How Some Deals Get Done in the Teeth Of an Economic Gale

The overall m&a market is being pummeled by a host of crosswinds – such as the economic downturn, tight credit, a jittery stock market, and both buyer and seller caution. Yet, some transactions can make it to completion – if the strategic stakes are high and the buyer has impeccable credit credentials. M&A: The market is down, and was down before the September 11 attacks, but deals are still getting done. Is it possible to identify any specific industries that are pretty active or specific types of deals that are getting done despite the overall decline in m&a activity? Foussianes: Before we can discuss September 11, we should talk about the environment before September 11. We now know that the overall market had been deteriorating for some time, and there has been pressure on m&a transactions from all fronts, primarily emanating from this economic uncertainty. The September 11 attacks have exacerbated that. With this as a backdrop, the transactions that are nevertheless proceeding primarily involve companies in sectors such as energy and power, financial institutions, and health care – industries that have broad fundamental dynamics that suggest that combinations are likely, logical, and indeed compelling. For these fundamental reasons, such sectors should continue to be active. Drug companies and security and defense firms also might become increasingly interesting as a result of September 11. Additionally, the economic weakness and September 11 have highlighted that there are a lot of vulnerable companies out there. This may result in an increase in unsolicited hostile activity in a variety of industries. Rimland: I think the long gestation-type transactions, like the General Motors sale of Hughes or the things that are going on with AT&T, have a better probability of staying afloat because they have endured over the last several months while the m&a market and the economy were weakening. They will probably continue to move on their natural course as they move toward key transaction hurdles. Some sectors of the marketplace are doing okay, or at least have been less impacted by the economy than others. Specifically, some of the services companies are holding up in equity valuations. First Data and Equifax look pretty good because they tend not to experience tremendous swings. The simplest place to look is the defense industry. People are looking again at what the conflict in Afghanistan means in terms of government spending for defense programs. We are faced with very different challenges in defense, and the companies in that field need to consider how to adjust. Selig: We have seen a decline in business across all industry sectors and all deal types and sizes. According to statistics, the market was down about 50% toward the end of 2001. In certain sectors, like technology and telecommunications, the decline has been even more precipitous. The area where we have seen the least impact is health care services. In fact, our business in health care has been up dramatically from last year. The health care industry is defensive in nature and, in fact, the health care equity market has been quite robust. We have seen over a long period of time a correlation between the equity markets and the m&a markets. When the equity markets are going down, m&a volume tends to go down and vice versa. So you expect that the industry sectors with a declining equity market will be showing a decline in m&a while m&a will hold up in the sectors where the equity markets are more resilient or have been more buoyant. In addition, the institutional market has become much more skeptical of announced m&a transactions. Perhaps the key example is the Compaq/Hewlett-Packard announcement when both companies lost significant portions of their market capitalizations. It’s a much more common development because the stock market is less accepting of transactions that are either dilutive to earnings at the outset or have less profound strategic rationale. On the other hand, corporate divestitures in which companies are exiting businesses that don’t appear to be core tend to be very well received. I think that companies will continue to be focused on doing deals in those spaces, where the equity markets have been strong and where there is a strong strategic rationale that they can articulate to the marketplace. Berger: I think we will see a number of issues resulting from the current environment affect the m&a marketplace for some time. On the buy side, I expect more deals to be done by those companies with stronger credit ratings that can take advantage of depressed stock prices because the capital markets are open to them. Some leveraged companies are less likely to be able to access capital for acquisitions. That is affecting strategic buyers that are high-yield credits or financial buyers. I think there will be a real opportunity for financially stronger companies to have a competitive advantage in getting deals done. It’s interesting that premiums paid to market are not really down. This reflects the classic problem that m&a is not symmetrical. Sellers still want to get a good price. They don’t want to sell cheaply if they can avoid it. But of course in down markets buyers are not confident and not optimistic and not willing to pay the current market price, so we have fewer transactions being completed. For the last several years, we were enjoying the opposite of this. Rising prices were an inducement to sell and they encouraged buyers to feel optimistic about the future. So an improving economy and equity market will be a tonic for our business. But for the immediate term, the question will be whether sellers will adjust to the reductions in the absolute value of their companies and be willing to take lower prices than buyers are now willing to pay. Selig: We also have to consider the time it takes for people to go through that recalibration because buyers now are, to some degree, sitting on the sidelines, especially if they are looking at stock deals. If their stock is undervalued, they are reluctant to move. More importantly, sellers are sitting on the sidelines because they are not quite sure whether they are facing a momentary dip in valuation or something that is going to be more long-lived. In the course of the last three to five years we have seen a number of cycles in the equity markets. As a result, people are fearful about jumping back in too soon. Rimland: There has really been a power shift. When the equity market was rising, a small company and potential target had power because it had a very credible IPO alternative that it could use to drive up valuations. Certainly, on the technology side, we saw increasing valuations all the time. We experienced a power shift as the Nasdaq market has fallen and smaller or private companies have had problems accessing capital. This huge power shift means that the large acquirer has a lot of power when compared with smaller companies that in the recent past could have struck a deal on better terms or at a better price. Berger: What makes this such a difficult market for m&a is that while we have been through recessions before and recognize that stocks are down and credit markets are tight, there has typically been a degree of confidence that the economic situation will get better. We can get a CEO to say, “Yes, I am bullish in the long run.” The short run is different because the terrorist-induced economic slowdown has produced a level of uncertainty about the future for which we do not have real experience in factoring into economic pricing and decisionmaking. There is an understandably natural tendency to hunker down, to be unwilling to take the next risk, because the factory or network that is so critical to the target’s success could be destroyed or, more likely, be deterred because the economic slowdown may last longer and the recovery be more uncertain than in previous recessions. M&A: Based on those comments, let’s turn to pricing. Are there any industries or deal types in which pricing has held up fairly well and others where it has been really weak? And what about George’s comment about hostile bids? Does this put a target in the position of maybe being bid for at a price that it doesn’t consider fair? Selig: So far we clearly haven’t seen a pickup in hostile activity, for a number of reasons. One is that you pay more when you do an unsolicited offer. Paying more is really a reflection of bullishness for a target company’s prospects and your own prospects. I agree that many companies will identify a number of targets as being undervalued. But going through the process of making an unsolicited offer takes a very aggressive corporate stance, and many companies are not of the mindset to do it right now. Rimland: When you look at valuations in general, I am less concerned about the P/E or the EBIT multiple than I am about the “E” (earnings) of EBIT. And over the last year there has been a steep decline in earnings that should raise concerns. I think that CEOs understand that P/Es go up and down. But when you have earnings or revenue levels drop 40% year over year, that is a very, very difficult equation to factor into an m&a valuation. In sectors like drugs where you don’t see those big declines, pricing will hold up a lot better than in industries that have weaker earnings. Foussianes: A few years ago, we sat around this table and talked about the attractiveness of the m&a market and how many companies were being extremely aggressive in using acquisitions as a tool to grow their businesses. We talked about the right way to acquire a company, the right way to integrate that company into the acquirer’s business, and the risks associated with that integration. Even then, we recognized it was hard to buy a business and it was hard to achieve the goals that the acquirer sets. It was a challenge. Now let’s think how much more challenging it is for the acquirer to meet those goals when the economic environment makes running their own business so tough. The lack of visibility in their own numbers makes it that much more difficult to pull the trigger on an acquisition, and that much more difficult to put a high valuation on those target companies. As it relates to unsolicited activity, we would expect a pickup as certain companies gain confidence and others continue to languish. Selig: The m&a business is fundamentally a business of optimism, and we are not in a particularly optimistic mood at the moment, either in the country generally or in the capital markets. Many of our clients are much more inwardly focused than outwardly focused. And, obviously, the extreme outward-focus involves large m&a transactions. Companies are focused on deleveraging their balance sheets and hunkering down in a very uncertain world. Until we have great visibility as to not only the earnings outlook for most companies but the geopolitical environment as well, it is going to be awfully challenging for them to make bold, aggressive moves that lead to large m&a transactions. Berger: Hostile m&a is the ultimate of aggressive moves. There are some good economic reasons why buyers might want to think about it now. Some companies may be attractive to buy because they are not affected by the economic decline and do not have earnings problems, and a financially strong buyer might be able to take advantage of low interest rates or a target’s depressed price. In general, though, it is a tough move because many potential acquirers have their own problems. Or they need to be prepared to wage a nine-month battle and may conclude that anything could happen in nine months’ time. M&A: When you do get people to the table, are the negotiations any more contentious than normal? And what are some of the points being haggled over, including price? Berger: Price and certainty of closing are still the key issues. Antitrust review is rising in importance because the GE/Honeywell outcome has caused people to be concerned where there is a European exposure. When there is a European element and a concern about regulatory scrutiny there, the issue comes up as to who is bearing the regulatory risk and what the buyer is committing to do to ameliorate antitrust concerns. Another element of certainty to closing that the current environment accentuates is in transactions in which the buyer needs to raise debt to finance the cash portion of a deal. We have seen some very intense negotiations on the bank financing commitment letter, since it is intimately related to the seller’s comfort level about the deal getting done. This is getting a higher level of scrutiny now than in more buoyant financing markets, in which people are more confident that the financing will be available at closing. Rimland: In stock deals, there is a lot of talk about when sellers can get liquid and what the varying time frames for price protection are. There are a number of horrible stories of venture capitalists that were locked in and could not get out before the value of their merger consideration dropped. The question of when you get liquid if you are the seller is becoming a much bigger issue to think about. Two years ago you weren’t necessarily worried about selling shares received in a merger. As a matter of fact, the seller might get, or want, more stock and be less concerned about lockups. Since September 11, there is a lot of concern about who takes the risk on liquidity. Foussianes: A lot of this is driven by market considerations. A couple of years ago, the market viewed acquisitions as a very bankable way to grow. Today, managements face more of a challenge in convincing their shareholders that particular acquisitions make strategic and financial sense. To announce a transaction and to have it fail prior to closing due to lack of deal protection or to the exercise of material adverse change or force majeure clauses, or to have it fail after closing due to poor integration planning, such as a failure to achieve projected synergies, can cause major problems for companies and their shareholders. That’s why we have seen deal negotiations place increased focus on provisions that deal with these factors. Selig: In general, boards are being much more deliberate about mergers and acquisitions. That was true even before September 11 because of transactions like Tyson Foods/IBP in which Tyson was ordered by the Delaware court to go through with the acquisition and was not allowed to use the MAC clause as a reason for pulling out. Companies are being much more deliberate about deciding whether to openly pursue transactions. Berger: The point about boards being deliberate is a very good one. They have to be careful, given the market reaction to deals like Compaq/Hewlett-Packard. It is a deal with huge potential synergies, driven by cost cutting – the kinds of synergies that the market has tended to believe as compared with revenue synergies. Here, the market dismissed it completely. I have spoken to a number of CEOs for whom the market’s reaction to Compaq/H-P has made them very nervous about what it means to be doing a large deal in this environment. A somewhat similar situation occurred with EchoStar’s announced acquisition of Hughes, in which EchoStar’s stock price reacted poorly at announcement despite the fact that a large amount of deal synergies are expected. M&A: The EchoStar/Hughes deal used a complicated, tax-driven structure. When deals are that complex, does the market turn them down because it doesn’t get what is being done? Berger: As a Morris Trust transaction, this deal fits a structural model that has become pretty well understood and accepted in America. I don’t think the market is discounting the prospect of its closing due to its structural complexity, which instead is being driven by the deal’s significant regulatory issues. M&A: Negotiations are reported to be time consuming, with a lot of effort focused on the MAC clause and other protections – something that had been going on before September 11 because of the IBP decision. Have any major language or condition changes actually gotten into the purchase contracts or has it just involved a lot of talk? Foussianes: My experience so far is that while this is getting a lot of focus there hasn’t been a sea change in the final form of the agreements. We talked about the downside of announcing a deal and having to pull it back. That outcome is not good for anybody – buyer or seller. Practically, it is difficult to find a new way to define either material adverse change or force majeure. The dynamic that we’ve experienced in negotiations is that when the parties start to talk about this kind of thing, somebody may throw out a number, saying, “Let’s define a material adverse change as a situation where EBIT-DA drops by X amount of dollars.” That starts down a path that gets very, very difficult. The first thing that the buyer thinks is, “Why did he or she choose that number? Do they know something that I don’t know?” All of a sudden the parties get into a very obtuse discussion of how to define what a material adverse change might be. Selig: Well, in the Burlington Resources agreement to buy Canadian Hunter Exploration, they had an unusual provision in their agreement. They could walk away if financial markets were closed for 10 days. That is not something that we’ve seen in those clauses. They aren’t specifically related to company performance but to acts of war or terrorism. Berger: I think it is unlikely that we will see material changes in who bears the risk of closing through MAC clauses, since both parties face the same environment, and it is hard to say it is more equitable that one party should bear that risk more than the other. Having said that, no doubt there will be some exceptions. This is, of course, one reason why deal volume is down. The current economic uncertainty helps to create a fundamental gap that is hard to bridge in the merger contract. Foussianes: What about a situation where a deal was signed September 1 with the expectation that it would close next May, because of regulatory review. If in early September there is a 10-day period when the market is not open, does that mean that the deal shouldn’t happen, even when the closing is eight months away? It can get very, very messy. Rimland: The reality is that over the years, people have not used the MAC as an easy-escape clause. We have seen wars, skirmishes, and some things we have never seen until September 11, and lots of weakness in the economy. But for the most part, people didn’t use the MAC clause as an excuse for cold feet. Even after the 1987 stock market crash, you didn’t see masses of people using MAC clauses to try to get out of deals. Berger: The MAC clause issue is perhaps not as important in a merger agreement as it is in the financing commitment associated with the deal. Lenders may be extremely nervous about lending when there is a terrorist act. We are already seeing financing terms reflecting this. I have seen a situation in which the seller has negotiated the financing commitment language with the buyer’s bank. This demonstrates how important the certainty of financing has become, since the buyer usually negotiates the financing commitment with its bank. Rimland: Lawyers and bankers historically have talking about MAC clauses in the purely hypothetical sense. It is not so hypothetical now. People are really concerned about these issues. M&A: What about the financing picture right now? The LBO people say it is very tight. Do you find that on the strategic side as well, or does it vary by quality of the company or borrowing power? And how is the financing picture impacting the doing of deals? Berger: I think it is very much a function of the credit strength of the buyer. Financially strong buyers can take advantage of very low LIBOR rates and very low Treasury rates, and investors and banks want to lend to such credits. For weak credits the financing markets stink, and that would be the technical term. Financial buyers are obviously looking for a leveraged deal where it may be hard to make the numbers work. Even in low-multiple purchase prices, if you only can get a little bit of leverage and you have to put in a lot of equity, equity returns are driven down to low levels. Foussianes: Historically, strategic buyers have always had an advantage over financial buyers because of the synergy opportunities, scale, and the management expertise that they can leverage. Today that advantage is accentuated, and that is why it is so difficult for financial players. The other difference that we see in the financing markets relates to seller financing. The traditional sources of financing – the bond, high-yield, and bank markets – seem stretched. This is why we hear about many situations in which large companies selling subsidiaries are considering taking back fixed income paper or keeping equity stakes in the buyers. It’s designed to facilitate more of a competitive auction for the businesses. M&A: Have any nontraditional financing sources jumped in, either to plug the gap or to take advantage of reluctance of orthodox lenders? Rimland: The only new thing we have seen is really a variation on equity, such the PIPES transactions done by LBO firms, which have a lot of variations. We also seeing a lot more deals in which people are doing longer-term private financing. Berger: Financial buyers are constrained in playing this role since they have been spending a lot of time tending to their portfolio companies’ financial problems, which reduces their ability to pursue new deals. They want to make their existing investments work, to get over the current slump, and have less time to pursue new situations. M&A: In the area of markets, market segments, or types of deals, is there anything that was basically an obscure, neglected, overlooked area that has surged to prominence and become worth acquiring in? Rimland: Anyone in the security business – physical security, information security – is very interesting. We have seen a lot of interest in those types of companies. People are looking at insurance businesses again. There is a lot of talk about how the insurance companies will weather the storm, what they will do in terms of premiums, how they will manage that risk. This is clearly an environment in which the premiums are going up, and they may have to think about the risk profile or whether the federal government will step in for a certain catastrophe type of insurance. Also, some of the defense companies may be interesting. Berger: An interesting sector that has obviously been badly hit is airlines. Airline consolidation has been greatly constrained by a difficult regulatory environment. If people were willing to stomach the enormous vagaries and uncertainties in that sector right now, they probably would receive a more welcome reception in Washington. So in this sense, it is easier. But it is clearly much more difficult for companies to agree on a price or exchange ratio in this volatile environment. M&A: What about international deals? The tension we face is worldwide. Are U.S. companies still willing to go abroad for strategic reasons? Are European companies continuing to move into the U.S.? Berger: Cross-border activity is roughly consistent with domestic numbers, which are down about 50% versus last year. So this is a global economic phenomenon M&A: Do you see this more as an economic problem or a political problem? Rimland: Unfortunately, the EU’s rejection of the GE//Honeywell deal, from the political perspective, really opened up a wound. People continue to talk about the different views of antitrust between the U.S. and Europe. But very few deals are fully blocked by one side and approved by the other, so there are not a large amount of deals to get all concerned about. But it is really an economic issue. The Europeans also have been hit very, very hard in terms of their markets and their valuations. They have had similar disruptions from a logistical problem. For a very simplistic view, say you are an American CEO and you have to travel into Asia or South America or the Middle East to buy a company. It becomes a lot more difficult in this environment and adds another level of risk. You have the financial performance risk and then the geopolitical risk, which makes it tougher. People are still looking. They are looking at valuations. They are looking at things that they can do. But it is certainly a lot tougher in this economy. Foussianes: Traditionally, most of the cross-border activity has involved companies in other countries buying into the U.S. These were primarily European companies. We were involved in early September in a couple of those transactions in which we advised buy-side European companies on entering the U.S. market or expanding their U.S. presence. They were very much subject to the same economic concerns that faced domestic deals. Nevertheless, some things have happened. RWE of Germany announced a deal to buy American Water Works right on the heels of September 11. The RWE press release discussed the company’s commitment to the industry and to the U.S. What better way to show it than to go out and do an $8 billion deal! After evaluating all of the economic and political uncertainties, the company pushed forward with the deal. M&A: Periodically we hear that restructuring is over, only to see a resurgence soon after. What is the situation now? Will divestitures be a strong force in the market going forward? Berger: I think they will. They are smaller deals, and less of a huge bet than a transforming merger would be – which tends to make these deals easier to get done. But divestitures still are subject to prices being down, and corporate buyers often don’t have to sell. So they can wait until the market improves to get a better price. For buyers, it may not be a make-or-break bet but they still are making a potentially meaningful bet on how they feel about that in the economic environment. Rimland: Competition in divestitures is down a little bit because we used to have a much stronger financial buyers market with financing in place. Now they have a tougher financing challenge, which means some divestitures will go to strategic buyers at reduced prices. Selig: I think strategic buyers are more likely to take the initiative on approaching divesting companies than financial buyers. Financial buyers are having a harder time coming up with the capital to provide for a purchase price that is likely to be attractive to a seller. But one interesting result has been that historically the financial buyers provided, if nothing else, the valuation basis. So before a large corporation might move on divesting a division or subsidiary – which obviously can be very distracting to the company and the last thing that they would want to do is fail – it would know that it could get at least a price of “X” because that would be algorithmically what a financial buyer could pay. Now the financial buyer is unable to pay that, which increases the risk of failure in terms of not being able to get an acceptable purchase price. That has caused a number of corporations to not embark on the divestiture process in this environment. Rimland: Financial buyers are still looking for value in it as well. In a commoditized financial market in which a lot of equity is being put into deals, they are looking for “their” edge -sometimes related to an existing portfolio company or past experiences in the same industry. M&A: How are your firms responding to the current market? What is happening internally? Are you hiring people? Foussianes: Internally, we are focused on making sure that we are structured appropriately to keep the right resources dedicated to our clients so that we can service them effectively and build long-term relationships. These companies may not be doing as many transactions right now, but when they do, we expect that we will be right there advising them. Rimland: We are working with our clients to navigate the difficult environment in the marketplace. Clearly, the buyers are getting much better deals in this market. It is a much tougher story for sellers. I don’t think we have seen as many bad and distressed restructurings as we saw through the last cycle when we had major companies doing massive restructurings in the context of bankruptcies. Selig: Bank of America has a combination of an investment bank and a commercial bank, so we are dealing with this environment by both trying to advise our clients and to provide financing to help them achieve their strategic objectives in this difficult environment for raising external capital. We strongly believe that those things that have driven m&a over the past 10 years are likely to continue for some time. Those drivers include the importance of critical mass. The market continues to reward companies with higher P/Es and higher multiples that are perceived to have critical mass and scale in their markets. Other drivers are the continuing globalization of businesses, the high cost of technology, and the importance of being part of industry reorganizations as they unfold. We think that while there will be a temporary pause, there is not likely to be anything longer than that and not likely to be a cessation of m&a activity over a long period of time. We are spending a tremendous amount of time with our clients so that they will emerge from this period well positioned in their respective industries to capitalize on opportunities. Berger: Presumably, we are all long-term optimists on the business, or we wouldn’t be here today. However, the difficult market environment makes all businesses reevaluate their structure, and m&a is no different. There is always a question of how a firm’s m&a effort should best be organized. And there is an ages-old debate about whether m&a should be its own separate group or whether m&a bankers should be part of industry groups. Different firms have answered this question in different ways, and have changed their minds over time. We believe in having an m&a group that is its own group, while working intimately with our industry groups.