Ep.39: Can The M&A Deal Rush Last?

So hello and welcome to episode 39 of The Market Watch. And instead of Piers Curran, I'm joined by Eddie Dolmez, who I'm sure our regular listeners are more than familiar with. But before I get into a conversation with Eddie, huge shout out to the community. Resounding response to the call to arms, uh, last week where we wanted to get people to just give us a little boost up the rankings of the podcast league tables. You guys responded. So thank you very much. The job is not done. I said the target by year-end is 100. We went from 61 to 78, which is a phenomenal effort. If we get a repeat like that, we don't need Christmas. We'll already be there by the end of October. So help us out. Jump on Apple if you're listening on that platform. Rate and review, as I said before, it really helps just get this out to as many people as possible. Share the love and the education. But other than that, let's get straight to it. And so I wanted to swap out Piers for Eddie because it's earnings season. It's that time of year. And it's really the first unofficial week that big corporate earnings really kick off in the United States. And that means it's the bank stocks that take precedence first. And we had JPMorgan earnings come out earlier this week. They were the first ones to kick things off. And so by numbers, The largest US bank reported a profit of $11.7 billion or $3.74 per share, up from $2.92 in the same period last year. And they basically beat expectations. But when you start breaking down the bank, I thought Eddy would be a great person to speak to, to understand that in more detail. In particular, some of the differential between trading activity and things like investment banking fees, which have been phenomenal. And I'm sure that's going to lead us down some other discussions. So just from the top then, Eddie, the bank earnings that you've seen so far, any first thoughts this week?

Yeah, so I think it's always useful to look at context in terms of why we look at these bank earnings. So everyone looks at JP Morgan particularly as a real bellwether for the economy, not just what they're doing as a business because they're so intertwined in the world's largest economy, the US. And as we know, the Federal Reserve basically lead all other central banks as well as they tend to follow. So it's always really, really important to— if you're going to listen to one bank's earnings call or listen to one CEO, it's going to be Jamie Dimon and JP Morgan because especially as they reported first, you can learn a lot and you can get kind of get to grips with what they've reported. It's going to be pretty similar for the other banks, uh, depending on, you know, of course, which banks they are. So if it's investment banking, kind of the investment banking of JP Morgan, that's going to of course be very correlated with Citi, Morgan Stanley, Goldman Sachs. So for example, if M&A volumes are through the roof and investment banking fees are through the roof for JP Morgan, chances are it's going to be the same for a Goldman Sachs or a Citi, for example. But as we kind of look at JP Morgan, as they kind of reported first, they've kind of really continued to, you know, actually be relatively positive on the economy. So the bank actually itself delivered really, you know, quite strong results. The economy continues to show growth despite Delta and the supply chain disruptions that we've— Anthony and I and Piers and I have discussed at length. So they've released another, I think, $1.5 billion in credit reserves as the kind of economic outlook continues to improve. They've also kind of mentioned about commercial real estate loan growth, kind of seeing some early signs in recovery, but it's really all about investment banking, and they actually recorded all-time high M&A fee, uh, kind of fees being generated. So the investment banking, financial advisory divisions, uh, of JP Morgan, but as well Morgan Stanley, Goldman Sachs, is really firing on all cylinders. And what I mean by that is M&A, so mergers and acquisitions. So investment banks advising both buyers and sellers on both sides of the transaction to acquire or merge with different companies, capital markets, so equity capital markets. So when you hear about IPOs, follow-on equity offerings, when a company raises more cash through selling some new issuance of shares, but also things like debt capital markets, so raising liquidity, or the investment bank JPMorgan advising and helping their businesses or their clients, so normal corporations, to raise liquidity through the capital markets. So all of that has been really, really strong.

Yeah. So I mean, just to give some context here, for JPMorgan specifically, their investment banking fees, because you were saying they were up, they rose 52%. Year on year to $3.3 billion. They smashed estimates there. Investment banks are raking in record sums, as you said, fees surging past $100 billion in the first 9 months of the year. A lot of journalists talk about in the media, which I'm sure a lot of listeners read about, is this rush of dealmaking. Just to strip this back a little bit before we go deep diving, why the rush?

Yeah, so that's a really good question, Anne. In 2020, I think it's always important to look at kind of— it's almost pre-COVID and now post-COVID. So in 2020, as we know, the COVID crisis basically hit in March 2020. Equity markets sold off, financial conditions tightened, and it led to dramatic central bank intervention. But what it also did was threw the economy and all the businesses that operate in the global economy into duress. Everyone was scared. Regardless of what business you were operating in, even if it was technology, but particularly, let's say, industrials, energy, I guarantee all of the C-suite and all the board members and all employees were like, we don't know what the next week looks like, never mind the next month. 'Never mind the next 3 months, never mind the next 6 months, never mind the next fiscal year. We don't know, are we going to get through this week, really?' Immediately, all businesses go into survival mode, if you like, and planning. What this prevents is deal-making, potentially. In March 2020, and really the first half of April 2020, dealmaking fell off a cliff. So volumes were dramatically lower because companies were really conserving their capital. It's all about shoring up your balance sheet so you can pay your employees, you can pay your suppliers, you can operate your business, or you can continue to operate. So it was really about that survival mindset. What you're not doing is going, "Wow, we should go out and make the next best acquisition, think about Instagram or WhatsApp, you're not going to go and spend that excess cash on something quite crazy, particularly in a world that's so, so uncertain. What this actually means from a banker's perspective is when they're advising on these transactions also, it's very, very hard to value a business. Some of you may be thinking, "Okay, in March 2020, even the big FAANGs, think fell about 30%. The small-cap Russell 2000, whatever you like, fell even more because smaller businesses are more susceptible to the economy, COVID. They're less financially strong. These businesses are cheap. Why not? Why would that mean deal activity falls off a cliff? It should increase it because you could see targets becoming more affordable and coming into certain price ranges, but it's very difficult to value a business when, okay, first of all, revenues potentially are shut off completely, cash flows are shut off completely. So from a valuation perspective, it's very, very uncertain. So when you're advising, let's say, a buyer, what do you pay for a target? Okay, what's the target worth in that really uncertain environment? You really don't want to pay for something and use up that cash. And for a seller, so if you're being purchased, you don't want to basically get sold for less than you're worth in normal conditions. So from a seller's perspective, you'll go, OK, I'll ride this out. I'll wait till we know more about COVID and then I'll kind of come to the table. So the M&A volumes really fell off a cliff. But as we kind of progressed into the second half of 2020, there was a huge amount of— well, there's a huge amount of different drivers. Okay. So we saw interest rates get slashed. Okay. So what does that mean? It means cheap financing, cheap money, cheap debt to basically raise, to go out and make acquisitions. Okay. And particularly for those businesses that actually somewhat— I'm doing a quote unquote— benefited from the pandemic, they were flush with cash. And they were like, "Okay, this is a great time to snap up some of these targets." Others really maybe were looking at deals to do pre-COVID, and then they got delayed because you don't want to purchase something that you're not very sure that it will survive in the next 3 or 6 months. But when the economy started to return and COVID became less scary, and of course later on in the year, November, we had the vaccine certainty, so we had vaccines basically, we had the US election and Joe Biden come into power. So all these risks kind of started to subside. So there was a huge amount of pent-up demand. Okay. And it's always— well, let's just put it this way. Building a business is very hard. Organic growth is very hard. So just building your business organically and generating revenues organically is very, very hard. Why do you do M&A? Why do you do deals? It's really to expand your business, right? Maybe new product lines, maybe geographical expansion, okay? Maybe— and very topical at the moment— it's supply chain consolidation, right? So there's a lot of horizontal, but more importantly, vertical mergers, right? So if you're a vaccine producer, if you're a medical supplies producer, if you're a manufacturer and you've now shifted all of your operations to Asia where it's low cost and you can benefit from that. And then COVID happens and freight rates, freight costs quadruple, there's supply chain bottlenecks and you can't get your input goods, then you can't sell your product. So now you're looking from a growth mindset, okay, what businesses can we acquire domestically to shore up those, let's say, supply chain issues? So particularly in points of stress, like we're seeing right now, you really need to be diversified, otherwise you're just not going to sell. So there's a lot of defensive action going on. There's also a lot of offensive. So think about the major trends that are apparent right now, and COVID made it even more apparent. Digitalization, right? Businesses having to come from legacy. And it doesn't matter if you operate in technology, If you operate in industrials, energy, they're all trying— you need to be tech savvy and digital, right? So there's a kind of tech flavour across all different kind of deal areas. So that's a big trend, and this is what companies are trying to acquire for. It's ESG and things like that, but it's all about one thing that COVID made very, very apparent for companies was the biggest and the best and the strongest financially, the strongest balance sheets did very well, right? And those that were more vulnerable to these kind of the economy and things like that did less well. So it's really bolt-ons. What can we do to become a bigger, stronger, financially kind of more, you know, sustainable business? So this is really what's driving a lot of the kind of volume from last year. And then, you know, it's definitely carried into this year. So I kind of mentioned interest rates. So they got slashed, of course, last year. So this cheap financing is fueling M&A activity. Companies are raising debt because it's almost free, right, to then go out and purchase companies. But the other side of that kind of function is equity, right? If you are a business and you've got the S&P 500 at almost all-time highs, the NASDAQ at very high elevated levels, particularly let's say if you're a tech company, you've got one lever to pull, which is cheap debt, but you've also got a very elevated share price. If you're doing an all-stock offering, for example, or you're selling some equity to raise some capital to then go out and do a deal, that condition is also very, very favorable for you. All of these different things are fueling this activity, as well as the the strong economy we've really had, really this year up until now kind of thing.

So one thing I was thinking as you were talking through that was that a lot of that activity seems spurred on then by this pent-up demand, as you said, on the initial onset. So it's kind of been a game of two halves, so to speak. I'm just wondering what the third quarter of this game looks like because rates are going up, let's say vaccination efficacy is potentially decreasing. There's some sensitivity at the moment around other subjects that are increasing, whether geopolitics or whether foreign shores in China and the property situation with Evergrande. Surely then this activity cannot continue in this direction forever. And I'm just asking the question, I guess, about going further forward then. Surely this needs to moderate back. It's almost like the environment now that's pretty crazy in the M&A space seems like the only way is down from here. And that because the economy started to show signs of it's already peaked, policies are now tightening. Surely the, the party's over. It's not completely— the party's not finished, but I just wonder what that means then, because obviously everyone's asking the question about equity. You know, if I'm looking at equity indices valuation at these levels, we're punching at all-time highs still pretty much. We've had some pullback recently. But I just wonder with the earnings, when we look at them in a more broad sense with the future outlook for corporates, potentially then a bit of a recalibration back to a degree of normality. It's almost like the GDP numbers we were seeing in the pandemic, monster declines, super recoveries, and now we're kind of somewhere in the middle. And it feels like earnings have kind of lagged that slightly and now It'd be interesting to see where we go from here.

Yeah. So yeah, on top of— I think what you were— well, you sounded like a UK journalist talking about the housing market about to crash. I think I know what report you're talking about in terms of Goldman Sachs revising down, for example, their GDP growth figures for next year, decelerating from this base effect that we've had this year and this pent-up demand. I think really I think the party will continue. I think if you think about interest rates and generally financial conditions, sure, we're talking about tapering starting in November, ending being brought forward in the middle of the year. So yields are on the upward trajectory, if you like, which makes funding costs higher. That's a fact. It would make raising debt to then go and do these deals more expensive. If we see tapering and more importantly interest rate hikes being moved forward from '23 to maybe next year and that hits stocks, equity markets, then of course that would essentially derail the feel-good factor. It hits generally wealth and then again it could have knock-on effects, let's say, into the housing market and all those different assets. So there's definitely a risk, of course, as always that these series of events could potentially derail or slow down activity. However, we're talking about almost the loosest financial conditions that we've ever had. And a 25 basis point hike in 2023 is most likely not going to derail this activity. Of course, there's some supply chain issues that we're battling with. There's the economy potentially— and we talk about stagflation— it's more of a deceleration from a 6% growth rate to a 4% growth rate, which is still above trend growth. OK, so the economy is decelerating, but it's not— we're not going into a recession. OK, so that environment is still relatively strong. If you think about the kind of logistics as well of deal activity, With COVID we've got vaccines now. We've got the Merck pill potentially as a double punch, things like that. I've been on a plane in the last 2 weeks. One of the things that commentators mentioned about, say, March 2020 deal activity when COVID hit was, oh, you can't go and inspect that business. You can't do your due diligence. You can't go and see that factory. You can't go and meet with the founders and shake their hands and look them in the eye to see if they're trustworthy. You can't do the legal due diligence. You can't go and I spend time with the software developers and check the code to make sure it's airtight. So all these things, but that didn't derail it because we found this beautiful technology called Zoom, and actually it didn't matter too much. But cross-border M&A is going to, you know, come roaring back. So we've seen kind of elements of this kind of coming through in the sense of, you know, travel's coming back, you know, the high-frequency data is improving in terms of flying around. So cross-border M&A took a massive hit last year, and it's been kind of the slowest to rebound. But now, you know, flights are going on, so that cross-border M&A could be the next tailwind behind these deals. So I believe that this party will continue. I think what the pandemic's exposed is that M&A and a growth mindset will pay you back dividends in times of big stress. So I think companies will continue to trend towards things like digitalization and the themes that were aforementioned.

Okay. So at the moment, we talked about participants such as investment banks, specifically, but also private equity firms. But I wanted to touch on hedge funds because I know you've mentioned to me before about how there's a very core element to human behavior, which is a very powerful emotion called jealousy. I'm sure hedge funds are looking at this thinking, how do I get a slice of this pie? I remember you talking to me about this before and about how they've entered the fray. What's the deal with the hedge fund side? How are they involved in this space?

Yeah, so these investment banking fees are going through the roof. They're advising strategic buyers. So imagine an Asda buying a Morrison's. They're advising private equity firms, so a KKR acquiring a Medline, for example. So that's— private equity are very much a core element of these volumes and general deal volumes. I think they've made up about 30% of the deal activity this year. You can add SPACs into that mix, but private equity are definitely there. There's about, or a rumored number of about $4 trillion in something called dry powder that they've got at their disposal. Okay. So private equity firms are very, very active and have been since the March 2020 kind of pandemic, deploying capital in those distressed assets, those kind of rebound stories, but also investing particularly in technology and software, you know, planning for the future. So private equity have a lot of dry powder. They've deployed, but they've got a whole lot more to deploy. So their returns have been very, very good. And this is leading to a bit of jealousy. Okay. So generally, what kind of firms do private equity firms invest in? It's kind of in the name as a clue, generally private businesses. Okay. So they're providing capital and making investments in these private businesses that they will then make operational improvements potentially in, or not do anything and sell at a higher multiple. So they're looking to generate a return by investing in a private company and then selling it to either a strategic buyer or another PE firm, essentially. So they've been doing very, very well. Over the last 5 years, their returns as a kind of industry have been double that of the hedge fund returns. Okay. So hedge funds, of course, they mainly— I think you can say that— invest in things like public equity. Liquid kind of assets. Private equity generally are investing in less liquid, more illiquid type assets, right? Private businesses where these companies are not listed on an exchange. Just like if you were to type in Apple share price, you could buy and sell Apple stock, right? That doesn't happen for private businesses, right? There's a buyer, like a private equity firm, they'll put in some capital and the general holding period or investment period will be something like 5 to 7 years, 5 to 10 years, 7 to even up to things like 20 years. Okay. So there's somewhat of a long time horizon there, but generally the returns have been very, very good. So now we've got a bit of competition with hedge funds entering the private capital space. And this private capital space has seen a lot of interest from even the big investment banks setting up private capital units, asset management units. And this private capital industry is worth about $7 trillion now. So it's still relatively small in terms of the overall market, but it's growing, and it's growing quickly. And I think Morgan Stanley had a 2023 estimate that it's going to double from $7 trillion. So it's growing. And there's a lot of returns to be made. So hedge funds are now competing with these private equity firms for these really, really attractive targets.

Okay?

And kind of what we mentioned just kind of in the intro was investment banks' IPO activity and equity capital markets activity has been also very strong. So IPO volumes have been very, very healthy. There's been a huge amount of interest because of the IPO pops referring to the kind of performance on the day or the weeks following an IPO. So there's been some great kind of pops on IPO day. But what this means for hedge funds is it's quite hard to get an allocation to an IPO, right? There's a whole book building process and the investment banks are allocating capital to pension funds, asset managers, hedge funds. And these hedge funds, if they do get an allocation, great, but maybe they're investing post-IPO, maybe on the first day, potentially after a 5%, 10%, 15% pop, for example. So what they're thinking is, okay, how can we kind of arb this and get in before this IPO, this company goes through the Series C and then goes to an IPO? They're like, okay, who does that? Well, private equity. And these private equity firms are, of course, investing kind of pre-IPO. So these hedge funds are now investing and there's been a record kind of investment of hedge funds investing in private equity and private capital away from the public equities. Of course, this is raising some alarm bells just because hedge funds are relatively liquid and they invest in liquid things. Sure, there's a lockup period and investors can redeem their money. However, it's a lot shorter than that of a private equity redemption period, right? 5 to 7 years or 10 years is quite a long time. So if you've got these hedge funds investing in illiquid private assets that have a long time horizon, there's somewhat of a liquidity mismatch there. So it could be a kind of trend that we all should watch. But there's a huge amount of competition for quality assets. And this is what's driving M&A activity. This is what's driving PE dealmaking. And now the hedge funds are kind of entering the party, looking for those really, really attractive private assets to get their hands on before that pre-IPO pop, so they can kind of capture more alpha and kind of grab some more of those kind of private equity gains.

Cool. Well, look, super interesting times. And there's a lot to digest there. That you've just offloaded. So what I'd say to anyone listening is that just, just jump to AmplifyMe.com, jump on the hub, and you'll be able to reach out to me and Eddie directly. So we'll look to wrap it up there. The other thing— thank you, Eddie, for your time today. But the other thing I was, I was going to add in, even if you're a new listener or you listen every week, If the latter, thank you. But just give you a heads up that we're going to start on the same podcast channel, this channel, a career hack series that will accompany then these just general weekly chats that I have with the team that are more kind of market specific. And we're going to drop those episodes on a Wednesday, and it's going to be with our head of China division, Zhao, who's kind of the expert who oversees a lot of our stuff about interviews, assessment centers, and group exercises, tips, tricks, hacks, how to perform better at those. So stay tuned for that. We'll drop the first one on Wednesday. Otherwise, it'll be back, probably me and Piers next week. So just to say thank you once again for those who rated and reviewed the podcast on Apple. Please, again, we're on 78 at times of recording. Push us up, let's get to 100. And yeah, everyone stay safe, have a great weekend. Thank you, Eddie, and catch you next time. Take care.