Caution Counts in a Chastened M&A Market: As the deal flow starts to pick up, firms will begin feeling the full impact of the realities of the new m&a environment.

At about this time last year the m&a market was digesting the Enron mess and a number of lesser accounting and corporate governance scandals that collectively raised questions about the veracity of financial reporting and internal controls. Since some of the companies involved in the scandals also happened to be frequent acquirers – Tyco International Ltd., General Electric Co., and International Business Machines Corp. – concerns about the accuracy of reported results sparked worries that active buyers’ growth-by-acquisition programs were not always on the up-and-up. And while not every company whose accounting came under scrutiny was a frequent acquirer, those firms with a number of deals under their belt faced the onus of, at least, clarifying their deal disclosures. A year later, people, for the most part, are viewing the sins of a few as just that, though a number of dealmakers say that many active acquirers continue to suffer from the perceptions of lingering skeptics. “I think that m&a has gotten a bad rap. Some people look at a WorldCom or Tyco and think that the reason they were successful was because of m&a, so the reason they failed was also because of m&a. Blaming m&a is like blaming a gun for any violence that’s done with it. For m&a to be successful, you have to marry it with solid strategic rationales and strong operations, and, unfortunately, there are a lot of companies out there that didn’t do that,” says Sam Rovit, a director in the Chicago office of Bain & Co. Michael Wathen, a partner in the transaction services group at PricewaterhouseCoopers, thinks that m&a per se is not out of vogue, but feels that some companies’ analysts probably are not interested in hearing big deal announcements right now. On the whole, dealmakers report that extremely high levels of scrutiny of frequent buyers’ external growth strategies is waning, though they warn that as a result of the scandals, there will be close study of everything that companies do. They also emphasize that even though suspicions about accounting accuracy and how companies have managed their acquisition programs continue to weigh on the deals market, there are more significant deal depressants to work around these days. The m&a slump, which was underway before any accounting improprieties surfaced, has thinned the ranks of would-be buyers and forced sellers into a holding pattern. Geopolitical uncertainty, a weak economy, hammered stock prices, and tightened credit have left investment bankers pitching fewer deals and spending more time consulting clients on strategic and business issues. Sellers are trying to come to terms with current valuations, and are focusing inward on their own businesses to get them into ship-shape condition for when they are ready to divest. “Many companies’ financial performance is not what they’d like it to be if they were going to market,” notes Kevin Dunn, managing director of m&a at Adams, Harkness & Hill. Buyers are also hunkering down, getting their ducks in order, and waiting for good businesses to come up for sale. Despite the current reluctance to execute transactions, dealmakers say that m&a has not fallen out of favor. In fact, they report high levels of interest in doing deals, which suggests that as soon as some degree of certainty returns to the m&a market, buyers will act on their pent-up desire to pursue acquisitions. But all will not be back to “normal.” When the deal flow starts to pick up, companies will begin feeling the full impact of the realities of the new m&a environment. Sarbanes-Oxley law, the ongoing war on terrorism, and increased eyeballing of companies’ every move will forever change the nature of dealmaking. In the new m&a environment, companies will need to do the right kinds of deals, deeper due diligence, and successful integrations in order to win the approval of Wall Street. No more “weekend due diligence.” No more overpaying for deals. No more integration done as an afterthought to a deal. No more CEO yes-men who cheer on their leader’s every move. No more buddies of the CEO serving on the board for the fun of it. This isn’t your father’s m&a. Reports from m&a pros are that boards are looking at deals more closely, largely because of the new duties and responsibilities outlined for them in Sarbanes-Oxley, one of the most substantial pieces of business legislation to come along in decades. Boards, no longer mere rubber stamps for CEOs’ deal proposals, are asking senior managers tougher questions about transactions and, in turn, top managements are asking deal sponsors tougher questions. Many boards are running scared, and some for very good reasons, but their fear is interfering with high-quality, strategic deals being completed, says Michael Kollender, managing director in the middle-market investment banking group at Ryan Beck & Co. “A couple of years ago, boards were often cheerleaders for transactions. Now there is a fear factor, and in part rightly so. It’s like a pendulum that has swung too far to one side, but in time it will find its way back to an appropriate balance,” he adds. Jim Cassel, founder and president of Capitalink, a Miami-based investment bank focused on middle-market and emerging growth companies, says that a day doesn’t go by without Sarbanes-Oxley coming up in discussions with clients. Sarbanes-Oxley definitely adds a new dimension to due diligence, says Wathen. “We are already seeing it in the marketplace. Sellers are asking themselves, What would buyers want to know?’ There is an incredible focus on sell-side preparation. You don’t want to put a company on the market, you don’t even want to go to your board or senior management with a sale proposal, unless you feel good that you can get a deal done,” he says. One of the dimensions of sell-side preparation, he adds, is scrutiny by the selling company of its own levels of financial and operational control. Under Sarbanes-Oxley, CEOs and CFOs must separately certify the financial and non-financial contents of their company’s annual and quarterly reports. The certifications encompass disclosure controls, internal controls, and general business issues. With regard to mergers and acquisitions, a buyer must step up its level of due diligence to assess a target’s internal and disclosure controls and determine how they would be integrated with its own control structure. In Wathen’s view, Sarbanes-Oxley and its Section 404 certification requirements are nudging sellers’ behavior toward being better prepared to divest a business and giving buyers more “ammunition” to fire at sellers. Richard Morgner, managing director of the m&a practice at Chanin Capital Partners, sees clients doing more due diligence, and insisting on longer lives of representations and warranties. “The more due diligence you do, the better the chances are that you’ll find liabilities,” he says. But whether intensified due diligence will allow companies to unearth more defects at potential targets and lead them to possibly pass on deals, dealmakers can’t say for sure, though they say that discovery of any risks or liabilities could certainly affect purchase prices. Some dealmakers report that they are seeing tough buyers pass on deals because they do not have confidence in the target’s financials, they don’t fully understand the risks associated with the target business, or they don’t like the contract terms being offered with respect to reps and warranties or indemnifications. Although Jack Capers, head of King & Spalding’s m&a practice, feels that there hasn’t been sufficient deal flow for companies to experience the full impact of Sarbanes-Oxley on m&a, he expects to see a much more conservative decisionmaking climate in Corporate America with regard to mergers and acquisitions. “When activity does pick up, I think companies will do more rigorous analysis of their opportunities. They will look at the impact of acquisitions on earnings and the accounting requirements for deals much more so than they did in the past. I think part of that will be related to Sarbanes-Oxley and part will be due to the realization that in the new, conservative atmosphere, companies are being punished in the market for bad deal decisions,” he asserts. As for foreign buyers, many companies have been hesitant lately to pursue acquisitions in the United States, the experts note, although their reasons have more to do with companies’ financial or strategic issues than with regulatory changes. Dealmakers guess that overseas firms’ reactions to Sarbanes-Oxley are that it may be a hassle to work under, but given the size of the American market and the opportunities the country presents, they can’t afford not to do business here. On a bright note, Cassel believes that as boards toughen up on deals, the confidence levels that buyers have in potential targets will rise. “Between accounting issues and Sarbanes-Oxley, I believe that, over time, we will have a dealmaking process that is more transparent, we will be better able to understand the risks and opportunities of potential targets, and we will better be able to determine the value of companies,” he says. Since there is not a large universe of deals being done right now, it is hard to gauge Wall Street’s degree of scrutiny as a result of Sarbanes-Oxley, says attorney Michael Rosenzweig, a partner in the Atlanta office of McKenna Long & Aldridge. In general, he thinks that analysts are looking with increased skepticism and scrutiny at everything that companies do, from mundane quarterly earnings reports to proposed transactions. “A lot of things were happening before without a lot of scrutiny. I think that anybody whose business it is to critique and examine those kinds of things feels a bit embarrassed about missing some of that stuff, so you are seeing the predictable backlash,” he states. As many companies have learned from experience, analysts, investors, and securities markets can be erratic, and even some carefully thought-out deals have been met with market skepticism on announcement. A new dynamic in the m&a market these days, experts note, is that if a deal looks like it is going to be a distraction to a company, even if the target’s business is a close fit with the acquirer’s core business, “there will be a lot of skepticism, and I think Wall Street will hammer the share price,” says Rovit. He points to Krispy Kreme Doughnuts Inc.’s acquisition of Montana Mills Bread Co. as a deal that may be part of a long-term growth strategy but which failed to get a warm reception from investors. Analysts following the deal noted that while Montana Mills is a great “potential” concept, the company is not yet profitable. There is no question in Rovit’s mind that the investment community is predisposed to being skeptical when a deal is announced now. “That would be the case if a buyer doesn’t have a great track record with deals or if a deal moves a company into new territory,” he says. Echoing that sentiment, Kollender adds that today’s deals will have to be highly synergistic, easily understood, and extremely low-risk. “They will have to fit like a glove,” he says. Experts agree that in order for companies to improve their chances of pleasing Wall Street and shareholders with their deals, and increase their odds of deal success, they should pursue transactions aimed at expanding their existing operations, not deals that take them into entirely new areas. In their view, the stock market, going forward, is going to prefer deals in which a company tries to increase its market share by consolidating smaller competitors, by moving into new geographic territories, or by adding new channels of distribution for its current products or services. Less tolerated will be deals that move a company into new business lines. Rosenzweig, whose practice is heavily focused on m&a, senses a significant amount of risk aversion in working with his clients and reports a definite increase in the formation of strategic alliances, joint ventures, and other m&a alternatives. Many experts would agree that alliances and joint ventures can be great tools for companies to gain access to new products, technology, expertise, and customers, all while spreading the risk by partnering with another firm. Yet, dealmakers give mixed reviews of these arrangements, noting that partnering has had a spotty track record. While the current risk-averse climate might seem like the perfect setting for a surge of alliances, dealmakers continue to debate how big the JV and alliance trend will become, but assert that risk-sharing arrangements won’t replace mergers and acquisitions in the long run. Companies should, however, be aware that in many situations, alliances are a viable alternative to m&a. Expressing lukewarm enthusiasm for alliances, some experts assert that joint ventures are among the hardest deals to pull off successfully, noting that they usually have finite life spans because the strategic or operational reasons for creating the alliance tend to “disappear” over time. “When companies that are not experienced in JVs form these types of partnerships, they tend not to be as thoughtful as they should be in determining up front what each party brings to the table, what to do if the venture doesn’t work out, how to split the upside or downside, etc. In JVs, you may be spreading the risk but you will also have to split the upside, so you won’t get the same bang for your buck as you would with an acquisition,” Rovit states. Rovit goes on to say that his firm is quite bullish on m&a right now. “For the right buyer, that knows what it is doing, that does deals that fit its strategy, does thorough due diligence, doesn’t overpay, and does a good job integrating, we think it’s a great time to buy.” Kollender says that his phones are busier now, and “people are talking about deals again.” “Boards are starting to authorize management teams to explore opportunities, which is different than where we were last year when boards were saying to management, Don’t waste your time here. Focus on the core business.'” Copyright 2003 Thomson Media Inc. All Rights Reserved. (http://www.thomsonmedia.com)