Flickers of Buying Interest Encourage Dealmakers

Bolstered by improved economic numbers and a sense of stability, acquisition-minded companies are again starting to look at deals – although staying cautious about outright commitments. Managements still want to be convinced that the economic upturn is for real, and a wide range of concerns from corporate governance to credit ratings to antitrust regulation slows major decisions. M&A: Recent economic numbers, including third-quarter GDP growth, are looking pretty good and suggesting a better tone in the economy. Are these data stimulating confidence in the economy among your clients and perhaps encouraging them to pull the trigger on initiatives like m&a or other major commitments? Daniel: There is a marginal confidence upturn in my client universe, which tends to be focused on middle-market-oriented companies. But it does seem to be registering that there are some positive economic signals such as the increase in GDP and the increase in production. And retail sales improved at a 10% annual rate, which is the fastest pace in 25 years. Because things were slow for a while, inventories were low. So a lot of manufacturing companies were looking to replace inventories and increase manufacturing to meet that demand. So there seems to be a positive feeling at a lot of the companies I talk to. We’re having a lot more dialogue with people about potential deals. It’s a little too early to tell if they’ll pull the trigger, but it seems to be heading in that direction. Polle: At the company that does large-scale m&a and executes company-transforming events, two conditions need to be in place for executives and boards to feel confident to do things. They have to feel good about their business, which is closely tied to the economy, and they must feel good about their stock price. A lot of my clients believe that things are getting better in the economy. I think they were surprised that the reported GDP growth numbers were as high as they were because they’re not seeing that in their own businesses. But a large part of my client base for the most part believes that the turn has occurred. I think there’s a lot more analysis and internal dialogue and maybe even external dialogue about doing transactions. But it’s too early to say whether there’s enough traction in the economy and in individual businesses to make managements and boards start aggressively pursuing transactions. Rifkin: I would add a third element and that is a sense of stability. I think that both buyers and sellers need to know that market conditions are not going to change dramatically because you never want to feel that you bought something at the peak or sold at the trough. So if there’s a sense that things are more or less stable and you can forecast results for a certain period of time, companies are much more comfortable making decisions. That’s what I sense has changed. I think companies are starting to believe they can now see where they are. They know what their outlook is, and understanding what their outlook is allows them to make decisions. Katzman: The economic outlook is getting better, and that is helpful. I think there’s pent-up demand for m&a. There has been such instability that clients have been holding off on making decisions about deals. They now see some stability – and even growth in some areas – and, therefore, they’re starting to get a little more optimistic about doing transactions. That being said, the stock market rose significantly last year in anticipation of economic improvement, and that has created some challenges. When considering an acquisition, an acquirer naturally expects to get a good return on its investment. Considering where stock prices are right now for many potential targets, it’s very hard for acquirers to figure out how to get acceptable returns if they actually buy certain of their selected targets at a premium. I think that is counterbalancing the slight momentum in the m&a market. M&A: We’ve seen a number of deal spikes, which run anywhere from one day to about 10 days in major deals. On October 27, when Bank of America and Fleet announced their deal, there were several other large deals announced, but the spurt wasn’t sustained. What differentiates these deals and these acquirers from the rest of the pack? Are any of these spikes signaling where the market is headed over the short term or the intermediate term? Rifkin: I would put these transactions in the category of deals that probably have been percolating for a long time and then suddenly got done. With Bank of America and Fleet, there had been conversations between the two companies for a number of years. Also, you’re looking at industries that had been consolidating over a long period of time. For a couple of years there wasn’t a lot of activity, but when conditions improved, activity picked up again. It wasn’t something that happened over the weekend of October 26. Katzman: Each and every one of the four largest deals announced that one day was intra-industry and, therefore, very middle-of-the-road in terms of strategic fit. Yet the initial market reaction to three of the four was on the negative side, which indicates some continued skepticism in the market regarding transactions. So, even though companies are more inclined to make acquisitions from a business standpoint, they need to recognize that there may be some short-term negativity in the market after deals are announced. With important strategic acquisitions like these, however, the long-term expected benefits generally outweigh any short-term market issues. Daniel: I think companies are buying market share within their industries. I saw that even when there weren’t that many deals getting done. So some of the larger deals of late seem to be a continuation of that trend. People are staying in their core businesses. I agree that these are simple deals. They’re not the complex ones we might have seen three, four, or five years ago. I would expect that deal counts will move upward, not dramatically but upward. I wouldn’t expect to see a whole host of megadeals and certainly not deals that move away from core businesses. M&A: Can we expect then to see more deals for the foreseeable future concentrated in consolidating industries or industries in transition where there’s more of a need to do some kind of m&a work? Polle: I think the most logical deals you will see are going to involve two companies in the same or similar industries doing deals that make obvious strategic sense. I think that dynamic will prove out for a couple of reasons. The investor community, as shown by a mixed response to the late October deals, is skeptical of large-scale m&a transactions today. The farther afield you go from a transaction that fits hand-in-glove, the tougher it is to sell it to the market. Second, if you can’t do a deal with some degree of real synergy, it becomes very difficult to make the numbers work from a valuation standpoint, or from an accretive/dilutive standpoint. Something that is much more of an acquisition criterion today than it was several years ago is return on invested capital. Without synergies, it’s very difficult to make transactions work by that yardstick, particularly large deals. M&A: Has it just trended that way or is because of some of the regulatory pressures that have been put on boards? Rifkin: I don’t think it’s a response to regulatory pressures. I think it has trended that way and the investment community has responded favorably to companies that have been disciplined about return on invested capital. There’s been a lot of publicity about bad acquisitions. Frankly, I’ve always been a little critical of this analysis because I don’t know how you can evaluate how a company would have done had it not made an acquisition. So to say an acquisition did or didn’t work is sometimes hard to measure. Nevertheless, there’s this attitude that in the past companies have overpaid and that integration of a lot of acquisitions hasn’t worked out. So I think buyers are being much more sensitive to the returns that they expect to realize. M&A: The analysts that conduct these studies showing value destruction don’t have the answer either! Katzman: There is no reliable way to benchmark relative performance post-deal, because the scenario in which the company doesn’t make the acquisition doesn’t exist so you have nothing to compare. That’s one reason why return on capital is so important to the investor community and to companies, especially when considering acquisitions. Today, acquirers must explain to the market how, and when, they’ll earn their cost of capital on deals. With that guidance, investors can better judge a deal when it’s announced, as well as track the deal’s progress over time. M&A: We’ve seen an increase in companies that have started to sell non-core operations. Is there some factor in the market or at the firms themselves that has made them decide that this is the time to divest? Is it indeed an indicator of future deal flow? Rifkin: Conditions for selling are better now than they have been for a couple of years. If you’re talking about businesses where there are no natural strategic buyers, financial sponsors are in the position to pay a better price today than they have been in a long time. Interest rates, obviously, are low. Leverage levels are higher than they have been in some time. So companies that are considering a divestiture look at market conditions today and say now is not a bad time to sell. If you have a business where there are strategic buyers, conditions also have improved substantially with the increase in the stock market over the last 8 months. M&A: How do you see the financing situation? Have lenders loosened up at all? Have your firms stepped in with any financing creativity to help out? Polle: We represented a food company named Michaels Foods three years ago when it was sold to a financial buyer. At that time the maximum leverage that the buyer could get in the market was 3-1/2 times EBITDA. Total debt was about 3-1/2 times. That business was sold about one month ago by one financial sponsor to another and the leverage that the new buyer was able to achieve was 5.5 times EBITDA. That’s a dramatic shift in a relatively short period of time. We’ve had dramatic differences in where the financing markets are. But over the last several months the financing markets have been pretty wide open. In the bank markets, people are lending more aggressively than they were, although there are some credits that the bank just won’t get in. The high-yield markets are white hot in terms of availability for financing. For investment grade companies looking to finance things, the bond markets are wide open and the equity markets are robust. The equity markets seem to like financing m&a deals. Rifkin: Financing is not the issue, but sometimes credit is. One of the problems I’ve encountered with larger companies is that they’re more sensitive to their credit ratings now than they have been in the past. The rating agencies have moved the goal posts back 20 or 30 yards. It’s a lot more difficult to get investment-grade ratings today than it was a year ago. So companies that feel it’s important that they maintain, say, an A1/P1 commercial paper rating or an A senior debt rating, are reluctant to take on more debt and run the risk of being downgraded. Katzman: The debt financing markets have been extraordinarily accommodating across the credit spectrum, which overall has been supportive to m&a activity. In addition, the IPO market is open again, which is also a positive for the m&a business. Daniel: One of the more positive signs I’m seeing is that lenders for about the last four to six months are being much more accommodative. We have deals for which the banks are oversubscribed. This is a universal positive right now for the market. M&A: Is anything happening at the negotiating table that is making the atmosphere contentious? What are the hot buttons that are getting people on either side exercised and may take time to resolve? Katzman: There isn’t any one item that has become more contentious or difficult. However, in today’s market it has become more difficult for buyers to pay sizable premiums and, therefore, other factors, including social issues, have taken on more importance. That makes negotiations a little more difficult, as you may be trying to compare value to less quantifiable items. In addition, acquirers are approaching transactions with a much higher degree of scrutiny. Potential buyers are absolutely conducting more thorough due diligence, and that just takes more time. Polle: The seller used to be able to limit that. The buyers may have wanted to have done more but either because of competitive dynamics or deal dynamics, they were comfortable or willing to proceed with transactions and do less. Today people will walk away from deals if they’re not able to do a greater level of inquiry than a couple of years ago. Rifkin: I’m running into one issue more often, and that is antitrust. If I were to say what I’m most concerned about it’s the fact that a lot of industries have become so consolidated that it’s getting tougher to do the next deal. So antitrust is becoming a bigger and bigger issue. Often it takes many months to resolve whether you’re going to have an antitrust problem. You can discover that only after you start the deal process. Companies can enter into an agreement and then sometimes wait six or nine months to find out if they’re going to get antitrust approval or what they would have to do to cure a problem. An example is the defense industry. After the Vietnam War, the defense budget started to shrink and there was tremendous consolidation. There were maybe 20 major defense contractors in the mid-’70s, but every couple of years you would see an acquisition and you got down to the point where there were four big defense companies. When two of the four tried to merge, they were told they couldn’t do it. If you happened to be an m&a bank that specialized in defense you had to find a different line of work. I think we’ll see that in more and more industries. Daniel: Another issue I see debated at the negotiating table reflects all of the things we’ve talked about in terms of the board’s duty of care and what is related to that in lock-ups and breakup fees. Everybody wants to do the right thing but at the same time get the best deal for themselves. But they don’t want the deal to be so good that it jeopardizes the ultimate takeover that they’re all looking to do. The Omnicare decision makes people very sensitive to that. M&A: What about pricing? Financial buyers are reporting that they’re paying higher prices Are sellers who wouldn’t sell before coming back? What are some of the movements on pricing in general? Daniel: As head of our middle-market advisory practice, most of my business is selling companies to private equity firms or strategic buyers. There is no question that there seemed to be a turning point around March of last year. For the two years before that, in almost every situation, strategic buyers could pay more, and would pay more, than financial buyers. Two or three years before, that wasn’t always the case. Starting around March, in at least an equal number of situations, private equity firms could pay more, and were willing to pay more, than strategic buyers. That assumes there wasn’t some obvious synergistic strategic buyer who could just pay multiple points above what anybody else could pay. I’m seeing much more competitive auctions where the strategics and financials are willing to bid strongly. Rifkin: Not only can financial buyers borrow more money and at more favorable rates but they’re also accepting lower rates of return. Some are finally acknowledging that fact, which they hadn’t been willing to do in the past. Traditionally, they sought expected rates of return of 25% to 30%. Now they’re sometimes looking at rates in the high teens. Katzman: Part of the reason that prices are higher is simply supply and demand. Over the past few years, private equity funds have amassed a lot of capital, and much of it remains unspent. This has caused a supply-and-demand imbalance, as the demand from buyers for deals has outstripped supply. In addition, financial sponsors are often willing to accept lower absolute returns today. Many financial sponsors target returns at certain levels above expected market returns, and expected returns for the equity markets over the next few years are lower than in the past. Therefore, financial sponsors can accept lower absolute returns while still outpacing the market by an acceptable amount on a relative basis. Rifkin: For strategic buyers, it’s a little more difficult to evaluate whether they’re paying higher prices because they tend to focus more on whether a transaction creates value and the impact the transaction will have on the credit rating. An accretive transaction can be accretive for a variety of reasons. One may be because the buyer’s stock trades at a higher multiple than the target’s stock. Another may be because the synergies are quite high. If they can make a transaction accretive and it doesn’t have an adverse credit impact, they’ll pay whatever it takes to be the winning bidder. In some cases, that price would look high on the historical basis and in other cases it might not. M&A: Does that square with the new emphasis on return of invested capital? Rifkin: I’m not sure, but we, as financial advisers, would not encourage our clients to make an investment if the returns were not acceptable. So when I refer to the parameters that buyers look at, if you can satisfy those parameters but not achieve an adequate return, I would like to think that none of us would allow our clients to do that. Polle: I think that the return is one of several considerations that companies have that has made some buyers more disciplined on price than they might have been. The other phenomenon you can talk about with pricing for public deals is premium to market. We’re in an environment today in which the premium that the average public company would expect in a transaction might be lower than it historically had been. In part, that is because stock prices are high and economic activity with the underlying businesses may not have fully caught up to where the stock prices are. In part, it’s tougher to make some deals work with the elimination of pooling accounting, even though goodwill is not amortized and some assets are being written off. That makes it more challenging to make some of the numbers work. Rifkin: I want to go back to the point of acceptable rates of return. It isn’t that companies were necessarily accepting rates of return that were unattractive; it’s that they weren’t as rigorous as they should have been in questioning projections. We’ve found that companies are just much more skeptical about the projections that the seller might provide. They’re doing more thorough due diligence than they had in the past. They just have to be convinced that the likelihood that these projections are going to be realized is far greater than it had been in the past. Katzman: With the economic outlook today for relatively slower growth compared to what the outlook was a few years ago, potential buyers naturally approach projections provided by potential sellers with more skepticism. Also, the market expects acquirers to achieve adequate returns in a shorter period of time. Return on invested capital is front and center to investors. This has introduced additional price discipline on acquirers, as the bar has been raised. The message from investors is to get not only a higher return but also to get it faster, even with lower growth expected in the target’s business. For the right strategic deal, the long-term benefit of the transaction is the ultimate goal, so it may be acceptable if the market reaction is not great upon announcement. However, clearly it’s easier to do a deal if you think the market will react positively out of the box. Daniel: Often a strategic buyer that competes in an auction with a financial buyer is much bigger than the target company. In those cases, the accretion/dilution analysis isn’t going to be very meaningful in telling the board whether they should do the deal. The metrics like what kind of return it’s going to give them is really the only thing they could hang their hats on. M&A: Where exactly do the boards fit in this? I’ve received reports that they’ve been much tougher and actually killed deals since Sarbanes-Oxley. Has this impeded transaction flows? Katzman: I believe that Sarbanes-Oxley and other regulatory reforms have been slight impediments to activity. Boards and managements have been focused internally and on non-deal matters, and this has taken a lot of time and effort. So there’s clearly that distraction. Sarbanes-Oxley also makes buyers more careful for a lot of reasons, which definitely impedes activity. However, the counterbalancing factor to some extent is that sellers may be more willing to sell, as it has become more difficult to be a public company in today’s environment. Polle: I think the role that boards will play in helping to transform transactions is still developing. It’s very difficult to generalize but I think that most boards feel that they need to be more hands-on than they were before. And most management teams are expecting that their boards will be more hands-on than they were before. Exactly how that dynamic will work out and how much more active a board will be in both determining acquisition strategy and, more importantly, passing on specific deals, is very uncertain. I’ve spent a lot of time in deals where members of the legal community were advising some of these boards on what they should be doing. If you talk to some of the deal lawyers, they have very different views. Some think nothing has changed. Others are taking the view that a board needs to take a much more activist role. Some advisers are really there to represent the board’s interests as distinct from management. I don’t know that we’ll have fundamental change but I think the dynamic will change. Each board is struggling and each board is figuring out how the dynamic will change for them, particularly with respect to things that result in large-scale company transformations. Rifkin: The change has been dramatic but I think that, overall, boards are less deferential to CEOs than they have been in the past. That’s good. Daniel: In terms of what Sarbanes-Oxley and also the changes in the research model are going to do to the m&a market, I think that Jim is right. In the near term everybody is just trying to figure out what to do and how to react to it. But I think that over time those changes may end up leading toward an increase in m&a activity for the simple reason that many public companies and private companies are looking for liquidity events. For example, being a public company, particularly for some sub-billion dollar companies, is no longer as attractive as it was before. So when you compare the equity market alternative to an m&a alternative, I think the m&a alternative is going to appear more attractive. M&A: The SEC came down on Deutsche Bank because of its role in the Hewlett-Packard/Compaq case and this has raised questions about multiple services being offered by the same financial and advisory institution in the same deal. How has this affected your firms with regard to providing multiple services to your clients? Rifkin: We’re all much more sensitive to perceived conflicts of interest than we’ve ever been. I think we always felt we could manage conflicts, but we now recognize that the world doesn’t necessarily see it the same way. I think the Deutsche Bank case is fairly unique because it involved a proxy fight, and proxy fights aren’t all that common. But we’re sensitive to problems. In the past, for instance, we might have advised one side of the transaction and been willing to provide financing on the other side. Now we might look at that quite differently just because of the perception. Polle: Competitive bids for services are things that people have always asked for. I think that the sensitivities at our institutions are higher, and we’re probably much more careful. We’ve probably all instituted a set of more specific policies and procedures to deal with this. But since we at Citigroup do so many things, these are bigger issues for us than for some of our legacy firms. Our procedures are in place. I will say that some of our clients are also sensitive to what their relationships are with their financial advisers and financing sources. There are some cases where it hurts you in terms of people not wanting too much business going to one place or having business linked. But in other cases it helps us when people actually want those things to be linked. So I think it’s a change but I don’t think it’s fundamentally crippling any of us from doing our business. Katzman: We have always been very careful about conflicts and perceived conflicts, but we’re even more attuned to it now. We’re spending more time not only trying to figure out if there’s a conflict but also trying to determine whether someone else, with 20/20 hindsight, will perceive that there may have been a conflict. M&A: Are there any additional advisory services that you’re providing for deals that you might not have been involved in a few years ago? And does this influence your decisions on hiring new people? Katzman: We’re providing, more or less, the same services we’ve always provided, but I think that the services are much more integrated today than they had been in the past. The financing element has become an increasingly larger factor in m&a. This is partly due to the demise of pooling, which has led to more deals in which some portion of the consideration is paid in cash. In addition, credit rating has become a more important issue, given the volatility in recent years, and, therefore, the appropriate financing structure is even more critical today. Rifkin: Unfortunately, we’re in the position now where we can’t provide all the services that we could two or three years ago because of the new rules on how we interact with our equity analysts. I’m not sure that we haven’t, to a certain extent, thrown out the baby with the bath water in that regard. The value we can add has probably suffered as a result of the new rules. Polle: I don’t think we’re fundamentally providing a different service. I think the emphasis changes. Our industry goes through its own trends. When things get really busy, we have more junior people that take the lead on more things and commoditize the product a little bit. We probably hurt ourselves a bit with our clients, and our clients are feeling a bit more sophisticated. When our industry shrinks, we have more senior people focusing on things that maybe they weren’t working on before, and we begin to add more value again. I think we’re at that stage where the shakeout in the industry probably has us providing better advice to clients just because of the volume. With less volume and with not that many senior bankers being taken out of the industry, clients are getting more senior focused attention than they were a few years ago. That’s an industry phenomenon, not a Citigroup phenomenon. Daniel: Our advice and our services are better integrated than they might have been in past years. Everybody needs to be aware of everything. If you can’t provide a particular service, giving advice or knowing where our client can go for those services is part of our job as well. Participants Marc Daniel Senior Managing Director, Head of Exclusive Sales Bear Stearns & Co. James C. Katzman Managing Director Goldman, Sachs & Co. Gregg M. Polle Co-Head of M&A Citigroup William D. Rifkin Vice Chairman, Investment Banking Merrill Lynch & Co.