I’m trying my best to stay out of the economic prediction game, especially when it comes to the overall performance of the economy. I’m not a macro guy, so I try to leave predictions and prognostications about the US and global economies to those who are better informed than I. However, I’m having trouble doing that.

It seems that hardly a day goes by that I don’t pick up a paper and see a headline about a deal (whether a private equity deal or a deal involving a corporate buyer) that doesn’t make me scratch my head. As I alluded to in my previous post (see Dumbfounded by the Data), the sheer volume of deals and the premia that firms are paying these days are eye popping. Just to summarize some of the stylized facts about the current market environment:

1. Deal value so far this year has exceeded $2 trillion (on pace to set another record, …and 71% greater than last year at this time)
2. Average acquisition premiums this year have been running about 49.5% (65% greater than the 30% historical average)
3. The use of leverage in these deals is at an all-time high (debt from European firms acquired through buyout, for example, is running at about 6.2 times earnings versus 5.1 times earnings in 2004 and 4.8 times earnings in 2003)

All this is no surprise given the state of liquidity in markets. If you believe the May 2007 report by the OECD, much of this M&A activity has been fueled by excess foreign exchange reserves in countries such as China, Japan, and India; recycled petrodollars from countries like Russia and Saudi Arabia as result of elevated oil prices; and interest rates that have been at historical lows across the globe over the past six years (see FT article).

But that begs the question, when (and how) will this madness end? As I mentioned in my previous post, I wouldn’t be surprised to see this episode end ugly.

Firms are increasingly debt strapped. In fact, I read a statistic last week that nearly 48% of all bond issues in 2007 have been categorized as below investment grade (junk) compared with 35% just several years ago. The risk spread on these “junk” loans are at an all-time low (about 3.3% over government debt). Moreover, more companies are stretched by the amount of debt that they’re carrying. Given the flood of liquidity in the market, the default rate in the U.S. is hovering at an all-time low of around 1.4%. The historical average for defaults is around 3% according to Edward Altman.

To me, this suggests that it’s just a matter of time before we witness an increase in distressed companies, an increase in default loans, and an increase in insolvency. At some point firms will be unable to service their monstrous debt obligations. For example, I’ll be interested to see how a firm like The Tribune Company, under the leadership of Sam Zell, will be able to pay off its debt – at 10.7 times earnings – in a business (newspapers) where cash flows have been steadily declining.

At the very least, in the near term default rates should rise back to their historical averages of around 3%. But if you believe that money has been too cheap and companies far too overextended, you might plausibly expect 10% default rates, similar to those achieved at the end of the dot com bust. And if you believe that the banks know something that we don’t, what should we infer from the fact that they have been recently building their distressed debt practices (see the interesting Bloomberg article on the subject)? Probably that they expect corporate performance to deteriorate at the very least, and perhaps, some kind of larger systemic market correction.

I have no idea when that market correction will come, and the fortunes of businesses are so intertwined with the fortunes of economies that the catalyst could come from almost anywhere (one quarter of poor corporate performance, central banks turning off the liquidity spigot, a decrease in consumer spending as a result of a housing bust, increased oil prices, increased inflation, war, etc.). Nevertheless, I believe that a correction is coming sooner rather than later. In my opinion, the deals have just gotten out of hand. There is little economic and strategic logic to support them (see Stupid Money Chasing Stupid Deals for details). Unfortunately, I also believe such a correction is necessary. We need to bring sanity back to the market (at the very least to the M&A market). My only hope is that the correction, in whatever form it takes, is neither deep, nor prolonged.

As a parting note, I will leave you with some food for thought about the potential timing of an upcoming market correction – a cheeky, though very clever article that appeared in the Times Online entitled “Sell! Twenty Reasons to Panic“. Enjoy!

This entry was posted on Tuesday, June 5th, 2007 at 6:36 pm and is filed under Corporate Strategy. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.