Dealmakers Stress: Ball Control in First Stage of Recovery

The 2004 edition of the mergers and acquisitions market has kicked off with advocates of ball control strategies dominating proponents of the long bomb. Key players with a transactional mindset, report m&a pros, are happy to grind it out in the trenches one deal at a time rather than shoot for a big score in one huge move – at least during the opening leg of the New Year. Buy-side hallmarks include keeping deal sizes within bounds, although not necessarily small, spending gobs of time in up-front homework on the pros and cons of likely targets, and, above all, sticking very close to core businesses with transactions that demonstrate strategic advantage from the get-go. If the 2004 m&a game doesn’t feature the glitziest of battlegrounds nor guarantee advisers the payoff bonanzas they commonly banked on from a single megadeal in the late 1990s, market insiders aren’t griping. The market, they report from their firing line positions, is actually in a recovery mode after a slump of nearly three years and a lot more deals, although hardly a boom, are in the works. The slow but steady progression, they add, may even be best for the deals market’s long-term health. On the strategic side, a broad base of companies in a wide swath of industries that had hunkered down during the recession are starting to look outside, enlist increasingly busy advisers, approach targets, and pencil acquisitions into their game plans. Simultaneously, the supply of targets has increased with more stand-alone companies going on the block along with excess divisions being marketed by large diversified companies. In tandem, private equity firms, which drove much of the dealmaking since the turn into the 21st Century, are stepping up the hunt to put still idle hoards of equity capital to work. “Strategic buyers were largely internally focused,” notes Glenn Gurtcheff, co-head of middle-market m&a at Piper Jaffray in a describing an important attitudinal shift on the buy side. “CEOs were not being paid for going out and doing more deals. They were being paid for making sure their own houses were in order, for delivering on their own operations and improving them, and making the best of a bad situation internally. What makes us very optimistic is that now we are beginning to see the strategic acquirer become very active.” This shift reflects the strengthening of the important drivers needed to warm the deals environment. Indicators of an economic upturn have encouraged managements to revive external expansion plans. Credit to finance deals is the most abundant and can be had the best prices and terms since 1999. Acquisition pricing, although typically varied by industry, company size and quality, and buyer objective, has settled at a point that is attractive to both buyers and sellers. The rise in the stock market has sparked increased use of equity as an acquisition currency. Many potential buyers that had been spooked by the explosion of corporate scandals are shaking off their reluctance to fashion major commitments. “General interest is up, the banks are lending again, and good properties are coming onto the market,” notes Peter McKelvey of L.E.K. Consulting. “And in the last six to eight months, a lot of the economic and political uncertainties have been removed.” But perhaps the key motivator is that many managements have returned to the inescapable reality that sound acquisitions often are critical to corporate health because they can counter stagnation at the top line. “Most industries have such low organic growth that to meet shareholder expectations of growth, m&a has to be one of the tools in your arsenal,” says Sam Rovit, a vice president and head of m&a at Bain & Co. Steven Bernard, director of m&a market analysis at Robert W. Baird & Co., says that the quest for growth in “more mundane industries” could send many U.S. players into acquisitions abroad. “In a lot of foreign markets, we see great growth opportunities,” he says. “The markets are more fragmented and less mature. So I think we’ll see a lot of cross-border transactions with U.S. companies looking to markets that have higher growth opportunities than in the U.S.” The renewal of m&a interest sparked more conversations than actual deals as 2004 began. That doesn’t surprise most pros, who note that playing it safe is the catch phrase for most players emerging from the twin malaise of a drooping economy and depressed m&a. “It takes time for deals to play out – from three to six months,” Gurtcheff advises. Moreover some of the key drivers, while improving, haven’t made it all the way back. Many companies, the pros report, haven’t yet booked the tangible gains from economic improvement while the stock market upturn still leaves prices well south of the former peak above 11,000. But Rovit says that many corporate buyers are exercising even more intense care and caution than normal because of the misfires resulting from acquisition overreach in the 1990s and earlier. As a result, he says, the few major deals of the last several months and into early 2004 have shown buyers unwilling to stray from their core businesses, regardless of the industry. That tack has been demonstrated in every area from services – Bank of America and FleetBoston in banking and Caremark and AdvancePCS in pharmacy benefits management – to heavy industry – aluminum producers Alcan and Pechiney – to transportation – the linkage of truckers Yellow and Roadway. It was further typified in the largest deal of early 2004, which was designed to meld Chicago-based BANK ONE Corp. into New York’s J.P. Morgan Chase & Co. to form the second-largest U.S. banking organization. “People are staying close to home because boards have raised the bar on what they are willing to tolerate in terms of m&a activity,” Rovit says. “If you stay close to home and have fairly high overlap, your risk is much lower. You are going to have less difficulty integrating your acquisitions and there are going to be cost synergies. These are the ones where economies should better than when you start to go further afield, buying a company to get into a new country, for example.” In addition, buyers are more into ball control because they face much rougher handling from boards energized by the spate of scandals, e.g., Enron, WorldCom, HealthSouth, etc., and the imposition of new responsibilities by the Sarbanes-Oxley law crafted to combat future governance slipups. Screening has become “more of a runway process,” says Rovit, who finds managements under the gun “as opposed to simply dumping a deal in their (directors’) laps and saying this is what we’re going to do.” As a result, it’s easier to get boards to approve horizontal, highly synergistic deals in which benefits can be demonstrated and, preferably, quantified, and develop sooner rather than later. “Boards are looking for a lot more data up front on whether the business model fits, whether there are any skeletons in the closet – financial, environmental, or legal skeletons – and more likely to look for a plan earlier than they did in the past. In the past, they would have waited for a deal to close and a couple of months later they would have looked for a plan. Now they are going to want the plan up front, when they are negotiating the transaction,” he adds. Conversely, such heightened scrutiny could become an Achilles’ heel for the m&a market. Although he looks for a moderate pickup in activity based on improvement in key deal influences, PricewaterhouseCoopers transaction services partner Robert Filek says that an ultra-cautious approach could lead to more broken deals. The “handshake strategic deal,” he asserts, is “not in vogue anymore” as buyers probe targets with more depth even before initiating contact. “Corporate buyers have been cautious for a very long time,” Filek says. “Under this mindset, there is a lot more scrutiny on transactions. The length of time to close is going to stretch out and more deals are going to break and not make it through diligence.” “Those,” he adds, “are the risks that you have any time you lengthen out the deal process and subject something to a higher level of diligence.” In fact, Filek suggests that the atmosphere is quite conducive to acquisition alternatives as companies try to balance development initiatives with stiff board demands. “Companies will continue to substitute lower-risk alliances and outsourcing for acquisitions in their pursuit of increased growth and profitability,” he says. Filek points out that alliances, although they are less than strategically or financially perfect, flowered during the deals slump that remained at trough levels through 2003. The number of mergers, acquisitions, and divestitures priced at $5 million and above, according to a preliminary count by Thomson Financial’s m&a database, totaled 5,981 last year. That figure actually was up a modest 4.3% from the 5,735 deals completed in 2002 and represented the first turnaround since a record 10,816 were notched in 1998. However, the volume was built on largely smallish to mid-sized transactions – underscoring caution amid difficult economic conditions. Dollar value in 2003 was $502.5 billion, a slippage of 18.4% from $615.8 billion the year before, and less than a third of the $1.78 trillion peak reached in 2000. But the professionals note that even in a year of modest activity, the m&a market managed to establish a firm base of dealmaking in industries that were only lightly impacted by the economic weakness. They included health care, banking and other financial services, and foods, among others. For example, the largest completion of the year – Pfizer Inc.’s $59.5 billion acquisition of Pharmacia Inc. – was in health care while the second-largest, HSBC Holdings PLC’s purchase of Household International Inc. for $15.3 billion, was in financial services. McKelvey notes that the hardy perennials felt strategic pressures that resisted economic cycles, such as pharmaceutical companies’ needs to expand drug offerings because of the slow pace of R&D results and financial services outfits’ needs to build scale and rationalize their operations. They are expected to remain important m&a players this year along with various sectors of manufacturing, software and computer services, insurance, and merchandising. The one m&a influence that may show the most dramatic improvement is deal financing, where lenders have turned from tight-fisted to accommodative over the last several months and are actually scrapping hard to land transactions. This is crucial to private equity dealmakers and mid-market buyers and sellers. Jeff Rosenkranz, co-head of middle-market m&a at Piper Jaffray, says that financing is “not an impediment to getting deals done, and that’s different than what I would have said 18 to 24 months ago.” “It is more rational, perhaps, but there is plenty of capital to get deals done,” he adds. “Senior debt is plentiful. The high-yield market, which is very important for the upper middle market, is very hot. There is a continued slight improvement in lending multiples, and I expect this to continue.” Joseph Kenary, managing director of corporate finance at CapitalSource, says that credit has thawed across the board, with a lot of new capital providers entering the market and established lenders demonstrating more willingness to get into deals. Among the newcomers, he says, are hedge funds looking for higher yields and serving as “one-stop” financing sources. Another sign of relaxation is that some banks – Kenary identifies SunTrust, BANK ONE, and Union Bank among them – are back to cash flow lending under the right conditions. “The leverage multiple was 2-1/4 when we started (in 2000),” he says. “We’re now seeing 3-1/4 and up. In the larger deals, it’s even higher. We’ve seen as much as four times, which is 1999 all over again. There is more liquidity and there are more lending sources.” Kenary adds, “The competition is the highest it’s ever been – but there is still a lot of business out there.” Although LBO sponsors now have greater access to borrowed money to augment their cash reservoirs, private equity dealmaking still won’t be a walk in the park. For example, Kenary says that lenders are still requiring the sponsors to put 30% to 40% in equity strips into the deal structure, which may cushion risk but depresses returns. Financial buyers also have to pay up. “They are paying top dollar for companies of size and stability and growth,” Bernard reports. “They have tons of cash to put to work and are willing to take lower returns with a 40% equity contribution. The reality is that they are willing to accept lower returns in return for putting their money to work.” McKelvey says that the sponsors’ dealmaking ardor is underscored by increasingly competitive bidding for top-flight businesses. “Whenever a good company comes on the market, multiple firms bid at generous prices and the auctions are more and more competitive. Each bidder is asking itself individually, What can we do differently to make the deal work?'” Other factors spicing the deals market include: Divestitures – Thanks to improved prices, diversified companies are bringing good non-core properties to market, the pros report. They had been holding back during the slump, disgorging only their less desirable operations that they wanted to shed regardless of price. Going Private – Dealmakers expect only a modest pickup in public companies taking themselves off the stock market either because of unsatisfactory stock prices or the cost of complying with Sarbanes-Oxley. However, they say there may be an increased number of sell assignments triggered by these factors. A key point to bear in mind, they say, is that Sarbanes-Oxley concerns or low stock price rarely is the sole factor in a sale or a privatization, which typically is a response to a variety of issues. Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com