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It did not take long for investment bankers to start talking about a recovery in mergers and acquisitions activity this year. Having spent the past two years cutting costs and repairing their balance sheets, chief executives are now seeking growth through M&A.

In recent weeks, a series of deals across several countries and industries has signalled improving confidence in corporate boardrooms. In the food sector, Kraft in the US paid $18.9bn (£12.6bn, €13.7bn) to acquire the UK’s Cadbury; Prudential, the UK-based insurance group, offered $35.5bn for AIG ’s Asian unit; and Merck, the German pharmaceuticals and chemicals company, sealed a $7.2bn deal to buy Millipore, the US laboratories supplier.

But in spite of this flurry of activity, volumes of worldwide M&A are still well below the levels witnessed during the recent debt boom, and bankers remain cautious about the outlook for the rest of the year. William Vereker, Nomura’s head of investment banking for Europe, the Middle East and Africa, says the fiscal crisis in Greece has affected sentiment in Europe and unsettled markets. “Chief executives lack confidence that the capital markets will be willing to support new issues and event-related capital raising,” Mr Vereker says.

Carlo Calabria, head of European M&A at Bank of America Merrill Lynch, says that while the pipeline of deals has built up in Europe, chief executives are reluctant to take action until they have a clearer idea about the outlook for the economy and the earnings of their target companies.

Recent volatility in capital markets has made it difficult for a bidder to value a target company properly. “Many chief executives think equity valuations are ahead of themselves and have made potential targets too expensive given the risks they still see out there,” says Simon Dingemans, head of European M&A at Goldman Sachs.

Bankers are hoping acquisitive emerging markets companies will help lead them into recovery. In the first six weeks of 2010, the $91.2bn of M&A in emerging markets such as Brazil, India and China accounted for 43 per cent of global M&A volume, according to data from Thomson Reuters. That figure compares with roughly $55bn-worth of US deals struck during the same period, which accounted for 29.5 per cent of worldwide volumes.

Henrik Aslaksen, global co-head of M&A at Deutsche Bank, says the market will continue to see cross-border – and, importantly, cross-regional – deals where the acquirer sees an opportunity to capture market share. “Emerging markets are increasingly active in this space as limited domestic growth spurs international expansion,” he says. “Brazil, for example, has already had a busy start with both in-country and cross-regional transactions by corporates seeking growth.”

The largest emerging markets deal so far this year was the $10.7bn bid by Bharti Airtel, the Indian telecommunications company, for the African assets of Kuwait-based Zain, which came after Bharti Airtel failed to acquire South Africa’s MTN twice. Reliance Industries, Wipro and Jindal Steel & Power are among other Indian companies that have said they are looking for acquisitions this year as the banking crisis creates opportunities to pick up cheaper assets.

The weakness of sterling – which has fallen almost 20 per cent against the dollar and the euro over the past two years – could encourage acquisitive companies to look to the UK to expand their businesses. The advantage of the UK is that, unlike in other countries, company law operates on a one-share, one-vote basis. Such shareholder democracy allows hostile bidders, in effect, to stage referendums on their offers.

But investors will not make it easy for bidders. During the bull market, shareholders rarely challenged the pricing or strategic rationale of acquisitions, but this has changed markedly during the past 18 months as investors have realised the value of scrutinising transactions. Institutional shareholders recently forced Rio Tinto to scrap its £19.5bn (€21.4bn) deal with Chinalco, the Chinese state-controlled company, in favour of a joint venture with fellow mining group BHP Billiton and a capital raising. Meanwhile, National Express, the UK bus and rail operator, abandoned a deal with private equity group CVC after investors voted in favour of a capital raising.

For those chief executives willing to brave investor reaction, financing deals have become much easier as banks repair their balance sheets and start to lend again.

There has been a clear trend of companies choosing to bypass bank debt and tap the capital markets directly to fund acquisitions. When bank debt is available, it remains expensive. An investment-grade company would look at paying between 300 and 325 basis points above Libor for bank debt today. Before the economic crisis, an equivalent borrower could have obtained those funds for less than 100bps. That compares with the average cost for investment-grade companies issuing bonds for acquisitions of approximately 120bps-125bps over Libor.

Even private equity deals are being funded again. In February, KKR snapped up Pets at Home, the UK pet retailer, for £955m, at 13.6 times earnings before interest, tax, depreciation and amortisation. The deal was funded with a debt package priced at 5.4 times ebitda.

Last year, foreign bidders accounted for only 610 acquisitions in the UK, with a value of £42.2bn, representing a 40 per cent drop in deal volume. In 2008, 1,019 foreign inbound acquisitions totalling £72.3bn were recorded.

However, although M&A during a downturn can tempt cash-rich buyers, industry experts advise caution because buying distressed companies does not guarantee higher returns for shareholders.

Recent research by Cass Business School in London found that acquisitions of distressed targets may have created value for bidders in the short term, but there was a struggle to improve long-term returns. Analysis of the bidders’ operational performance one year before a deal and three years after the combined group was created showed a sharp deterioration. Bidders in such deals underperformed those in non-distressed deals.

A target was defined as distressed if its interest cover ratio – a key measure of a company’s ability to pay its expenses, including debt – was less than 1 and featured in the bottom 25 per cent of the relevant industry in the year before the deal was announced.

It will take another boom and bust before investors will be able to judge the performance of deals struck as activity starts to recover.

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