Deals of the Year, in a Year of Deals

It was a record period for mergers and acquisitions—and 2007 could be even bigger

A near-perfect set of conditions is set to drive mergers and acquisitions to a global record in 2006, and dealmakers are optimistic that 2007 could be even stronger. Deal volume for the full year won't be available until 2007, but market researcher Dealogic says global volume could well exceed the record of $3.3 trillion set in 2000, the height of the tech bubble. It already has surpassed $3.7 trillion, and likely will top $3.8 trillion by Dec. 31. That would be a 28% gain over last year.

There was no lull for the holidays this year. On Dec. 18, shares of Harrah's Entertainment (HET) rose after news reports said private equity firms Apollo Management and Texas Pacific Group had bid $16.7 billion for the gaming company. Also on Monday, Apollo agreed to acquire real estate group Realogy (H), which includes Coldwell Banker, Sotheby's and other franchises, in a $9 billion deal. And Express Scripts (EXRX) launched a hostile, $26 billion bid for Caremark Rx (CMX), a pharmacy benefit management company that had agreed in November to merge with CVS Corp. (CVS). A few years ago, those deals would have ranked among the largest leveraged buyouts ever. Now, they're relatively routine transactions.

The deal wave drove investment-banking profits and bonuses to record levels. On Dec. 12, Goldman Sachs (GS) reported the biggest annual profit in the history of the securities industry, as it closed its 2006 financial year at the end of the third quarter. Goldman Chief Financial Officer David Viniar credits the $9.5 billion profit to a solid global economy, confident CEOs, consolidating global industries, and a stock market that has picked up steam since a summer slump. He says that, as the year draws to a close, "Conditions should remain strong in 2007," (see, 12/13/06, "All That Glitters Is Goldman").

Another senior investment banker agrees that the strong M&A market could last through the coming year—and perhaps beyond. "Deal volume could exceed $4 trillion in 2007," says Boon Sim, head of M&A for the Americas at Credit Suisse. "We aren't in a bubble scenario, since valuation remains reasonable by historical standards and is significantly lower than in 1999 and 2000," he adds.

Here's a look at the trends that shaped 2006, and how they're likely to play out during the coming year:

Private Equity

There's no question that private equity was the dominant trend of the year. Fund raising by private buyout firms is expected to hit a record $225 billion this year, according to the Dow Jones Private Equity Analyst newsletter (see, 11/7/06, "The Money Behind the Private Equity Boom"). Private equity giant The Blackstone Group announced that it was going to raise a record $15 billion fund—and then it boosted the target to $20 billion because of strong demand. Blackstone set a record in November for the largest buyout ever, with its $36 billion acquisition of Sam Zell's Equity Office Properties Trust.

Private equity deals are expected to surge deeper into record territory, even though their huge profits of the last two years might slow. Private equity funds, particularly big players such as Blackstone and Kohlberg, Kravis Roberts, have turned in profits of 50% or more. That can't continue, one industry executive says. But profits could easily remain in the 30% range. That's good enough to draw massive amounts of money from public and private pension funds, which have played a big role in funding the private equity boom.

Corporate Buyers Can't Compete

The growing power of private equity players has made it difficult for corporate buyers to keep up. "Strategic buyers have a hard time competing against private equity firms," says Joe Ravitch, a senior media banker at Goldman Sachs. Private equity funds have an advantage because they can take advantage of low-cost leverage. Public corporations tend to use more expensive sources of capital, such as their own stock, when making deals.

There's a chance that strategic buyers could enjoy more influence in 2007. If the stock market continues to rise, corporations will be able to use their stock to make bigger deals. Time Warner (TWX) has seen its stock rise from the high teens to the low 20s this year. One banker says Time Warner could jump back into the market as a buyer if its shares hit $26 or so.

Higher Debt Levels and Prices Lead to Rising Risk

As private equity firms compete for deals, prices are rising. And the use of debt is on the rise, too (see, 9/12/06, "Bidding on Freescale Sets Off Alarms"). A few years ago, debt typically amounted to three or four times an acquired company's cash flow. Now, debt levels routinely rise to twice the historic average.

There's no question that still-low interest rates and strong corporate profits mean companies can often tolerate higher debt levels. But investors also have simply decided to accept more risk without seeking a higher return. If the economy shifts for the worse, deeply indebted companies could face higher rates as they refinance. That could send them into trouble, investment bankers say.

But default rates are half the long-term average of about 4%. Defaults and bankruptcies could rise significantly without causing a crisis for the economy. And distressed debt investors have raised a ton of cash, which they can't wait to put to use.

Consumers Benefit

In the past, consolidation has led to fears of higher prices and monopolies. But for the moment, big companies appear to be competing head on. This is particularly true in the communications market, where wireless, cable TV, and phone companies are competing with one another, according to Michael Price, senior managing director of investment banker Evercore. "This is the year that regulation became irrelevant. The market is policing itself. Big communications companies are competing against one another, and they have the balance sheets to sustain a generational battle," he says.

The disruptive power of new technology is forcing companies to compete. Upstarts from telecom pioneer Skype to YouTube and Facebook are amassing huge audiences in short periods of time. That's compelling big companies like News Corp. (NWS) to take chances on up-and-comers such as MySpace. Big phone companies such as Sprint Nextel (S) are investing in WiMax wireless networks, which are cheaper and more powerful than regular wireless networks. Telecom companies are rolling out high-speed fiber lines to residences, too.

At the same time, the growing power of developing countries from Brazil to India and China is on the rise. Brazilian mining giant CVRD (Companhia Vale do Rio Doce) turned heads this year with its $18 billion hostile takeover of Canadian mining company Inco. Also this year, Rotterdam's Mittal Steel struck a deal for a $33 billion merger with Luxembourg-based rival Arcelor, creating the world's largest steel company.

There are plenty of factors that could disrupt the flow of deals, and stop the record 2006 from evolving into an even-more-active 2007. Interest rates could spike, energy prices could unexpectedly rise, or a geopolitical conflict could erupt, disrupting markets and the deal environment. But these days, investment bankers are relishing their success in 2006—and expect there will be plenty more time for dealmaking in 2007.

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