What could derail the M&A boom

A number of factors have driven the M&A market to record levels. Here's what might turn off the flow of deals.

By Grace Wong, CNNMoney.com staff writer

LONDON (CNNMoney.com) -- A swell of private equity buyers, solid corporate profits, the availability of cheap debt and robust liquidity have all helped propel the boom in mergers and acquisitions.

U.S. merger volume has risen to $1.2 trillion so far this year, according to deal tracker Dealogic. By comparison, deals in the U.S. totaled $1.5 trillion for all of 2006.

While many in the industry agree that activity has peaked, they also say the fundamentals underpinning this activity remain strong. In short, barring some external shock, few expect the boom to go bust.

At the same time, the factors keeping the deals flowing are strongly linked, which means that a problem that crops up in one area could trigger a chain reaction of difficulties for the market. Here's a look at what analysts are watching for.

Economic growth. Solid economic growth has translated into strong corporate profits, as well as record high stock prices. That, in turn, has boosted deal values and contributed to overall optimism in the deal market.

But corporate profit growth in the U.S. is losing momentum. Second-quarter earnings for the S&P 500 are expected to grow just 5.5 percent, according to Thomson Financial, compared with growth of 16.3 percent in the quarter a year ago. Plus, there are concerns that problems in the subprime mortgage market could spread and further dampen earnings.

But several companies, including Coca-Cola (Charts, Fortune 500) and Johnson & Johnson (Charts, Fortune 500), are enjoying a boost from growing demand from international markets. As the global economy keeps chugging along, many companies are well positioned to keep doing deals, analysts say.

"There's pent up demand among [corporate buyers]. They're ready, willing and able to do deals," said Steve Krouskos, partner in transaction advisory services at Ernst & Young.

Debt markets. Corporate buyers haven't been the only ones hungry for deals. Private equity firms, aided by cheap debt and loose lending terms, have been a major force in the M&A market.

But there have been recent shudders in the credit markets, where investors have been pushing back on risky debt offerings. If big deals like the Chrysler leveraged buyout aren't able to secure financing, that may cast a chill on future private equity deals, many market watchers say.

"[Financing problems] could really slow down the pace of larger deals - and the inability of big deals to go through would certainly slow down what is the best year for M&A transactions," said Brett Barragate, a commercial finance lawyer at Jones Day.

Still, some say private equity firms are strong enough to withstand a downturn in the credit markets. Buyout firms have more money in their coffers than ever before, and it will take more than a tightening of loan terms to crimp their activity, they say.

Liquidity. The outlook for private equity deals also depends on the willingness of banks to back these deals, which is becoming a bit more difficult for them.

"The liquid debt market is the key driver [behind M&A] right now," according to Steven Bernard, director of M&A market analysis at R.W. Baird and Co.

Banks are still putting up money for M&A, but they're running into trouble when it comes to spreading out the risk of these loans to other investors, who have curbed their appetite for this kind of debt.

If banks are left holding too much of this debt, they may suddenly turn their backs on buyout deals, which could spark a broader credit crunch.

"Banks could shut the lending window quickly, which would shut down liquidity to the market and have a ripple effect," Bernard said. But he added that so far, it doesn't look like the jitters in the credit markets are bad enough to have a dramatic effect on the deal environment.

Inflation. A rise in inflation could trigger an increase in interest rates. Higher rates would increase the burden on private equity buyers, who already are dealing with tougher bond and loan terms.

"A dramatic rise in interest rates could harm deal flow. Private equity firms build a lot of their transactions around interest rate expense," said Barragate from Jones Day.

A rise in rates could also send stock prices lower, which would diminish the buying power of corporations who use shares to finance deals.

Central bankers around the world have been raising interest rates in an effort to keep inflation at bay, but so far it looks like the Federal Reserve will keep holding rates steady in the U.S.

Inflation fears flared earlier this summer, but appear to have eased since then. The yield on the benchmark 10-year Treasury note, which is influenced by inflation expectations, has fallen to 4.91 percent after going as high as 5.3 percent last month.