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Fed Fueled M&A Destroys Capital

Tyler Durden's picture




 

Submitted by Doug French via Mises Canada blog,

The world’s central bankers have given companies the urge to merge. Merger and Acquisition (M&A) activity has already reached $2.2 trillion this year according to Thomson Reuters Deals Intelligence, up 70% from this time a year ago.

The deals are big, with eight acquisitions, each over $5 billion, being announced in just a single week in July.   However CEO buying sprees do not create new jobs and new products that make our lives better, but are instead just wasteful malinvestments that destroy capital.

Post crash zero interest rate policy has spurred M&A around the globe. For instance, 2011 was considered a blockbuster for global mergers and acquisitions, with the total number of deals and values both rising by over 20 percent for 2010, hitting $2.4 trillion.

Besides the egos of CEOs, the Fed’s cheap money drives M&A. Wall Street began to fall apart in the summer of 2007 with the M2 money supply standing at $7.3 trillion. The Fed has hit the monetary gas and by June 2014, M2 was just short of $11.4 trillion, a 56 percent increase.

Six-month Libor (the London interbank offered rate) was 5.37 percent in July 2007, it is currently 33 basis points. Lots of deals will work on paper with rates that low.

Firms have lots of cash earning little of nothing Bloomberg reported in March, “U.S. companies outside of the finance industry are holding more cash on their balance sheets than ever, with $1.64 trillion at the end of 2013.”

Another factor is increased government interference. Professor Peter Klein’s work on entrepreneurship has determined that firms make acquisitions when faced with increased uncertainty, citing regulatory interference and tax changes as major causes of uncertainty.

When faced with increased regulatory interference, firms respond by experimenting, making riskier acquisitions — and consequently more mistakes. Klein concludes that unprofitable acquisitions tend to come in industry clusters and that these clusters are likely to arise from intensified regulation. So, while money’s cheap and government keeps getting more intrusive, CEOs figure, “Let’s roll the dice and buy another business.”

Many times  they pay too much. Warren Buffett wrote in the Berkshire Hathaway 1982 annual report, “The Market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do…. A too high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”

A former director of Coopers & Lybrand explained to author Mark Sirower where high acquisition prices come from. “Lotus is the culprit in failed acquisitions. It is too easy to assume anything you want in perpetuity without any understanding of the economics of an industry, and package it in a beautiful report.”

In his bookThe Synergy Trap, Sirower says valuation models turn on three things: free-cash-flow forecasts, residual value, and a discount rate. All three are heavily influenced by Fed policy.

The cost of capital is integral to making these assumptions. The lower the assumed interest rate or cost of capital, the higher the price for the acquisition that the models will justify.

Once interest rates go up, these valuation models will be blown to pieces,

But is bigger better?

Austrian economics has determined that there are limits to the size of a firm. The Left wrings their hands about giant corporations taking over the world, but it doesn’t work out that way. According to Max Landsberg and Dr. Thomas Kell at the consulting firm Heidrick & Struggles, nearly three-quarters of mergers fail. The hookups of AOL and Time Warner, Snapple and Quaker Oats, and Sears and Kmart make the point.

Mises determined that socialism can’t function because there are no market prices in a socialist economy to distinguish more- or less-valuable uses of social resources.

Peter Klein writes in his bookThe Capitalist and the Entrepreneur that Mises wasn’t just talking about socialism. Mises was addressing the role of prices for capital goods.

Entrepreneurs make guesses about future prices and allocate resources accordingly to satisfy customer wants and turn a profit while doing it. If there is no market for capital goods, resources won’t be allocated efficiently whether it’s a socialist economy or otherwise. The market economy requires well-functioning asset markets. Without these prices, decision making is distorted.

Murray Rothbard extended Mises’s analyses to considering the size of firms, and the problem of resource allocation under socialism to the context of vertical integration and the size of an organization.He wrote, “ultimate limits are set on the relative size of the firm by the necessity of markets to exist in every factor, in order to make it possible for the firm to calculate its profits and losses.”

To make implicit estimates, there must be an explicit market. “When an entrepreneur receives income, in other words, he receives a complex of various functional incomes,”Rothbard wrote. “To isolate them by calculation, there must be in existence an external market to which the entrepreneur can refer.”

As firms get too big, economic calculation gets muddied because firms do not receive the profit-and-loss signals for their internal transactions. Managers are lost as to how to allocate land and labor to provide maximum profits or to serve customers best.

As these firms grow (especially by acquisition), one part of the company is often the provider and another part of the company is the customer, yet there are no market prices to allocate resources efficiently. Rothbard wrote,

Economic calculation becomes ever more important as the market economy develops and progresses, as the stages and the complexities of type and variety of capital goods increase. Ever more important for the maintenance of an advanced economy, then, is the preservation of markets for all the capital and other producers’ goods.

Professor Klein makes the point that

as soon as the firm expands to the point where at least one external market has disappeared, however, the calculation problem exists. The difficulties become worse and worse as more and more external markets disappear, as [quoting Rothbard] “islands of noncalculable chaos swell to the proportions of masses and continents. As the area of incalculability increases, the degrees of irrationality, misallocation, loss, impoverishment, etc, become greater.”

When firms expand, company overhead expands. And there is difficulty in allocating overhead or any fixed cost for that matter amongst various divisions of a firm. “If an input is essentially indivisible (or nonexcludable), then there is no way to compute the opportunity cost of just the portion of the input used by a particular division,” explains Klein. “Firms with high overhead costs should thus be at a disadvantage relative to firms able to allocate costs more precisely between business units.”

Federal Reserve monetary policy over the last couple decades has not produced real economic growth but instead bubble after bubble — with each bubble (or each group of contemporaneous bubbles) being bigger in aggregate and more damaging than the one that preceded it.

These bubbles destroy part of the capital stock by diverting capital into economically unjustified uses, explains economist Kevin Dowd. The central bank’s artificially low interest rates make investments appear more profitable than they really are, and this is especially so for investments with long-term horizons, i.e., in Austrian terms, there is an artificial lengthening of the investment horizon.

A company is the ultimate long term asset, which is not just a group of employees and the current inventory of products or services but a package of previously made, long-term capital investments.

“These distortions and resulting losses are magnified further once a bubble takes hold and inflicts its damage too: the end result is a lot of ruined investors and ‘bubble blight’ — massive overcapacity in the sectors affected,”Dowd explains. “This has happened again and again, in one sector after another: tech, real estate, Treasuries, and now financial stocks, junk bonds, and commodities — and the same policy also helps to spawn bubbles overseas, mostly notably in emerging markets right now.”

Savers are punished and encouraged to risk capital on ventures that don’t make economic sense. And CEOs, fooled by the faulty assumptions buried in their valuation models, see cheap money as the path to building empires.

Inevitably these empires crumble, destroying precious capital in the process.

 

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Tue, 08/19/2014 - 18:50 | 5117169 q99x2
q99x2's picture

End the FED

Move in with swat teams and haul their asses to prison.

Tue, 08/19/2014 - 19:41 | 5117277 TeethVillage88s
TeethVillage88s's picture

q99x2;

True the Fed is big time systemic Corruption and "Dissipation".

But the whole System of System are dragging us down mainly since Corporations & Money can "NOT" be Patriotic or act for the Benefit of the USA or the World (we are trans-national now).

- Capital Flight
- Brain Drain From Industry
- Federal Lobbying for Corporate Subsidies & Tax Breaks
- Off Shore Corporate Tax Havens
- Compensation Schemes like Deferred Wages
- Fed Policies that Directly Link to Paper Investments, Paper Transactions, Rentier Behavior, Exporting US Dollars to other Trade Markets, Casino type Investments rather than Brick & Mortar or Capital Expansion
- US Congressional Financial Conflict of Interest every Day
- No Integrity in Financial Ratings in USA
- No Integrity in US Accounting Standards
- No Standard Financial Instruments
- Lobbying for anything w/ PACs for Anything
- LBO that lead to Decapitalization & Jobs Losses & Collapse of Business Entities
- Decapitalization not being recognized as Deflationary & Weakness in the Economy
- Increases in Social Program Enrollment & Reliance not being recognized as Weakness in the Economy & Governance of USA
- Credit & Derivative Linkages recognized as Weakness in Banking, Economy, Stability & Governance
- Fake, Narrow, Corrupt, low Utility Government Statistics in GDP, Inflation, Unemployment, Social Stability, Future Tax Base, Future Consumption, Etc
- Fake Narrative of the Cost of War, Financial Health of Nation, $17.6 Trillion in Federal Debt, Low Velocity of Money, Eroding Demographics, and meaning of $59 Trillion in Total US Debt

Yeah, I forgot a few... Feel free to add

Military Concepts of Emergency Planning is very useful here in Economics as well. In particlular I am concerned with Comodities, things that are limited and subject to Market Shocks:

- Water Utilities
- Waste Treatment
- Power, Electric Grid
- Communications
- Transportation for the public between work, home, and Markets
- Agricultural Basics
- Meat, Fish, Poultry
- gasoline, Diesel

The US Utility Act in the Depression created this idea that Government could help prevent Severe Economic Shocks. Partly it was humanitarian... The 1970s Gas Crisis may have been a result of going off the Gold Standard, but I am not sure. A gas crisis, our living history, tells the truth about Economic Shocks.

National Stock Piles is a solution to this. Whether you agree to a Government Refinery of Gasoline or Subsidies for Crops is a matter of Opinion.

https://en.wikipedia.org/wiki/Public_Utility_Holding_Company_Act_of_1935

PUHCA was one of a number of trust-busting and securities regulation initiatives that were enacted in response to the government investigations of the Wall Street Crash of 1929 and ensuing Great Depression, which included the collapse of Samuel Insull's public utility holding company empire. By 1932, the eight largest utility holding companies controlled 73 percent of the investor-owned electric industry.[2] Their complex, highly leveraged, corporate structures were very difficult for individual states to regulate.

Tue, 08/19/2014 - 20:41 | 5117717 Save_America1st
Save_America1st's picture

Fascistic, statist, monopoly....that's really what this is all about.

 

Tue, 08/19/2014 - 23:14 | 5118329 TeethVillage88s
TeethVillage88s's picture

Thanks. I was beginning to think ZH Patriots didn't know that they were being used tonight. But think readership is low on this article.

But I am always repetitive which is very bad for TV Viewers and ZH Readers have heard it all...

Team Vodka

Tue, 08/19/2014 - 19:55 | 5117521 kchrisc
kchrisc's picture

"Move in with swat teams and haul their asses to prison."

Problems is, the SWAT teams work for the banksters, and their pol and crat puppets.

And it should be, "Guillotine the Fed!"

An American, not US subject.

Tue, 08/19/2014 - 20:10 | 5117580 yogibear
yogibear's picture

Quick trials for the cocky PhDs being traitors. Also seize their assets to pay off the national debt.

Tue, 08/19/2014 - 18:51 | 5117172 NOTaREALmerican
NOTaREALmerican's picture

As long as the top 10% Elysium Management Class benefits too, it's all good.  

Tue, 08/19/2014 - 20:13 | 5117587 g speed
g speed's picture

M&A  just takes a mechaincal design theory and applies it to business models ---Bucky would marvel at the salesmanship-- big payoffs for "advisers, lawyers, and brokers"  ( aka experts on wall street). 

Good article

Tue, 08/19/2014 - 18:53 | 5117179 LawsofPhysics
LawsofPhysics's picture

I have been saying this for years...

As immoral and evil and QE (printing) is, ZIRP (NIRP in real terms) is far far more destructive for real capital, innovation, savers, and society  in general, it is essentially a "let them eat cake, while some of us get money for free" policy.

Tue, 08/19/2014 - 19:22 | 5117350 negative rates
negative rates's picture

They respond with, you can have your cake, or you can have your cheese, or you can have your cheesecake. And that becomes the straw that breaks the camels economic back. 

Tue, 08/19/2014 - 19:30 | 5117399 LawsofPhysics
LawsofPhysics's picture

What they say is irrelevant, it ends the same way, and chance always favors the prepared.

Tue, 08/19/2014 - 18:56 | 5117202 falak pema
falak pema's picture

Universal Empires dreamt of mergers and acquisitions either by marriage or by war.

Its always produced the opposite effect to the one wished for : a self fulfilling prophecy of doom through greed. 

When you fool yourself to think more risk is less risk, moral hazard recognition and common sense go out of the window. All you have left is "la folie des grandeurs!"

We know how that ends. 

Tue, 08/19/2014 - 18:56 | 5117203 Caviar Emptor
Caviar Emptor's picture

Biflation will be the undoing of the mega-leveraged M&A blockbuster deal. On the one hand, deflation will mean no pricing power. Demand is eroding as the middle class shrinks. Without the promise of ever rising disposable income there will be no expansions despite population growth. On the other hand, inflating cost inputs will hurt margins. And so these companies will go through endless cycles of downsizing and cost cutting, merely adding to the deflationary forces. It's a Goldocks downward spiral!

Tue, 08/19/2014 - 19:02 | 5117238 LawsofPhysics
LawsofPhysics's picture

"Demand is eroding as the middle class shrinks."  --

This statement would be true if those people were disappearing and did not still require heating oil to keep warm and food to stay alive.  There are now 7+ billion people on the planet, all competing for a better standard of living and all the resources and energy that make that possible.  The major of those folks live on less than a few dollar a day.  Americans do not really understand things like "poverty" or "oppression", looks like they may get to find out soon enough.

Tue, 08/19/2014 - 19:23 | 5117351 Caviar Emptor
Caviar Emptor's picture

You have touched on the problem: the more competition over basic resources, the less disposable income anyone has for buying tassels loafers. What was called middle class was a euphemism for yuppie class, in turn a euphemism for "wannabe rich". Those days are gone. So if you combine rising cost of necessities with stagnant growth and declining real incomes diluted even more through competition then you have declining demand for the items that the mega mergers will be selling

Tue, 08/19/2014 - 19:29 | 5117385 LawsofPhysics
LawsofPhysics's picture

Honestly, I really don't give a shit what the "mega mergers" are selling.

Let me be very clear about what my tribe and I are preparing for.  Simply put, there is no monetary, fiscal, economic, or political solution to resource scarcity.  There never has been and never will be.

Tue, 08/19/2014 - 19:33 | 5117424 Caviar Emptor
Caviar Emptor's picture

True dat. I don't buy their crap either. Be selective though: what looks essential might not always be ...http://m.us.wsj.com/articles/u-s-orange-juice-sales-fall-to-record-low-1...

Tue, 08/19/2014 - 20:04 | 5117559 cougar_w
cougar_w's picture

Nothing, is what is essential. It's all this oh-i-can't-go-on-without-"X" is why we're in the ME blasting every one and every thing to rat shit.

Party is over, chumps. Get by with less and if you can then get by with nothing at all because nothing is what's on the global economic menu, boys.

Tue, 08/19/2014 - 20:44 | 5117732 TrustWho
TrustWho's picture

The Black death significantly reduced population. Less pair of hands forced technology advancements leading to higher productivity and ultimately created the european renassaince.

The 0.1% know this historic fact. E-bola like viruses and war will wipe out 65 - 75% of world population. Most of you on this site will not survive, so I would say ENJOY.

Tue, 08/19/2014 - 22:08 | 5118043 emersonreturn
emersonreturn's picture

cougar, i am changing to a vegan diet, having read the China Study, which confirmed the effects animal proteins have on humans long term, but bottom line it coincides with what the economy, budget, will allow.  so far it's been difficult as i do like import cheeses etc. but it works on the money spent. so i think the diet is a keeper...if i choose to stay on the planet for all that is inevitable.  love your posts, thank you.

Tue, 08/19/2014 - 19:00 | 5117214 Atomizer
Atomizer's picture

After all the centralized / Decentralized M&A pacified mergers take place, the customer base will be extinct. Ma Bell (telecommunications) and Enron always provide the M&A barometer for failure. Don't forget about MF Global. 

 

Tue, 08/19/2014 - 19:03 | 5117245 Hohum
Hohum's picture

Interest rates going up.  LOL.

Tue, 08/19/2014 - 19:09 | 5117271 ebworthen
ebworthen's picture

M&A = pink slips.

Tue, 08/19/2014 - 19:15 | 5117315 medium giraffe
medium giraffe's picture

all your base are belong to wallstreet

you have no chance to survive make your time

 

Tue, 08/19/2014 - 19:34 | 5117423 cougar_w
cougar_w's picture

Release all Fed. For great justice.

Tue, 08/19/2014 - 19:16 | 5117320 Larry Dallas
Larry Dallas's picture

As much as I agree with the Tylers and the Mises, I don't see at catalyst for increases in rates anytime soon. For rates to rise, you need a sell off. If there is a problem or a provocation, people will rush to Treasuries.

Why would Mr. Yellen raise rates on her own credit card balance?

Tue, 08/19/2014 - 19:18 | 5117330 spinone
spinone's picture

thats what we call wealth concentration

Tue, 08/19/2014 - 19:21 | 5117353 atomp
atomp's picture

IIRC, M&A peaks occurred around '00 and '07.  Are we there yet?

Tue, 08/19/2014 - 19:26 | 5117379 AdvancingTime
AdvancingTime's picture

Money has become so cheap to borrow that many people are now arguing that you must take it even if you don't know what to do with it. It is hard to imagine how much this is distorting the economy, markets, and reality in general. A total disconnect between life on main street and the financial world is occurring and it is putting the economy in a very dangerous place.

It is often hard to determine what is true, but a report on Bloomberg that 32 Trillion dollars in funds were held in offshore accounts around the world made me shutter. How safe is this money, and what exactly is it doing? Can you say Cyprus? More on this subject in the article below.

http://brucewilds.blogspot.com/2013/05/cheap-money-more-and-more-and-mor...

Tue, 08/19/2014 - 19:31 | 5117416 cougar_w
cougar_w's picture

"Besides the egos of CEOs, the Fed’s cheap money drives M&A"

Maybe a little. But mostly companies are trying to survive in a blown global economy. Rather than compete for fewer customers they just eat each other. Having laid-off workers and pocketed the savings they have huge cash hordes with which to do this. I think part of the haste we've been seeing is wanting to buy up other companies before stocks go any higher (hey thanks Fed!) since everyone knows they will go up and everyone also knows the valuations mean nothing except that M&A becomes artificially expensive.

Tue, 08/19/2014 - 19:34 | 5117425 Peak Finance
Peak Finance's picture

Call it what it really is

M&A = they are now eating each other

Tue, 08/19/2014 - 20:42 | 5117722 TrustWho
TrustWho's picture

The Black death significantly reduced population. Less pair of hands forced technology advancements leading to higher productivity and ultimately created the european renassaince.

The 0.1% know this historic fact. E-bola like viruses and war will wipe out 65 - 75% of world population. Most of you on this site will not survive, so I would say ENJOY.

Tue, 08/19/2014 - 21:59 | 5118009 yogibear
yogibear's picture

Kaboom! There goes the jobs. Merged functionality and duplication. Fewer and fewer jobs.

More people on welfare and Social Security disability. Higher and higher US government deficits.

Wed, 08/20/2014 - 08:17 | 5119068 Raoul_Luke
Raoul_Luke's picture

Yes, indeed.  QE has had the exact opposite of its intended effect.  The economy is almost literally drowning in liquidity.  A dearth of capital isn't our current problem, a surfeit of government is.  Too much tax (spending), regulation and central planning style interference in markets has killed our entreprenurial zeal, leading to less economic opportunity (as measured by start ups and job creation).  And as the Fed attempts to "fix" this problem with monetary policy, it only ends up driving this M&A activity in a relentless pursuit of E to keep pace with liquidity driven increases in P.  This is economic self destruction at the hands of our political and banking elites.  If we don't start voting for smaller government and more economic freedom we are destined to follow in the footsteps of our counterparts in Europe and Japan.  Permanent recession lay dead ahead of us - and we chose "forward!"

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