One of the most striking features of this business cycle has been the volume of mergers and acquisitions. The worldwide volume of M&A activity in 2006 exceeded $3.8 trillion — surpassing the previous record reached during the 2000 equity market boom — with an astonishing 33,141 individual transactions.

As 2007 has unfolded, deal activity has continued to surge. In the first six months of the year, announced trans-actions rose over 50% to reach a remarkable $2.7 trillion.

The current M&A wave is fundamentally different and arguably more economically sound than prior booms. The size of the deals as well as the degree of leverage and method of funding differ. Risks are more widely distributed. Transactions are spread across a broader range of industries and are less skewed toward the United States. Significantly, private equity and hedge funds are playing much more important roles and now account for over one-fifth of all transactions.

A favorable environment
The conditions that have encouraged and supported this M&A boom are unprecedented:

• A global economy that is in the midst of its strongest business cycle since the early 1970s and will likely set a new record for growth and duration.
• Cheap and easy financing has been readily available and remains ample even after the recent rise in interest rates and the current turmoil in credit markets.
• Corporate profits and cash flows are at record levels and balance sheets are uncommonly strong.
• The influx of capital into private equity and hedge funds remains enormous. The private equity industry alone is forecast to raise over $500 billion this year. Contributors include institutional investors, wealth managers, Asian central banks and Middle East sovereign wealth funds.
• The opportunities for private equity and hedge funds to arbitrage the relative value of ownership (record returns on investment) and debt (relatively low cost of capital) remain substantial.

M&A activity has been a key factor driving stock prices higher. Takeover premiums, for example, have augmented returns, and transactions have reduced the supply of shares in public hands. Not surprising, fears of a slowdown in M&A activity have periodically afflicted market sentiment as record levels of deals have persisted. This is now occurring because of rising interest rates and turmoil in credit markets.

The impact of credit spreads
Unquestionably, credit spreads are widening and risk appetite in loan markets is declining. Many pending deals might have to be renegotiated in terms of pricing, deal structure and leverage.

But these developments must be considered in context. The recent widening, for example, leaves credit spreads still on the narrow side relative to historical standards. Moreover, several models suggest the effect of the current rise in credit costs — and possibly the use of less leverage in a given deal — reduces the expected return for the buyer by less than 100 basis points.

Over 680 private equity funds have strong incentives to invest the massive funds they have raised. The opportunities to accomplish this remain substantial. The quality and performance of underlying businesses and rationale for many buyout deals has not changed. For such reasons, the golden era for mergers and acquisitions is not likely to end anytime soon.

Orie L. Dudley Jr., Chief Investment Officer