M&A and EMU – International Perspective

If we make the heroic assumption that European Monetary Union (EMU) will be successful, what will be the impact on the European mergers and acquisitions market?

The single currency and market will have the combined effects of reducing transaction costs, removing exchange-rate risk and increasing price transparency. All these changes should intensify competition and open new trading opportunities, thereby encouraging businesses to invest in new markets. However, there will also be longer-term changes, including:

* impact on industry of transparent euro-denominated prices;

* impact of a deepening corporate bond market on banking and traditional financing structures; and

* impact on equity market of cross-

border portfolio diversification.

The consequences of these changes are not obvious and raise several questions related to the European M&A market:

* Will the number of deals be affected?

* Will deals be funded differently?

* What exits will there be for private equity investors?

* Which countries and/or regions will be successful within the new market?

Number of Deals

In Europe

In principle, the single currency should help to boost the M&A market across Europe.

A successful single currency would:

* as previously mentioned, reduce transaction costs, remove exchange-rate risk and increase price transparency, which in turn should boost trade and provide new opportunities for companies to invest;

* create a stable economic zone that would enjoy the benefits of low inflation. This would act as a framework around which firms could plan and invest. The European Central Bank (ECB) expects to achieve low inflation, and those countries joining EMU in the first wave have seen long-term interest rates fall toward German rates. This added stability should result in higher levels of deals and investment.

* encourage corporate reorganisations.

Effect on Other M&A Markets

The 11 European member states joining EMU in the first wave in 1999 should make up the second largest combined gross domestic product in the world, but should the membership extend to the full 15 as expected, it will represent the world’s largest GDP. This could lead to increased M&A activity by drawing investment away from other regions of the world.

Another view is that the new market will not have any effect on other M&A markets for the following reasons:

* the economic stability of the euro area has yet to be proven, and there may be significant economic turbulence in the transition period.

* as the transition to the euro continues, complications are expected to arise in subsequent waves of participants.

* Europe lacks the flexibility enjoyed by the US, leaving the area open

to volatility, which may well hinder investment.

Funding of Deals

EMU should bring about larger liquid bond and equity markets, which should stimulate businesses to capitalise on these new financing and investment opportunities to fund deals differently.

The Bond Market

At present, the majority of European companies use traditional bank credit as their only source of external debt finance because the European bond market is not as deep or as liquid as the US market and lacks the associated expertise.

The advent of the euro should help lead to the creation of a single liquid corporate bond market, characterised by reduced volatility, increased liquidity and expertise, with the market forecast to boom as it opens up to more companies.

The changes wrought by EMU could lead to companies enjoying higher bond ratings than governments, as the ECB cannot bail out defaulting governments. It is therefore conceivable that an institutional investor may choose a corporate bond rather than a government bond.

The removal of foreign-exchange risk could lead to growth in the market for higher-yield bonds as investors might be more willing and able to accept higher risks.

This in turn could impact the debt financing strategies of small- to medium-sized companies, as they would have access to a bond market, where no such access existed.

Equity Markets

The advent of the euro should lead to a big increase in cross-border equity portfolio diversification, and equity trading may become focused in fewer, highly liquid stock exchanges. Again, this might help to increase M&A and IPO activity as investors will be able to diversify their portfolio across a much larger market without taking on currency risk. The speed of this rebalancing of portfolios will depend on investors’ confidence to invest in foreign markets.

It is likely, though, that investors will continue to judge prospective returns for the equity market by individual country risk; this will still be a prevalent factor until the necessary reforms are implemented by European countries to create a stable and optimal economic zone.

Which Countries Will Succeed?

At present, the European market does not constitute such an economic zone. The mechanisms needed for success as demonstrated by the US market are:

* labour flexibility;

* government deregulation; and

* capital mobility and diversified asset holding by residents.

Under a single currency, European countries would be unable to devalue their currencies to adjust to economic or competitive shocks, and at present there does not appear to be the labour flexibility and government deregulation in place to cope with such shocks. In particular, social, economic and cultural barriers to labour mobility (e.g., language difficulties) remain high. These could lead to serious long-term financial and political consequences.

This possibility might, however, focus the EU’s attention on the disastrous consequences of failure for EMU, creating the necessary momentum for establishing a stable economic area. European countries would be faced with no alternative but to accept reforms such as lower corporate taxes, more flexible labour markets and lighter regulations, or lose their competitiveness.

Flexibility is important if businesses are to invest in the European M&A market. Labour markets, and particularly wage bargaining, need to be realistic to take account of productivity, and employees need to be well skilled.

So far there has been a headlong rush into the German and French markets, but these countries may not be the ones that succeed in the long run. France in particular has been resistant to change, with labour regulations tightening to impose a maximum 35 hour working week. Countries at the forefront of change, such as Spain, are expected to prove attractive to the M&A market in the longer term.

Exits for Private Equity Investors

With the advent of EMU and the larger liquid bond and equity markets, exits for private equity investors should rise because:

* increasing liquidity in equity will encourage growth in IPOs;

* more corporate buyers will be offering exit possibilities; and

* a deepening bond market might encourage secondary buy-outs.

Conclusion

EMU will create a zone of economic stability that will encourage investment; however, a number of structural problems with inflexible labour and government regulations exist. These will inevitably cause problems, but reforms are likely to be implemented.

The impact on the bond and equity markets, along with continuing corporate reorganisation, should encourage M&A activity; private equity can be expected to play a large part in this.