A hedgies’ take on M&A in 2016

Author: | Published: 29 Feb 2016
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Mike Winston of Sutton View Capital discusses the importance of intrinsic value investing at this point of the cycle

At a time when many corporates, banks and law firms are dedicating entire departments to preparing defences against more aggressive, event-driven investors, others are just beginning to recognise the value they can bring to the table. Against this backdrop Mike Winston, founder and managing principal of New York hedge fund Sutton View Capital, talks to IFLR about activist tactics, overall trends in M&A and the enduring impact of the dreaded interest rate rise.

What do you see as key M&A trends to look out for in the US in 2016?

As we head into the sixth year of US economic recovery and interest rates remain low, the prospects for global M&A appear bright in 2016. Although deal volume fell 30% year-on-year in January, several factors point to a prosperous year. Sluggish top-line growth, limited opportunity for margin improvement, $6 trillion (as of the fourth quarter of 2015) in corporate cash, and increased boardroom confidence should together help the pace of transactions.

While 2015 was the year of the mega-deal, 2016 may instead be driven by a large number of small and medium-size deals. We see positive trends in Asian outbound M&A and commodity and financial institution-related deals. While private equity players now face regulatory constraints on leverage levels, they have $382 billion of capital available for investment purposes and have shown a willingness to engage in increasingly creative transaction structures, including large-cap private investments into public equities.

What sectors or regions will you be focusing on in 2016, and why?

Commodity-related sectors such as oil and gas and mining are ripe for consolidation. Low commodity prices have forced down interest coverage ratios and credit ratings. The high-yield market remains closed to exploration and production (E&P) companies in particular. We would expect to see a wave of reorganisation activity and consolidation. Many US non-traditional oil and gas assets, in particular, have been rendered unprofitable for the time being because finding and production costs of $35-$50 per barrel do not generate profit with prevailing oil prices in the low thirties. Whatever happens to US non-traditional production capacity in the short run, acquirers may reflect on how the re-emergence of the US as a net exporter of oil – and its ability to switch on fracking assets on short notice – may compress oil and gas commodity cycles, cap petroleum prices and lower the value of reserves.

"Large-target European companies are fair game"

Technology, media and telecommunications (TMT) and pharmaceutical deals may continue as companies have an opportunity to gauge any early success enjoyed by peers that transacted in 2015.

Within TMT, independent cable TV channels appear ripe for consolidation. The need for greater bargaining power with newly consolidated cable companies and the threat from subscriber cord cutting both make clear the need for revenue synergies and cost savings. Cable channels will likely have some deadweight subscriber losses, because viewers that leave will not necessarily pick up a given channel via a tablet, smartphone or over the top device, such as an Apple TV. Managing that shift and coping with the subscriber losses are both challenges best dealt with by larger, combined companies.

Regional banks may also see an increase in deal activity because of increased regulatory burdens. Many small banks have just one compliance officer, and so the cost savings from greater scale in M&A may win out relative to spending on greater staffing and infrastructure.

What effect, if any, has the Federal Reserve's rate rise had on deal flow, and how do you see it affecting it in the future?

The expectation of rising rates pulled some deals into 2015 but rates are still historically low, and small rises in rates should not slow the pace of M&A in the full year. The Fed has not contracted its balance sheet – it buys new treasuries as those on balance sheet mature – so even with rising rates, the environment remains highly accommodative. The spike in market volatility related to a rise in rates has had a more meaningful impact on deal activity than the rise in rates itself. The second order effect of higher relative rates of interest in the US is a stronger dollar – which may lead US corporates to acquire more assets abroad. At the intersection of renminbi (RMB) depreciation and US dollar strengthening rests a question that Chinese corporates will likely turn to their M&A advisors to help answer.

Have you noticed any interesting developments in terms of deal structure in the past 12 months?

In terms of deal structure, the use of the demerger, or spin-off, instead of the merger should be a continuing theme in 2016. At the behest of activist investors, spin-offs and divestitures are viewed as a means to improving reporting clarity and bolstering valuations.

"While 2015 was the year of the mega-deal, 2016 may instead be driven by a large number of small and medium-size deals"

We've seen the 60/40 inversion and board and shareholder willingness to sell below the 52-week high. While we have also seen a somewhat greater use of stock as a component of deal consideration, we still observe otherwise limited use of collars.

We have also noticed new all-cash Chinese acquirers in the recent past, including Syngenta and Terex. While the motivations of each Chinese acquirer vary, one cannot help but suspect that the all-cash nature of the consideration reflects a continuation of the exodus from the RMB on the part of Chinese domestic residents and corporations.

With activism on the rise, there have been reports of boards preparing more proactive defence mechanisms. What is your opinion on this – do these tactics work?

Goldman Sachs, Evercore and some other major investment banks now have entire teams dedicated to activist defence, and an increasing number of law firms are staffing for this function. The surviving greenmailers and corporate raiders of the 1980s have returned, along with a new crop of hedge fund managers, to take on corporate mismanagement yet again.

Their tactics clearly work, though not every company fits the same template. The composition of the shareholder base, recent stock performance and corporate governance all have a large role to play. As co-lead plaintiff against the board of Dole Foods in their 2013 management buyout, we discovered that the court system can sometimes be a more effective route than a proxy fight. In Dole's case, the CEO was found guilty of fraud for providing one set of financials to his board and another to his bankers. It was a huge win for shareholders, but not all campaigns have as clear an endpoint as Dole.

It is easier to run an activist campaign in a bull market, because confidence inspires risk-taking. Some of the Schedule 13D filings we see appear driven by those seeking to call attention to a position that has fallen, rather than investors initiating new positions in already depressed names and pressing for change.

What are activist investors looking for?

Like all event-driven investors, activists are looking for returns and a clear path to completion for each situation. That may mean targets should meet a set of criteria, for example, a non-staggered board, a concentrated shareholder list, limited anti-takeover provisions and a stagnant share price.

Do you see the trend of US activists targeting Europe continuing in 2016?

Yes. If we look at European companies with a $100 million market cap or more, activists launched 31, 57, 53, 33 and 67 campaigns in 2011, 2012, 2013, 2014 and 2015, respectively. Those European campaigns accounted for roughly 20 percent of global volume over the past five years, and 21% in 2015. Of the 67 campaigns from 2015, 44 of the 67 targeted companies had over $1 billion in market capitalisation. So, large-target European companies are fair game. While cultural attitudes may to continue to act as a limiting factor in Europe, as in Japan, the trend toward greater global corporate accountability is supported by the observation that activist funds ended the year with roughly $123 billion of assets under management.

About the contributor

Mike Winston, CFA
Founder and managing principal

Sutton View Capital

New York, US
T: +1 212 754 2200
E: mike.winston@suttonview.com
W: www.suttonview.com

Michael D Winston, CFA is the founder and managing principal of Sutton View Capital, an employee-owned hedge fund sponsor and adviser. Sutton View was founded in 2012, and is focused on event-driven and intrinsic value investing.

Prior to launching Sutton View Capital, Winston was a portfolio manager at Millennium Partners, where for five years he and a colleague managed a $750 million merger arbitrage and event-driven capital allocation. Winston received an MBA in finance and economics from Columbia Business School in 2005, and a BA in economics from Cornell University in 1999. At Columbia he completed the school's programme in value investing. While at Cornell he studied for a year at the London School of Economics, and twice won the eastern US division for policy debate. He began his career in 1999 with Credit Suisse First Boston. Winston is a CFA Charter Holder, and a member of the Economic Club of New York.