Why Investment Bankers Are Adding Critical Skills for M&A Clients

Buying and selling clients are demanding a wider range of value-adding services from large investment banks and the bankers are responding to keep the lucrative business. The days when services stopped at deal structuring, valuation, and fairness opinions are gone. Bankers today are called on to advise on such areas as basic strategies, product market impact, competitor responses, and, increasingly, stock market reactions. M&A: Deals are becoming different and more daring and a lot of new ground is being broken. Beyond the traditional roles of investment bankers, what additional services do you provide in this environment? For example, do you spend more time educating and advising clients on the consequences of the deal, such as competitor response and stock market reaction or whether the strategy is viable? Stefanick: Clearly, one of the outgrowths of the industry focus at Wall Street firms is that we have insights into the competitor reactions to many mergers and acquisition transactions. One of the things that our clients look to us for is to tell them how the transaction may change the competitive landscape in a particular industry and what the competitors’ responses may be. We try to form a view of the ultimate shape of the industry. In another more delicate area, we are increasingly being asked by our clients to function as something of a stock market prognosticator in terms of what the market reaction will be to their transactions. Nobody can say for sure what the market reaction will be but we can certainly discuss the kinds of issues the market will consider in evaluating a transaction. There is also an important distinction between the short-term and long-term market reaction to a deal. Harris: We live in a world where the stock market pays for growth and reflects its perception of growth in a company’s multiple. When companies buy they want to do everything they can to understand the implications and how the market will react. I think that one of the areas in which we continue to develop is in our ability to tell our clients what the reaction will be as it relates to goodwill and how the market will view the goodwill. Whether you can or cannot sell an EPS concept is wrapped up in the market prognostication element. It is something that we do increasingly as we talk to clients about announcing transactions. Additionally, one of the major drivers of the whole m&a market is globalization. We see a large amount of cross-border activity and we believe that we are going to see that continue to develop. As a result, we spend a fair bit of time educating clients, whether they are based here or in Europe, Asia, or South America, about the particular deal elements – structural or otherwise – that are indigenous to the country in which they are going to buy. Gatto: In many of these transactions buyers are moving into new markets where they are not fully familiar with structuring, regulatory, and marketing issues. Clients are looking to us to assess what will happen to their stocks and how the deal should be marketed to their own shareholders and those of the target company The intricacy and challenge of these transactions become even greater to the extent that the transactions involve stock as consideration. In these deals, buyers are concerned about flow-back – whether shares issued as merger consideration will come back to their local market and whether the market can absorb those shares. They also are concerned about pooling and about cash earnings. Each of these elements has a tremendous potential to impact their stock’s trading value following announcement of the deal. Clients are looking to their investment banker to make that assessment on market impact and do it in a fairly clinical fashion well in advance of launching the deal. M&A: How is the proposed ban on pooling of interest accounting figuring in your counseling of clients? Are they upset about the elimination? Is it deterring them from doing deals or perhaps accelerating some deals until the ban takes effect? Harris: I don’t know how the whole pooling thing is going to turn out and I am not sure that any of us do. But I would agree that there is a substantial amount of momentum in the regulatory community to push it over the finish line. I do think that some deals will get done in the context of that deadline – to try to take advantage of the fact that pooling is going away. I think there also may be a moderate amount of interruption because of the proposals and we perhaps may see some slowdown. But I don’t think there is going to be a permanent impairment to the business. A lot of companies are very focused on cash EPS. We think that the institutions are getting to the same perspective, although they are not quite there yet. It still is something that is very much industry-specific, and in some instances it is company-specific. But at the end of the day, we are all going to have to deal with it. We are all going to have to accept the fact that there is likely to be a change and to continue to try to push the institutions to embrace a cash EPS concept. Stefanick: While there was a number of pooling deals in 2000, one of the surprising things was that there was no rush to get deals done before the window potentially closes. What that means from our point of view is that people have been focused on doing deals that make a lot of sense, both strategically and financially. They have not been rushing to get deal done simply to get pooling treatment. With regard to the goodwill issue, there are certain industries where it may be easier to get shareholders focused on cash EPS or cash flow because that is the model by which these companies are valued. In many other industries, however, companies are EPS-focused, and there is something of a reluctance to be the first one on the block to try to get investors focused on cash EPS. But clients generally acknowledge that the change in the rule shouldn’t slow down the number of deals. Investors will be forced to look at these companies in a different way when, in fact, the rules do change. But it is not going to greatly alter how the deals get done or how they get structured. The market eventually will get comfortable over time with cash EPS if that is the way that valuation perspectives go. Gatto: Over time, the market seems to be embracing a cash EPS concept. Even in sectors that had traditionally been viewed as being oriented to GAAP or reported EPS, we are seeing multiples of cash earnings becoming more important. In the food and beverage area, for example, Unilever bought Bestfoods and created fairly large dilution from a reported EPS standpoint. The deal was embraced by the market because the strategy for the deal was right. The shareholders were able to understand the strategic merits of the transaction and understand the strong accretive effect on cash earnings per share. A few weeks later, General Mills announced the acquisition of Pillsbury. While General Mills stock declined following that transaction, it by no means declined on the order of magnitude of GAAP earnings dilution. That signified to us further acceptance by investors of cash EPS. Having said that, there still are a lot of pooling discussions going on behind the scenes. CEOs in a number of industries are still quite eager to race to get a pooling transaction done while we still have pooling accounting because the new purchase rules are so uncertain. M&A: With stock market reaction to a deal becoming increasingly important, what steps are you taking, beyond the traditional DCF work-up, to prepare clients for the outcome and perhaps mitigate damage? Gatto: I think we are seeing a greater reliance on the part of our corporate clients to depend on the investment banks to work in conjunction with the investor relations and public relations people to effectively sell the transaction. That means a careful thinking through with the management team and the PR people of the strategic case for the transaction. I think that the investment community is scrutinizing transactions much more carefully today. It is common to see the initial market reaction as being negative and the buyer’s stock declining after the announcement. This is in contrast to a year ago where even after fairly dilutive transactions, the buyer’s stock would increase. The market needs to fully understand the strategic rationale. It needs to understand where the synergies are coming from and the likelihood of their being realized. It needs to understand what up side there is in these transactions above and beyond cost synergies. And it needs to accept that the management team that is going to integrate the businesses actually has the capability to get it done. All this has to be done against a backdrop of many large transactions that haven’t delivered what had been promised. Stefanick: The market’s visceral reaction right now is negative with regard to announcements of large stock-for-stock transactions. So, we are spending a lot of our time coaching clients to expect that reaction initially, although in the long run it may mean absolutely nothing. For the long run, we are spending a lot of time coaching clients and helping them to understand that they need to hit whatever objectives they set forth for the merged company. If the transaction makes strategic sense and they can hit these objectives, the market will have a very positive reaction. But the market right now is a bit gun shy, in light of a lot of recent failed merger transactions. Harris: The stock market is obviously a dynamic animal. Fifteen months ago we would have been talking about how positively it was receiving many of the deals that were announced, irrespective of whether there was or wasn’t dilution. So, the stock market’s criteria for looking at deals have changed quite a bit in the last six months. I think that you have to keep reminding clients of that fact. I think the best advice we can give our clients is to be thorough and be prepared. At the end of the day, is it a strategic transaction that you believe in, that you are going to do, and that you have to execute. The market should take care of itself over time. You can only do what you can do to manage the market’s expectations. You can’t make the market behave the way you want it to but you can provide a thorough delineation of the strategic rationale, what the synergies are, what the opportunities are, and where you are going. You can set milestones that are achievable and achieve those milestones as you go forward. To a certain extent, the market’s reaction is also a function of credibility. When certain companies announce transactions, their stocks go up just because they have track records of making the numbers, making things happen, and creating value for shareholders. M&A: Am I getting the correct impression that where investment bankers traditionally just structured and helped complete the deal that you are now spending more time working with clients about what they must do financially and strategically after the deal closes? Stefanick: I don’t know that things have necessarily changed in terms of what we actually do. I think there is just a greater awareness on the part of our clients about these issues. I think we have always been providing the same kind of advice about these matters, but the stock market is more sensitive to these issues and our clients are more sensitive to these issues. Harris: The institutional investor has matured and become more sophisticated and is more demanding than the institutional investor of 10 or 15 years ago. I think we continue to generally provide the same type of advice, but we have to change and mature with the market. I think we have done that. Gatto: We are going through a period of enormous change that is manifested by advances in technology that have affected virtually every industry. As a result, companies are grappling with how to confront that change and they are using m&a as part of their program to improve their competitive position. CEOs want to make sure that by moving forward on m&a transactions, they will enhance their value in the marketplace. I think that they are looking to their advisers for additional comfort that the market’s reaction will be acceptable. You can’t fault that in an environment where the market has reacted negatively to many recent transactions. CEOs realize that their positions are on the line and that they have got to demand more from their advisers. M&A: That is an interesting twist because it seems that in the past, those functions were largely handled by management and strategic consultants. Stefanick: Well, take the share-for-share cross-border deal. That is a relatively new phenomenon and is an area where we are spending a fair amount of time these days helping to guide clients through what may happen. That means literally going down the shareholder list and figuring out where the supply is going to come from and where the demand may come from so that the supply that shakes loose on one side of the ocean is soaked up by demand that the issuers and investment bankers will try to create on the other side. This is a relatively new analysis compared to what we did a couple of years ago. M&A: Your banks have set up industry specialization groups which are, among other things, supposed to provide some m&a services. Is there any demarcation between these groups and m&a bankers on deal advice? Is there some point where you step in after the industry specialists have stated the process? Harris: The industry guys and the m&a guys are really shoulder to shoulder. Take financial institutions as an example. Not only would you have a financial institutions coverage officer but you would also have a financial institutions m&a product expert who would be versed in all of the m&a product elements and know what is going on in that industry. I think it is difficult to conceive of a situation, as competitive as the world is today, where you would regularly call in m&a generalists. We still maintain an m&a generalist pool, which is a lot smaller than it used to be. There are lots of transactions that fall into more general arena, but by and large, our focus is industry-specific. Gatto: Our approach is to combine product experts and industry experts in sectors that account for a large share of mergers and acquisitions activity. Financial institutions, telecom/ media, and technology are examples of areas where we have such concentration. We do have a generalist mergers department and can offer our clients a group of professionals with many years of focused m&a product experience. In many of the more complicated deals, such as cross-border deals and takeover defense, you need to have that expertise available for clients. It is very difficult for that expertise to be resident in every industry group. M&A: Are you saying that it comes down to a case-by-case situation? Stefanick: That is right. The lines are growing increasingly blurry between the industry groups and the m&a group. What is clear is that we need to maintain a very consistent, strategic dialogue with our clients. In some cases, that may develop early on in the industry groups and then migrate more toward the m&a group as you get into a particular transaction. But in as many cases, the m&a group is in the transaction initially, helping to maintain that strategic dialogue that is critical to sourcing these deals. M&A: What about the clients? They have been bringing more work inside. Is there a point at which they can’t go any further and have to call in the advisers? Stefanick: Some companies have very large internal staff. They run their own screens and have very clear ideas as to what they want to do by way of mergers and acquisition transactions. Often what we find, however, that they lack perspective on what may be actionable, and they rely on investment bankers for advice on what may be actionable and how to get it done. They also want to know what the market reaction may be to one transaction among several alternatives and how to prioritize the alternatives. Often, they are too close to it, and an outsider’s point of view may change the priorities. Sometimes they source a deal themselves. Other times, they may ask us to do a search on their behalf while they are doing one themselves to see how the results compare. Or they may rely on us to effectively do the entire screen for them. Harris: Over the last 10 or 15 years clients have become more sophisticated. They probably do much more in-house than they did back in the mid-’80s. But by and large, we still don’t see many situations in which an adviser in not involved. We continue to play a significant role in transactions, irrespective of how much of the up-front work or the ongoing work is done in-house. Gatto: One interesting facet of the investment banks forming industry groups is that the strategic dialogue between the banks and their clients is probably more intense today than it was 10 years ago. The dialogue and the interaction that takes place between banker and client very often is taking place at a much earlier stage. We all rely on idea generation capabilities and we talk to our clients about the actionability of transactions that will strengthen their competitive position. M&A: Our data show that there is a decline in both completed and announced transactions. Is there anything to your knowledge that can explain this kind of slippage? Harris: Given the backlog that we have, we believe that 2000’s announced deals will be up from 1999’s. However, we did see some slippage and a little bit of softness, particularly over the summer months. I think that most of that probably relates to the fact that we had a fairly volatile stock market last spring. In the technology sector in particular, a significant number of technology deals were driving the volume in the first half of 2000. As those currencies readjusted in the minds of the public market investor, that had a dampening effect near term on some of those transactions that were in the pipeline. I think we are starting to see the deal volume firm up again. I think we will see that carry itself through in terms of momentum through the balance of 2000 and into 2001. One other observation is that I get the sense in talking to clients, particularly on the industrial side and some of the more economically sensitive industry areas, that there is a perception that the economy, while still strong, is slowing down. How dramatic the slowdown will be, and whether it is a soft landing or a hard landing, will have an effect on the m&a market, particularly as we get into 2001 Gatto: Of 1999’s $3.3 trillion in announced transactions, about 35% was in the telecom, media, and technology (TMT) area. There was a big jump in the first quarter of 2000, largely as a result of the Time Warner-AOL transaction, valued at about $180 billion as well as other large-deal activity in the TMT sector. With the falloff in the Nasdaq in the spring of 2000, we saw a rapid decline in TMT activity. For industrial companies, the non-TMT sectors, the level of activity has been pretty consistent throughout 2000. Europe has fallen off somewhat and that gives us some cause for concern. But, overall, the major factor explaining the reduction of activity comes from the slowdown in TMT. Stefanick: Clearly, the tech market sell-off earlier in 2000 had a chilling effect on deals in that sector. And the first signs of an economic slowdown probably had something of a chilling effect on transactions in other industries. But once it became clear that the bottom wasn’t going to fall out of the economy, we saw a real resurgence in our deal backlog, in industrial transactions in particular. M&A: Has the prospect of an economic slowdown caused any loss of confidence among company buyers? Or is it generating an attitude that there are more buying opportunities because some companies won’t be able to withstand a downturn? Stefanick: Contrast it to last time we had an economic recession, which was in the early ’90s. Companies came out of the ’80s in many cases with balance sheets that had more leverage than they could bear in a recessionary period. That significantly reduced the number of m&a transactions. Even though there were some buying opportunities, people didn’t have the balance sheets to take advantage of them. The world is a lot different today. Relatively speaking, many companies have much healthier balance sheets. They learned their lesson from 10 years ago and are much better positioned to take advantage of the buying opportunities. So, we think you will see a fair amount of that happening. Gatto: About 40% of 1999’s aggregate m&a dollar volume was tied up in transactions of $10 billion or larger in size. Since many of these transactions are in the telecom, technology, and media area and we see a slowdown in that area, it is hard to forecast the that we will have quite the same level of activity moving into 2001 unless there is a resurgence in TMT. Having said that, a potential slowdown in the economy both here and in Europe doesn’t necessarily slow down m&a activity in some of the other sectors. Many of the industrial companies that had traded with P/Es somewhere in the mid-twenties in 1999, now are trading in the low teens, or even lower. We foresee more restructuring activity and recapitalizations taking place and potentially more merger activity, including unsolicited bids, among companies that know that they need to act to shore up their positions. Harris: Another thing to keep in mind is that all of the things that have been driving this market for the last decade still exist. The trend toward globalization is only going to increase. Cost containment is critical and technological convergence, particularly across the TMT sector, is continuing. While many of the currencies in that sector have been hit hard, the basic fact remains that there will be a lot more convergence across that sector as the lines between technologies blur. Those types of factors quite strongly still exist. They are still going to be at the root of what is driving this market. Will stock market volatility, economic slowdown, to the extent that we have one, and other factors have an impact? Sure they will. But I think that the underlying drivers are still very much in force and will continue to drive the m&a market forward. M&A: What kind of reversal in either the general economy or the stock market, in magnitude for example, would slow things down and make any skittish about major acquisition commitments? Gatto: I think it would take a series of factors. One would be a major upward shift in interest rates. We saw a gradual upward shift by the Fed over the course of last year. Another would be a major down draft in stock prices, although we have seen a roughly flat S&P over the course of last year. Further tension in the Middle East and higher oil prices could also impact deal activity. Stefanick: Generally speaking, a loss of confidence in the economy, the interest rate environment, and the stock market would be problems. How importantly any of these individually weigh on a company or on a CEO’s decision-making process tends to be situation-specific. But if confidence in these areas erodes, companies tend to become more inwardly focused and concerned about a long recession. And the need to conserve cash will have an effect on m&a activity. M&A: Aside from acquisitions, would the conditions you describe slow all kinds of corporate development initiatives? Harris: I think it is going to take a fairly significant sequence of events to really erode confidence in the minds of the CEO and the board of directors and among institutional investors as well. We still believe that the CEOs are on the offensive. The CEO and the board believe that the stock market pays for growth, and if you can’t generate the growth internally you do it by acquisition. Because of all the reasons that have been enunciated here today in terms of strategic imperative, we perceive people still are looking at deals. A major sequence of events may cause them to look more inward than outward. But that would have to happen before you would see a major reversal in deal activity. M&A: Some of the deal valuations today do not seem to square with other harder nosed factors we are talking about. Are any new tools or techniques being used to figure valuations and prices, not only in the technology areas but in the more traditional companies as well? Harris: I think we have seen a return to a much more rational valuation approach by the stock market, particularly in the technology sector. I think we would all agree that the market got ahead of itself in terms of how it valued what essentially was a future revenue stream that may or may not have ever achieved profitability. The technology sector is littered with companies that were trading at fancy multiples and fancy valuations eight or nine months ago, or earlier, and now are trading at a fraction of those prices at today. Many of those, frankly, are not going to survive. I am not sure that we, as bankers, are really doing anything differently. There are certainly valuation techniques that are peculiar to the technology sector, just like the valuation techniques that are peculiar to the energy area, given the nature of the asset. I don’t think that we are really doing anything fundamentally different. I think what you see out there is a fundamental change in the way that the public markets, whether it be the IPO market or the m&a market in the technology sector, have changed their view of value and what “value” means. There has been a reemergence of emphasis on when the company actually is going to make money. Gatto: I think you have a very cynical market right now in which investors are asking, “Is value being created?” In the telecom sector, where investors look at the huge capital expenditures, they are asking, “When will companies start to generate returns?” They are rethinking the high multiples that many of these companies carried earlier in 2000. M&A: Increasing numbers of mostly old-economy companies, fed up with their stock prices, are asking your banks to develop strategic alternatives, basically putting themselves up for sale. Are we going to see more of these? Is there no future for these traditional firms as public companies? Stefanick: We are seeing increasing competition for investors’ dollars. This is perhaps most acute in “old economy” companies. It used to be that a $1 billion to a $5 billion market cap company had no trouble attracting investor attention whereas today many $10 billion companies are having trouble attracting investors in out-of-favor sectors. For many “old economy” companies, top-line growth closely follows GDP growth rates. These companies have done a pretty good job over the years of restructuring their businesses and taking costs out. They may even be growing earnings 10% to 15% a year consistently. But they get to a point where, even if they have done a very good job, the question is what is next. Where is the catalyst to attract investor interest if the investors are looking at high-growth, large market-capitalization TMT companies? These companies can look internally, and perhaps they have a fundamental plan that they believe in, with the hope they can go it alone. Or they may look to make acquisitions that will help to extend their top-line growth. Maybe there is some exciting new market that they could enter. Or they could take more costs out of the business and extend the 10% to 15% bottom-line growth rate. But if they feel that they can’t grow any further by way of acquisition and the organic growth in the company isn’t sufficient to cause investors to buy into or simply remain in the stock market, companies in this position are increasingly deciding to evaluate strategic alternatives. I should point out that this won’t be unique to “old economy” companies. It will also be very applicable to technology companies. For example, in cases where the burn rate is a bit faster than the companies had expected, the need for capital in the midst of a weak equity market will likely cause many technology companies to evaluate strategic alternatives. Harris: Some of the increase in the strategic alternatives announcements among the old economy companies was also a function of the tremendous divergence between where an old economy company and new economy company traded. That only heightened the issue that Paul raised, which is that investors have a finite amount of time to devote to where they are going to invest money. The stock market performance in the new economy sector was glorious until last spring. Old economy companies suffered as a result from a valuation perspective. When you reach a point where you are struggling with where your stock trades relative to what you believe the intrinsic value is, you are going to explore how to increase that value. I think that as the technology, media, and telecom sector rotates a bit back toward Earth, you will see some increase in investor enthusiasm for the old economy companies. Investors may realize the attractiveness in those types of assets in a volatile stock market. Gatto: When you look at a market where investors have come to expect 30% to 40% returns or better among the growth sectors, it is very hard for them to turn their attention to returns between 8% to 10%, which they see in many of the old-economy stocks. If those returns themselves become unpredictable when these companies miss earnings forecasts, investors will turn very quickly away from them. We have been telling our clients that the market will reward a significant premium in P/E multiple to the large-cap leaders in any of these given sectors, particularly if they are delivering quarter after quarter of predictable earnings. When these companies miss earnings, of course, they get taken down as well. But the smaller companies that don’t offer investors liquidity and have weaker fundamentals are going to have a much tougher time on an ongoing basis in the public market. Many of these companies are candidates for sale – whether to a strategic buyer or LBO fund. M&A: There have been some blockbuster restructurings of late, such as AT&T and MCI WorldCom. A lot of it seems to be designed to take apart companies put together by acquisitions on the provisos they haven’t worked. Are we going to see more companies rethink their entire acquisition strategies so they don’t get into positions where they have to do break-ups? Stefanick: Look at the empirical evidence. Companies like GE and Tyco have been models of success in using acquisitions to help sustain growth. Other companies have stumbled a bit. Professional managers who continually seek to provide the best returns for shareholders typically look to their earnings record and stock price performance to gauge the success of their acquisition strategies. You wouldn’t expect to see de-mergers among companies with strong records. When companies have missed earnings and/or have received rather harsh reactions from the marketplace, they perceive a need to do something to improve the return so there is better value for shareholders. Hence, we see the break-up of some of these companies that heretofore had been very acquisitive. Harris: You see examples of a stock market that rewards companies for performance and for meeting objectives that are set. So, I think that whether it is created by m&a or otherwise, companies will need to adapt and change and create value for shareholders consistent with the market’s expectations. There are companies that have put together fairly large enterprises through m&a programs over the last five years. If they don’t meet objectives, they don’t hit numbers, or the world changes before they can, they are going to need to restructure, revamp, get off, or do what they need to do to put value in their equity. Gatto: Ultimately, it comes back to the concept that investors are demanding that companies do everything they can to maximize value for shareholders. To a large degree it is a function of good strategy and good execution for the successful companies. If a company is stumbling because of a bad strategy or poor execution, the CEO needs to find another path. Or else the board or the shareholders of that company are going to get somebody else to choose that new path. M&A: What kind of m&a activity do you expect in 2001? Harris: We have had an amazing run here for the better part of a decade with record year after year in this business. Given the composition of the marketplace today and how important the TMT sector is, the erosion in valuation that exists in that sector, and the lesson of the power of the currency, if you will, all of that is going to have impact on the overall volume in the m&a marketplace in 2001. I strongly believe that all the basic drivers of the business remain in place-globalization, cost containment, product development, technology convergence, and more All those drivers are still in place and will still create what I believe will be a big year in the marketplace. Our deal backlog supports this view. Stefanick: TMT may not need to recover immediately, but if it has at least bottomed out and people see some stability there, we will see large transactions resurface in those sectors. Further consolidation in Europe, and even in Asia, will potentially lead to some very large deals. Global financial institutions represents another potential area for further consolidation and large transactions. In the industrial spaces, as long as we do not have a hard landing in the economy here or elsewhere, our view is that the level of m&a activity in 2001 has the potential to be at least what it was in 2000. Gatto: I think that it is hard to envision yet another record breaking year in 2001, especially with the slowdown in TMT. With the downturn in the stock and credit markets, CEOs are going to be somewhat more cautious on m&a deals. But at the same time m&a has to continue being a strategic tool, if not perhaps the most important strategic tool, for companies to maintain a competitive posture in a rapidly changing global marketplace. It is that fact that gives us comfort that 2001 should be a good year.