estimates of intrinsic or fair market value.

After years of anemic performance for small-cap businesses, shareholder frustration is high. Although reluctant to negotiate a deal when valuations were at a fraction of their value estimate, now that valuations have re-rated, these shareholders may be more receptive to an offer at a modest premium today, even if that offer remains well below fair value.

In many cases, the buyers are management or include management rolling in their equity into the new privatized company. With a clear asymmetric informational advantage, minority shareholders may be getting the short end of the stick, but the majority appear willing to take the liquidity and move on.

Market outlook

Major stock market indexes ended August near record highs after recovering from the correction at the beginning of the month. The S&P 500 was up 2.4% in August, while the Nasdaq Composite rose 0.7% and the S&P/TSX Composite gained 1%. Meanwhile, the Russell 2000 was down 1.5% in the month.

With inflation falling as labour markets cool, the market focused on the U.S. Federal Reserve Board’s commentary to understand how many more rate cuts to expect through the end of the year. With equity markets at highs and rates coming down, there is a favorable tailwind for M&A deal flow in the months and quarters ahead.

While the forthcoming U.S. election may add some uncertainty to markets, we expect M&A transactions to remain robust through year-end as valuations and interest rates are likely more material factors for acquirers. For private equity buyers in particular who have trillions of dollars of capital waiting to be deployed, higher interest rates have been the key hurdle holding back activity. With rates set to fall and potentially fall fast and far, we could be entering an M&A upcycle.

Investment implications

M&A activity has seen a challenging period with 2023 representing the lowest level of deal flow in decades as rates were raised at a record pace to fend off post pandemic inflation. We are now entering an environment where those headwinds will turn to tailwinds as interest rates are cut and deal activity is set to increase. With equity markets at highs, corporations and private equity firms loaded with capital and financing conditions set to improve, we are optimistic about outlook for M&A and merger arb returns.

Arbitrage spreads have remained wide on both a relative and absolute basis and could see further widening as deal volumes increase. This favorable backdrop for M&A contrasts with the headwinds for short-duration fixed-income securities, which are set to see their yields decline as interest rates fall. The non-correlated, tax-efficient return potential of arbitrage appears attractive in this environment and investors would be well suited to consider adding an alternative strategy that can complement or substitute short-duration fixed income.

Notes

1. Deal Intelligence I as of August 8, 2024.
2. Umer Khan and Audrey Elsberry, “$35.57B snack deal revives global large M&A activity.” S&P Global, Sept. 9, 2024.

Amar Pandya, CFA, is Portfolio Manager of the Pender Alternative Arbitrage Fund and the Pender Alternative Special Situations Fund at PenderFund Capital Management.

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