To the list of reasons not to do a mega-merger add this one: Big deals often cause the combined company’s credit rating to drop.
In a study of 150 U.S. merger and acquisition deals worth $5 billion or more since 2000, Standard & Poor’s found that 25 percent of the time the initial ratings impact after the transaction’s announcement was a downgrade of the buyer by one or more notches. As the years go by after a deal, a decline in credit quality (as viewed by S&P) is even more likely: 53% of buyers eventually had a one-notch or greater downgrade. (Click here for an interactive chart.)
Significantly, the analysis did not include leveraged buyouts by private-equity firms, whose use of extraordinary leverage almost always results in downgrades.
The central point of the S&P report is that “large M&A has been a bad omen for overall credit quality,” says Allyn Arden, a director at S&P. “You may not see it initially, but longer term the trend is definitely down.”
The risks that prompt downgrades include weaker pro-forma credit measures, reduced free operating cash flow, and concerns about the combined outfit’s business risk profile, says S&P.
Given expectations for continuing strong corporate credit markets and extremely low interest rates, more companies will put their rating at risk by funding large deals with an increasing amount of debt relative to equity and cash, says Arden.
“Management often considers it less important for companies to carry high investment-grade ratings in a low-interest-rate environment and an improving economy,” S&P says in the report. Adds Arden, “The difference in spread between an A- and a BBB rating is still fairly narrow, so companies are willing to fund an acquisition with slightly higher interest costs.”
Deals announced in 2013 have been a mixed bag, in terms of how they’ve affected credit ratings. Verizon Communications’ $130 billion purchase of a 45% stake in the Vodafone Verizon Wireless partnership caused S&P to lower Verizon’s rating to BBB+ from A-. Standard & Poor’s expects Verizon’s leverage to rise to 3.4x from 3.0x and forecasts that Verizon’s “funds from operations to debt” will fall to the “low 20 percent range.”
Likewise, when Thermo Fisher Scientific announced it was buying Life Technologies for $17 billion, S&P lowered the specialty diagnostics and laboratory products company’s rating to BBB from A-. It also put the rating on “CreditWatch with negative implications.” Thermo Scientific hasn’t disclosed financing details, but it has said it would use $9 billion in debt, pushing its leverage to about 4.5x, S&P says. “It would be a dramatic increase in leverage,” Arden notes.
On the other hand, when Comcast agreed to buy General Electric’s stake in NBC Universal Media, S&P raised its rating to A- (with a positive outlook) from BBB+ (with a stable outlook), because “the incremental debt to fund the [deal] was less than original expectations, and the company [said] it was revising its target leverage parameter to 1.5x to 2.0x, from 2.0x to 2.5x,” according to S&P.
In other cases, a large M&A transaction is only one factor in a company’s fall from creditworthiness. Since 2000 this has occurred in industries like hotels and gaming, wireline telecom and print media, which “have suffered due to increased competition, secular declines or overcapacity,” says S&P. Notable acquirers that have faced such troubles include retailers Supervalu and Sears Holdings, and high-tech companies Alcatel-Lucent and Hewlett-Packard. In some cases, the acquirer’s rating recovered.
Finally, almost half of mega-deals do not dent the buyer’s credit rating over time. In the S&P study, 21% of the time there was no impact after an M&A announcement, and in 26% of cases S&P actually upgraded the combined company. A credit rating can even survive a notoriously bad deal. The infamous Time Warner-AOL merger destroyed shareholder value, but Time Warner’s credit stayed investment grade due to the diversity of its businesses, S&P points out.