More so than any other bull market in the past, the current one has been driven by central bankers as well as by CEOs and CFOs (and their investment bankers). The former have provided ultra-easy monetary policy since late 2008 in an effort to avoid another Lehman-style financial meltdown. The latter have borrowed lots of easy money to buy back their shares. More recently, they’ve also been merging with and acquiring other companies.
When stock prices plunged at the beginning of the year, perma-bears explained that the prospect of four rate hikes by the Fed this year, as suggested by the FOMC’s December 16 “dot plot
,” would reduce buyback activity. They said the same about M&A activity as financial conditions tightened earlier this year.
Last Wednesday, the US Treasury announced new rules clamping down on so-called “tax inversions.” That immediately blew up the $160 billion Pfizer-Allergan merger, which would have been the second-largest M&A deal on record if completed, according to Dealogic. The proposed merger of Halliburton and Baker Hughes is also at risk, as the government raised anti-trust concerns.
Might the rule changes depress the broader M&A market? Not according to Goldman Sachs CEO Lloyd Blankfein, whose firm ranked No. 1 for global announced M&A volume in Q1. He says activity hasn’t yet peaked. ”Volumes as a percentage of market capitalization are still below prior-cycle peak levels,” Blankfein wrote in his annual letter
to shareholders, released Friday. ”We see this as a sign that there is still some room to run for M&A activity, particularly when equity markets show signs of sustained stabilization.”
Blankfein said he expects to see more consolidation in several sectors, including industrials, energy, mining, food, media, and telecom. Interestingly, he didn’t mention health care in general nor pharmaceuticals in particular.
In an April 5 interview with Business Insider,
Matt McClure, Goldman’s co-head of M&A in the Americas, said, “While volumes are lower, the complexion of the M&A market is not dissimilar to 2015 in that it’s mostly driven by strategic buyers.” He added, ”A lot of the drivers for a healthy M&A market persist — corporates face a relatively low-growth macro backdrop and they’re using M&A to grow their top line. And while we remain in a fairly low cost of capital environment, it’s still an attractive time to be buying growth.” He pointed out that while volumes were down in Q1 on a y/y basis, they were actually up from the same period two years ago. In fact, 2015 was the best year on record for M&A activity, with announcements topping $5 trillion throughout the year.
I asked Melissa, our in-house corporate accounting pro, to review the Treasury’s rule changes and to assess the likely impact on M&A this year. Her conclusion: “Inversions might not be as big a deal as headlines suggest because they’ve been a small share of M&A. New rules, however, might have just stopped inversion deals from becoming a bigger deal for M&A.” Here are the facts that led her to this conclusion:
(1) Sizing up inversions.
A March 16 Harvard Law School Forum note
titled “What’s Behind the All-Time High in M&A?” reported: “While inversion deals make up a large share of headlines, they are actually a relatively small portion of global M&A. According to Bloomberg, there were nine inversion deals last year. The total value of these inversions was $236 billion, which is a fraction of the $2.5 trillion of M&A involving U.S. companies.” Additionally, tax inversion deals compose just about 5%-6% of global M&A activity, according to a Credit Suisse analysis highlighted in an April 8 Zacks article.
Tax inversion deals had been increasing until they hit the Treasury’s brick wall. The Congressional Research Service identified 23 inversions since 2012, compared to only three in total in 2010 and 2011, with nine of them happening last year. And the new rules have likely quashed more than a handful of additional pending deals, the much-talked-about Pfizer-Allergan merger and more as listed last week by CNBC
(2) The loophole.
In an April 8 fact sheet,
the White House outlined the new rules designed to stop tax inversions, which were characterized as a tax loophole: “In a typical inversion, a U.S. company acquires a smaller company based in a foreign country — usually a low-tax country — and then locates the residence of the combined company in that other country for tax purposes.” While benefiting the after-tax bottom line for inverters, the practice of course lowers the US tax base.
“[Corporate] inversions [will] cost the U.S. Treasury as much as $40 billion over the next ten years,” a White House infographic
shows. Using a carrot-and-stick approach, the White House has suggested that it would reinvest the savings from tax reforms, including limiting the inversion loophole, to lower the corporate tax rate to 28% in order to put the US in line with major competitor countries. The average corporate tax rate in the US is around 35% compared to Ireland’s about 18% rate. Pfizer would have taken up residence in Ireland had it acquired Allergan. (By the way, Ireland’s industrial production has grown by leaps and bounds past the rest of the Eurozone’s, growing at mediocre rates, thanks in part to inversions, which tend to account for output produced elsewhere as though it was made in Ireland!)
(3) Serial inversion rules.
The Treasury Department used its authority to make it more difficult for companies to pursue the loophole. It changed the rules for “serial inverters” — i.e., US companies that relocate to a foreign country (the first inversion) only to be acquired as a foreign entity by another US company (the second inversion).
According to the White House: “Treasury’s action restricts serial inversions by not counting inversions or foreign acquisitions of U.S. firms occurring within the last three years when applying the formula that determines whether an inversion is subjected to penalties or blocked by existing tax code rules.” In the case of Allergan, stripping such deals out of the company’s market cap would have made the company an unacceptable inversion partner for Pfizer, blowing up the benefits of the deal, as reported in an April 4 WSJ article.
(4) Earnings stripping.
In a separate, but related, crackdown on tax-avoidance practices, the Treasury Department attacked earnings stripping, “a tactic that large foreign-based companies use to avoid paying U.S. taxes by artificially shifting their profits out of the United States. They are able to shift profits by having their U.S. affiliate pay interest on a loan from an affiliate in another country, typically a low-tax country. This is a win-win for the corporation: the U.S. affiliate lowers its taxes in the United States by deducting the cost of their interest payments, and then the foreign affiliate owes little or no tax on those interest payments. ... Treasury’s new action addresses earnings stripping by re-characterizing certain related-party interest payments as dividends that cannot be deducted.”
Dr. Ed Yardeni
is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.
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