We’ve seen so many “top of the market” indicators in recent years, none of which have actually proved to be the “top of the market”.
So I’m wary of attaching too much importance to yet another one.
But news that merger and acquisitions activity – driven to a great extent by private equity deals – has hit an all-time high is certainly worth looking at in a bit more detail.
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After all, the last time we were at these sorts of rarified heights, it was 2007. And we all know what happened then.
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Private equity deals have hit a new record
Private equity has been in the news a lot recently, and there’s no sign of this changing soon.
Global mergers and acquisitions (M&A) activity hit an all-time high this quarter, helped along by record-breaking activity from private-equity companies. The total value of deals hit $1.5trn in the second three months of 2021. That’s the fourth quarter in a row of £1trn-plus volumes, notes the Financial Times.
Focusing on private equity, the first half of this year was the busiest for the sector since records began 40 years ago, according to data provider Refinitiv, with nearly 6,300 deals.
Record M&A activity does tend to go hand-in-hand with toppy markets. Why is that, and does that mean this is a warning sign? Let’s think it through.
A market in which a lot of deals are being done has a number of characteristics. All of these help to explain why the more frenetic the activity, the closer to the top we tend to be.
If a lot of deals are being done, it means there’s a lot of money looking for a home. In turn, that means there’s a lot of competition for deals. In turn, that means desirable assets are going to go for a lot more than they would in a duller market.
As a result, you get a “reach for yield”. Investors make steadily more optimistic assumptions to justify putting their money to work. Eventually those assumptions reach the point where they’re just plain over-optimistic.
It’s basically your classic bubble behaviour. A combination of loose money and an influx of new investors (private equity has drawn a lot of new institutional money over the years as many of the best companies have been remaining in private hands for longer) drive enthusiasm for a sector.
Said enthusiasm drives up the valuations in the sector until they are just too far away from reality to be sustainable. Something happens – usually the money becomes a bit less available than it was the day before, either because central banks tighten and then a big player goes belly up – and the bubble pops.
So where are we now?
Wherever we are in this cycle, it’s fair to say that we’re closer to the end than to the beginning. As Lex in the FT notes, private equity deals in the US were being done at a median average 14.7 times enterprise value (EV) to ebitda multiple (that’s a fancy price/earnings ratio basically). That’s very, very expensive by historic standards. In 2019, it was 11.5 according to PitchBook, and that was a record high.
Meanwhile, returns to investors have been declining, adds Lex. About 20 years ago, private equity was beating public markets in terms of returns. Now it’s about the same and sometimes a little lower. That shows you that valuation is becoming an issue.
There’s another interesting data point. Amid the last big private equity boom, US giant Blackstone went public. That was in June 2007, which was pretty much the top of the market.
Right now, the next IPO that everyone’s getting excited about in the London market happens to be private equity group Bridgepoint. Now, Bridgepoint is much smaller than Blackstone, but the point is not the size – it’s the idea that now is a good time to go public (in other words, now is a good time to sell up while you can).
What’s the counterargument? Well, it’s hard to see debt getting a lot more expensive in the near future (though even a small shift matters when markets are this overstretched). Also, if you adjust for inflation, we aren’t quite at the highest levels ever seen (that happened in 2000) although I’m not sure inflation is all that relevant in this context.
Finally, I suppose the pandemic may well have artificially boosted the figures in the same way that it’s juiced global housing markets. This is probably the best counterargument, although it just points to a longer period of time before we top out – it doesn’t take away from the fact that activity is still overheated.
Anyway, I can’t honestly say if we’re near a top or not – my crystal ball conked out a while ago. But this is certainly not the sort of activity you see near a bottom.
I’m not saying you should be pulling money out of the market or even making any big adjustments to your asset allocation. Just stick to your plan, and try to stick to the cheaper markets. Private equity is mostly a “growth” rather than a “value” phenomenon, so it’s all part of that “jam tomorrow” bubble in some ways.
Oh and if you’re looking for value and investment ideas, make sure you listen to our latest podcast, out today. Merryn catches up with MoneyWeek favourite, Jim Mellon, who shares his views on markets (and banks in particular), gives us his punchy predictions for the future of agriculture, and explains why Dubai could be the “new Hong Kong” – have a listen here.
Until tomorrow,
John Stepek
Executive editor, MoneyWeek
