M&A activity’s record year: Reasons for continued optimism

Since the end of the financial crisis, we have felt that conditions were in place for a significant increase in merger and acquisition (M&A) activity. As investors will likely recall, the years 2005–2007 witnessed record levels of activity due to heavy involvement from corporations as well as private equity. The downturn in activity during 2008 and 2009 was dramatic, and while the years 2010–2013 saw the number of deals increase from those low levels, the value of the deals was subdued.

Making a big deal out of it

2015 sets a record

Data: FTSE Russell, via Bloomberg Analytics

While 2014 was much stronger than the previous four years, 2015 significantly exceeded every other year in terms of the value of the deals and became the first year where completed and pending deals exceeded $1 trillion. (See chart above. Note that we refer here to deals specifically within the Russell 3000® Index universe, which puts the total substantially lower than the much-cited $4.6 trillion recorded for all types of deals globally.) And while we believe that in 2016 it will be difficult for M&A to match the level set in 2015, we do expect conditions to remain very favorable for deal activity. As a reference point, even if the value of M&A declines by $500 billion from 2015, it would still be the second-largest year on record!

The reasons that we remain optimistic include:


Continuing modest economic growth
With domestic — as well as international — growth expectations remaining modest, companies are eager to show revenue growth. Generating revenue growth becomes more difficult during an environment of low inflation and low interest rates when coupled with average gross domestic product (GDP) growth. Successful integration of an acquired company allows for revenue growth, while at the same time controlling expenses.

Capital spending
Corporations have been disciplined during this economic recovery, and capacity utilization has remained in the upper 70% range for several years. Given that GDP growth expectations remain modest, there is no reason to expect the utilization rate to move toward 82% — the level that historically has led to inflation pressures and major increases in spending. We believe that free cash flow will remain high as a result of modest spending, and M&A activity is a natural beneficiary along with dividends and share repurchases.

Strong corporate balance sheets
Corporations have maintained strong balance sheets, flush with cash, even while they have executed large amounts of share repurchases and increased dividends. It is possible that the desire for revenue growth will make M&A activity more of a priority versus the popular alternative uses of cash.

Banks’ desire to lend
Banks remain well capitalized and their loan portfolios have been growing. Many banks are interested in lending money to companies making acquisitions as long as the companies are not being saddled with excessive debt.

The political environment
Election years bring uncertainty regarding the potential regulatory environment. Companies may feel that it is best to act before there is any change in leadership.

Setting the stage at the portfolio level

As portfolio managers, our investment process favors companies that generate strong, sustainable free cash flow. Companies that generate strong free cash flow have traditionally been viewed as more likely acquisition candidates due to the potential financial accretion to the acquiring company. While a company’s potential as an acquisition candidate is not a catalyst in our investment decisions, when one of our holdings is pursued by a bidder we generally view it as a positive event (in a sense, it confirms our initial assessment of the company’s attractiveness). Several such events have played out in the recent past; among the companies that we own in our portfolios, seven were acquired during 2015.

Speaking of portfolio holdings that become acquisition candidates: it’s not preordained that we will hold them through the closing of each deal. We may do so in certain cases, but in other cases we may sell takeover candidates from our portfolios before the deal closes. Sometimes we may decide that a company’s shares are trading at a notable exit point, even if the deal isn’t scheduled to close for some time.

In other situations, however, our assessment may indicate that shares have the potential to appreciate after the deal is finalized, making it sensible to remain invested in the stock. In large part, the decision to exit a position depends on fundamental and financial factors that are specific to each deal.

Looking forward, we believe that the outlook for M&A remains favorable as companies continue to seek ways to put excess cash flow to work for the benefit of shareholders.

Why emphasize free cash flow?

By its textbook definition, a company’s free cash flow is the amount of cash it generates after subtracting expenses related to maintaining (or expanding) its core operations. This category of expenses typically includes large-scale endeavors like acquiring new equipment, repairing older facilities, and pursuing new lines of research and development.

We believe a company’s free cash flow provides exceedingly reliable evidence of its ability to generate cash, offering a level of clarity and insight that is not always matched by other traditional indicators.


The views expressed represent the Manager's assessment of the market environment as of January 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 362-7500. Investors should read the prospectuses and the summary prospectuses carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

The Russell 3000 Index measures the performance of the largest 3,000 US companies, representing approximately 98% of the investable US equity market.

All third-party marks cited are the property of their respective owners.

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group.

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