Industry Watchers Expect Uptick in M&A Activities

Distressed sales and increased activity within key market sectors are expected to breathe new life into the stalled mergers and acquisitions (M&A) environment during the second half of 2009.  However, industry watchers caution that ongoing troubles within the financial markets coupled with uncertainty over how quickly and to what extent the economy will recover in the near-term will continue to impact deal flow and value.

“Many M&A professionals believe there will be an uptick this summer, if uncertainty about the economy declines.  Although the economy might still be bad, if participants have a better feel about where things are headed, then M&A activity should resume, especially for those looking to purchase distressed companies at bargain prices,” said William H. Venema, a member of the Business Law practice of Epstein Becker Green Wickliff Hall, P.C.’s Texas office (www.ebglaw.com).

He notes that companies are primarily looking for “bargain prices” in their acquisition targets and adds that “deal provisions such as warranties, indemnification provisions and earn outs are definitely changing to reflect a shift to a buyer’s market.  Also, mega deals that are financed with lots of debt are unheard of.  Middle market deals, where debt financing is less important, have not suffered as much.”

ACG M&A Survey Reveals Opportunities, Obstacles

Venema’s comments were echoed in the Association for Corporate Growth (ACG) Thomson Reuters Mid-Year 2009 DealMakers Survey released in May.  The latest twice-yearly survey revealed the most negative outlook in its five-year history, with 88 percent of dealmakers saying the current M&A environment is fair or poor, compared to 86 percent in December 2008.

However, 56 percent of the middle market investment bankers, private equity professionals, corporate development officers, lawyers, accountants and business consultants who participated in the survey expect the number of M&A transactions to increase, while 34 percent expect it to remain the same.

An expected uptick mergers within the healthcare and life sciences, manufacturing and distribution and financial services sectors was one reason for the optimism.  Most, however, expect distressed sales to comprise a significant percentage of transactions throughout the remainder of 2009.

Nearly one-half predict that distressed deals will comprise one-quarter to one-half of all deals, while 39 percent say they will make up one-quarter or less and 14 percent say they will make up the majority of all M&A activity.  Likewise, more than one-half of private equity respondents are pursuing acquisitions of distressed companies, either as part of an already existing or newly adopted strategy.

The survey also indicates that the credit crunch remains the greatest obstacle to M&A activity, albeit not as severe as in December.  It was blamed by 33 percent of respondents vs. 43 percent in December.  Also faulted were sellers unwilling to sell at multiples offered (27 percent today vs. 22 percent in December), and the weak economy (17 percent today vs. 16 percent in December).

“The M&A environment is clearly stalled, but there is a growing sense that we are at or near the bottom,” said ACG Vice Chairman Dennis J. White, senior counsel with McDermott, Will & Emery LLP.  “The anticipated increase in activity will be led by sales of distressed companies to bargain-seeking private equity firms and strategic buyers.  Deal normalcy will have to await a genuine loosening of the credit markets and an overall improvement in the economy.”

Middle Market Down but Not Out

According to Thomson Reuters, the volume of all worldwide mergers and acquisitions totaled $480.3 billion in announced deals during the first quarter of 2009, a decrease of 28 percent over the first quarter of 2008.  Of this total, M&A deals in the mid-market (transactions under $500 million) fell 48 percent from the first quarter of 2008, totaling $98.3 billion.  The first quarter 2009 total marks the first sub-$100 billion quarter for mid-market M&A since the first quarter of 1996.

Some expect that middle market number to rebound, primarily due to an increase in sales under Section 363 of the U.S. Bankruptcy Code.  Section 363 allows asset sales, which are generally faster and less complicated than sales of assets by troubled companies outside of bankruptcy.

“I think the middle market is just seeing the beginning of the default wave, which will result in increased bankruptcy filings,” said Michael A. Fixler, managing director, CM&D  Capital Advisors LLC (http://www.c-m-d.com/capital_advisors.php), a Detroit-based affiliate of CM&D specializing in investment banking services primarily for middle market companies.  “The restrictive terms contained in DIP financings, to the extent it’s available, will force companies to complete the proceedings much more quickly, which will make reorganizations more difficult and result in more 363 sales.  There will be opportunities to purchase companies at attractive valuations.  Additionally, there is some liquidity in the lending markets, albeit at more expensive pricing and more conservative underwriting.  As this continues to loosen, M&A activity will increase.”

However, Fixler points out that multiples remain low and will stay that way until there is more availability of financing, cash flow lending in particular.  Buyers are also conservative and skeptical of companies’ performance, which contributes to low valuations.

Too, because of the state of the financial markets, buyers are having to increase the equity components of purchase prices.  Sellers are also finding it increasingly necessary to finance some of the purchase price in order to complete the transactions.

There are attractive opportunities out there, however.  Fixler notes that there are also instances where a business combination is the best solution for two underperforming companies, resulting in a combined enterprise that is stronger and better able to survive the economic downturn – a front he predicts will not see much change through the end of the year.

“It will take longer than that for the financing markets to return to more normal levels,” said Fixler.  “Further, consumer and business spending will be a major driver to turnaround many businesses.  Many companies have been cutting expenses in light of the economy, but revenue continues to be a problem and this is true beyond the retail sector.  Until there is more stability in the economy and buyers are more confident about the recovery, buyers will continue to be conservative on valuations.  Without it, buyers have to price in the risk that the economy gets worse and/or takes longer to recover.”

Kenneth H. Marks, ACG member and managing partner with High Rock Partners, Inc. (www.highrockpartners.com), a Raleigh-based boutique strategy and investment banking firm, concurs.

He notes that the valuation expectations of middle market sellers, defined as those with $10-250 million in revenues, have not reset relative to “the appetite or ability of private equity groups to leverage and purchase.”

Marks, who co-authored Handbook of Financing Growth: Strategies, Capital Structure & M&A with fellow High Rocks managing partner and president of ACG’s Research Triangle Chapter, D.L. “Sonny” Williams, adds that there is little senior debt available except for the very best deals.  And for the deals that are getting done, overall total debt/EBITDA multiples in the middle market are down approximately 1 turn to ~2.4x, and senior debt/EBITDA is down ¾ turn to ~1.9x.

It is “somewhat of a bar bell effect,” he said.  “On one side, the distressed deals are getting done because they must and on the other end, the very best companies are able to attract buyers at good prices.  The companies in the middle find themselves unable to attract the buyers at the desired, or historical, prices, so they are waiting or can’t get a deal to the table.”

According to Marks, second lien financing, Tranche B and other forms of junior debt that were primarily provided by hedge funds are gone.  Senior lenders have also reduced the amount they are willing to lend, creating a gap in the financeable and selling value of a company.

“Using mezzanine debt to fill the gap creates too great a cash burden on the target company, so it’s tough to get deals done.  Some private equity groups are starting to fund the gap themselves with equity for a while with plans to refinance when the credit markets improve,” he said.

Marks adds that deal flow is up for asset based lenders, which is causing a backlog and delay in completing some transactions.

And while getting deals done is slow, there are opportunities “for stronger players in the market to acquire competitors with balance sheet issues, basically good companies with financial problems,” he said.  “Some venture funds are having to rationalize their portfolios and shed businesses that they can’t afford to continue funding.  This creates buying opportunities for strategic consolidations or expansions.”
 

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