Cautious Buyers Open Their Wallets Slowly: The deals market is warming up, but buyers are remaining levelheaded, and have yet to revert to their old ways of overpromising and overpaying.

Big deals are finally back – and not a moment too soon. To say the least, the last few years in the deals world have been real snoozers. Recessions just aren’t fun, and introspection just isn’t exciting. Sure, cleaning up balance sheets, slashing costs, and shoring up corporate governance are noble tasks, and were well called for following the Enron mess and the many lesser accounting and corporate governance scandals that collectively raised questions about the veracity of companies’ financial reporting and internal controls. And, since some of the companies involved in the scandals happened to be frequent buyers – 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. The M&A slump thinned the ranks of would-be buyers and forced sellers into a state of abeyance. The few buyers that ventured into the quiet market did nothing to push the envelope. But after enduring years of merger malaise, it’s nice to see corporate buyers emerge and start spending again. Financial buyers, who never really retreated to the sidelines during the slump, are bolstering the deals upswing by intensifying their search for targets and selling off portfolio companies that are overdue for exiting. Wall Street seems to like the M&A surge, and no doubt dealmakers are happy with their additional workloads. But as easy as it would be for deal pros to get caught up in the exuberance, they are remaining levelheaded – and tough on pricing. Valuations are inching up, but pros from the deal trenches assert that pricing is tempered by discipline, and supported by sound strategic aims. For the past few years, discipline and caution have been the mantras of dealmakers. They learned a lot of hard lessons from their foul deals of late 1990s. But dealmakers are only human, and the desire to win is a fundamental human trait. It would be easy to allow emotion to creep into negotiations, yet industry participants expect today’s chastened dealmakers to adhere to their more-cautious negotiating style, even as the market heats up and competition intensifies. At least for now, deal pros say, buyers are remaining sober-minded, and have yet to revert to their old ways of overpromising and overpaying. “I don’t see things getting out of control. Buyers are too smart and boards are too worried about doing a bad deal,” says Chris McMahon, a Managing Director at Robert W. Baird & Co. “We had gone through a period recently where there was a penalty if you were perceived to be a serial acquirer. Now I think that a well-thought-out strategic deal – even if it’s priced at the upper band of what people perceive to be the valuation metric – is viewed favorably.” For deals in the $1 billion-plus category, he adds, the synergy opportunities, like those in P&G/Gillette, generally are “pretty substantial in helping to justify the purchase price.” In the under $1 billion segment, there has been a “creeping up” of pricing, but not at what he considers to be an “alarming rate.” “Because there are more players in the game and valuations have risen for lots of different reasons, buyers may be paying more than they’d like to be, but they certainly are finding themselves in a position where they can justify the price,” he adds. Glenn Gurtcheff, a Managing Director and Co-Head of Middle Market M&A at Piper Jaffray notes, “It’s a good, solid M&A marketplace and a good amount of prudence is out there. Yes, there are aggressive people out there. Yes, they want to put money to work. But they’re not acting irrationally. When I’m sitting across the table from someone negotiating a deal, they’re still damn tough. Nobody’s running for the finish line just for the sake of running for the finish line.” The M&A market tentatively began turning around in late 2004 and opened 2005 with a bang. In a whirlwind M&A week in late January, Procter & Gamble Co. shelled out $57 billion for Gillette Co., SBC Corp. bought rival AT&T Corp. for $16 billion, Citigroup Inc. unloaded its Travelers Life & Annuity unit on MetLife Inc. for $11.5 billion…and the list goes on. Desire to do deals is supported by rising stock prices and abundant debt and equity financing. Availability of debt allows buyout firms to pay more, Gurtcheff notes. “But just because there is more debt out there it doesn’t mean that people have forgotten about those targets that melted down during the worst of the downturn. I haven’t seen evidence of deterioration in the quality of deals or the quality of due diligence,” he asserts. McMahon adds that he’s witnessed acts of discipline among the private equity community. In some cases, financial buyers are taking on less leverage in deals than the market will bear in order to capitalize their targets more conservatively, he says. Pointing to the financial buyer community, Stephen McGee, a Director at Grant Thornton Corporate Finance, notes, “What I would look to as a leading indicator is the private equity and debt markets. If a lot of private equity deals start taking place at significantly higher multiples, because banks are lending more money than they should be, that would concern me.” Echoing the views of his fellow dealmakers, Bob Filek, a Transaction Services Partner at PricewaterhouseCoopers, says that “buyers are sensible, for now, yet the pressure to do a deal when your competitor has done one has historically caused executives to make decisions that are more emotionally based, and I can’t say that won’t happen again. But for right now, companies have really changed their M&A process, are doing a lot more diligence, are understanding the deals much better on the front end, and generally are doing good, strategic deals.” He adds that one reason some people may feel that the market is heating up too fast stems from how quickly megadeals resurfaced. “If you look at 2004, the number of people willing to lend increased rapidly, and then there was a big jump in deals. That’s why people may feel that way.” Interestingly enough, the dollar value of U.S. deals done January 2004 to January 2005 is up about 50% while the number of deals is down 14%, McMahon notes. Globally, volume is flat to down about 1% and the number of deals is down 18%. The buzz is all around valuations now, but McGee confides that financial buyers selling to fellow financial buyers concerns him more than pricing. “Why would one want to buy from another? If you’re adding your 30% expected ROI on top of another financial buyer’s 30%, how are you going to make your 30% return? They aim to buy low and sell high, but if you’re buying from another financial buyer, in theory you’re buying high, unless the seller is taking a lower return just to get some liquidity.” Financial buyers are furiously seeking opportunities for investing their money, spurred by investors’ warnings to “use it or lose it.” In their quest for deals, they’ve increasingly been willing to buy a business from another financial buyer. Not long ago there had been a stigma to buying a company from a fellow financial buyer, the thinking being that the first buyer already had made the “easy money” and little value was left to be wrung out by the second private equity owner. That thinking has almost completely dissipated, dealmakers note, but as McGee points out, it can be hard to imagine how the deals can meet the return expectations of both owners. Filek doesn’t have problem with the practice, noting that “financial buyers bring a variety of skills to the table.” “Some have different skill sets in smaller deals and some have skills that are better fit for larger deals. I think it’s natural that you have a migration from one subset of financial buyers to another.” Dealmakers generally are satisfied with valuations in this early stage of the M&A recovery, noting that pricing levels are attractive enough to entice sellers but not too high to deter buyers. They agree that deal prices still have quite a ways to go before reaching the frothiness of many of the late ’90s deals. Pointing to recent price-related data, Robert Reilly, a Managing Director at Willamette Management Associates, notes that premiums, even for recent megadeals, have been in the 30% to 35% range. “That’s actually relatively low when compared with the last few years,” he says. “The purchase prices are higher, but the premiums are low compared with long-term and short-term trends. Those premiums indicate to me that there is real analysis doing into deals and that buyers are still exhibiting caution.” In fact, the recent contraction in premiums mirrors a slight pullback in multiples of target company EBITDA. Shrinkage in both the multiples and premiums suggests that buyers still were controlling, to a large degree, what they paid in acquisitions. Valuation experts like McGee really sense a “difference” in the M&A marketplace today, due to reporting and governance requirements laid down in the past few years. Says Reilly, It’s not the attitude we saw in the late ’80s and early ’90s of let’s throw money at anything and hope to get a 30% to 40% return. We know that eight deals will turn out to be dogs, one will break even, and one will be a superstar, and that’s where we’ll make our money.’ I don’t think that buyers, even though they have lots of money to invest, are just throwing spaghetti at the wall, hoping it will stick. I see them doing much better due diligence.” “The real question, he continues, “is what’s going to happen later this year or next year when the really good acquisition targets are gone and there still is money to invest? I don’t think it will be a matter of buyers paying too much for good deals but rather buyers paying for deals that just don’t make strategic sense for them.” And that’s one of the major mistakes made by acquirers in the merger boom of the late ’90s. Losing sight of strategic objectives in a deal can trigger a chain of mistakes – choosing the wrong target, paying the wrong price, being saddled with a dud. Others who ended up with doomed deals had justified the purchase price on synergies that were more imaginary than real or too hard to achieve. Still others were plagued by overpayment from the beginning, even though their targets fit like a glove strategically. Since that time, there has not only been a change in how dealmakers negotiate and price transactions but also in buyers’ deal drivers. At the height of the last deals boom, megadeals were largely being driven by a desire for size and scale. Today, strategic acquirers are relying on dealmaking as a way of consolidating fragmented industries and gaining growth in their top and bottom lines. “Like it or not, now we’re in an environment where the expectation of the capital markets are such that they expect to see growth. They expect to see organic growth and growth by acquisition. Companies need to figure out ways to grow the top and bottom lines, and acquisitions are part of that,” Gurtcheff says. Boards may be far more cautious about okaying deals but they realize they can’t stay out of the deals arena forever. Many companies accumulated hefty cash reserves during their years of cost-cutting and internal housekeeping. And since Wall Street now wants to see growth – both internal and external – acquirers’ boards must put that money to work by funding growth initiatives, despite any reluctance they might have. So it seems that weekend due diligence is a thing of the past, as is overpaying for deals, CEO yes-men who cheer on their leader’s every move, and buddies of the CEO serving on the board for the fun of it. Today, boards are eyeing deals more closely, largely because of the added responsibilities outlined for them in Sarbanes-Oxley. They’re no longer mere rubber stamps for CEOs’ deal proposals, and they’re asking senior managers tougher questions about transactions. The failed deals of the late ’90s are burnished in their memories. “Will this environment turn into a free-for-all? I don’t think so,” notes Gurtcheff. “The scars are still fresh, and I think dealmakers will still be prudent and will price deals at reasonable levels. Will there still be people who will play defense as well as offense, trying to keep a deal from someone else? Sure, that happens. But, at the end of the day, people eventually say no more.'” Copyright 2005 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com