Rich pickings for L1 as M&A supercycle fires up

L1 Capital’s new Catalyst Fund is unique in several ways. Not least of all is that the concentrated portfolio holds just ten stocks. James Hawkins, Partner and Head of the Catalyst Fund at L1 Capital, says that each stock must clear three gates to enter the portfolio.

The first two are L1’s Quality and Value hurdles, which dramatically reduce the investible universe in any market environment. The third hurdle a stock needs to clear is to have an identifiable catalyst that will unlock embedded value within the company.

The current emerging M&A supercycle creates fertile ground for finding the types of catalysts the L1 team is looking for. And Hawkins expects this backdrop will provide a strong tailwind for companies to realise value from under-appreciated or strategic assets.

In this video, Hawkins shares four factors underpinning the current M&A supercycle.

Edited transcript

What is your view on the outlook for M&A activity?

In the last 15 years, there have been two genuine instances I would class as M&A supercycles. The first one was leading into the GFC. The most recent started at the end of 2020 and is really just getting going.

We're seeing M&A activity at heightened levels now for a few reasons. Firstly, there's a real backlog of transactions, that would have normally happened during calendar 2020 which did not happen. And that was for good reason because companies and boards were very focused on the global health pandemic as they should quite rightly have been.

Secondly, the cost of capital is very, very cheap. The risk-free rate, the 10 year US treasury rate, is close to all-time lows. So, the cost of capital is low and also equity capital is readily available, and at cheap costs.

This change creates a need for boards to do things. There's been an acceleration of many trends, for example, if you're a retailer through online shopping as a result of the pandemic. Online shopping and e-commerce were already here, but the speed and rollout of it has been accelerated.

And then finally it's really about business confidence. Boards have come from a very low level of business confidence and as the world starts to open up and there's a vaccine rollout, with proven high levels of efficacy, boards are becoming more confident as to what living with COVID may well look like.

What could derail the M&A cycle?

Monetary or fiscal shocks are often a precursor to the ending of M&A cycles. A significant rise in the risk-free rate would increase the overall weighted cost of capital, which might be a precursor to that M&A supercycle finishing. It could be a macro shock or if there's any tensions between countries in various parts of the world. So, it’s anything that influences boardroom confidence in a negative way. Boardrooms don't like uncertainty and anything contributing to uncertainty can undo the trend of an M&A supercycle.

We often hear about portfolio managers explaining how they pick stocks. But how do you know when it's time to sell?

In terms of how stocks enter the portfolio – because that will influence our thinking when to exit – they need to get through three gates. Gate 1 is Value, gate 2 is Quality, and then the third gate is for the stock to have one or more catalysts. And it's that third gate, the Catalyst gate, which will accelerate and bring forward the type of private equity returns from the publicly listed markets from this fund.

In terms of when a stock is deemed appropriate to exit, it's very much dependent upon those catalysts having been enacted. Once those catalysts have been enacted, the real private equity-type returns from the stock would have been realised. And it's at that point that we'll look to exit the stock.

Alternatively, if the catalyst has not been achieved, for some particular reason, it's at that point in time that we may look to exit the stock. But it's all with regard to what we deemed to be fair value for the stock, relative to its future prospects in the market at large.

We typically exit the stock in the entirety for a couple of reasons. Firstly, once the stock has achieved what we deemed to be fair value, it's appropriate to be exited at that point in time. But also we are, of course, limited in the number of total stocks that may form as part of the catalyst portfolio. So if we, gradually exit stocks over a long period of time, it limits our ability to exit one position to enter another position simultaneously.

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