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“Each of the last six great merger waves on record [going back more than 125 years] ended with a precipitous decline in equity prices,” according to Professor Mathew Rhodes-Kropf of Harvard Business School. I recently recalled that piece of capital market history because, after several years of very strong merger and acquisition (“M&A”) activity, I have been hearing more and more about merger failures and waning enthusiasm for M&A.

For example, FactSet reported less than a month ago that U.S. deal volume and aggregate value in February 2016 were at levels less than any of the past twelve or more months. Furthermore, Pitchbook reported just last week that private equity deal flow and exit volume continued their slide. In fact, U.S. deal value and closings in 1Q-2016 were at their lowest levels in any of the past 11 or more quarters.

Could we be witnessing the end of the seventh great merger wave? If so, then why?

An old colleague and M&A advisor who mentored me back during my Toronto days where I started my career recently wrote about how North American acquisition activity has slowed due to historically high valuations and concerns that economic expansion may be near its cyclical peak. Those surely are contributing factors but he left out something I have repeatedly wrote about: the decline in liquidity in this 7-year old credit cycle.

Acquisition financing has become more expensive and harder to come by given higher credit risk and financial stress conditions. This would certainly slow down leveraged-buyouts given they live and die with lender appetite. The former Chairman and CEO of Citigroup, Chuck Prince, knew this best. In July 2007, only four months before he abruptly resigned after Citigroup reported disastrous results, he said on the topic of buyout financing: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

I don’t think bankers are still dancing as enthusiastically as they once were in this 7-year old credit cycle. In fact, bank lending has begun tightening. I know this because the Federal Reserve surveys senior loan officers from up to 80 large domestic banks and 24 U.S. branches and agencies of foreign banks on their lending practices every quarter. What is ultimately measured from this survey is the net percentage of these banks tightening their standards for commercial and industrial loans. Since the survey began in 1990, these banks have tightened their lending standards almost 50% of the time.

Bank-Lending-Tightening_2016-04If you click on the accompanying graph, then you will see that the past three recessions (grey areas) all happened during times of tight lending (red bars). In the recessions that began in 1990 and 2001, they occurred when approximately 40% and 51%, respectively, of banks tightened their lending standards for commercial and industrial loans made to large and mid-market firms. In the recession that began in 2007, it occurred when only 19% of banks tightened lending.

More recently though, the survey of senior loan officers showed that lending tightened in each of the past two quarters and has recently increased to 8% of the banks (yellow dashed line). Though it is absolutely possible for this new tightening trend to reverse, it looks unlikely. In the past 26 years, two initial consecutive quarters of tight lending have always led to more tightening, which has always ended in recessions. Moreover, tightening has never reversed, before a recession was realized, after 8% of banks had already tightened lending standards. It also seems unlikely to reverse given, as mentioned before, the degree and level in which liquidity, credit risk and financial stress conditions have worsened in recent months.

Eventually, the music will stop: it always does. If bankers don’t keep dancing though, then investors should make arrangements to speak to their investment fiduciaries.  Tight lending standards impact not only M&A transactions, but equity markets, too. As mentioned earlier, merger waves have consistently ended with what Professor Rhodes-Kropf of Harvard Business School refers to as a, “. . . precipitous decline in equity prices.”

Whether or not you believe bank lending standards will continue to tighten and/or equity prices will precipitously decline, please consult an investment fiduciary before making any investment decisions.

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