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Tight credit markets plus a down economy add up to a buyer's market.
Kate O'Sullivan, CFO Magazine
June 1, 2008
Economic gloom abounds these days, but there is one ray of sunshine: the mergers-and-acquisitions market. Companies have more acquisition opportunities now than a year ago, when deep-pocketed private-equity firms dominated the scene and steep valuations kept many companies on the sidelines. "For a strategic buyer, this is the best time in two years to be buying," says Nick Chini, managing principal at Bainbridge, a consulting and M&A advisory firm.
Valuations are returning to earth as the economy slows and private-equity buyers retreat, says Chini. True, the deep freeze in the credit markets has sharply curtailed deals north of $1 billion or so. But for transactions under $500 million, "there is plenty of capital, especially for strategic acquisitions," says Chini. Moreover, companies that can access the debt markets will enjoy favorable interest rates, thanks to the Federal Reserve's many rate reductions in the past year.
Not all industries have bargains, though, and not all sellers will be eager to settle for lower prices. And given the uncertain economic outlook, companies must proceed with caution. Acquirers should evaluate their own financing needs before embarking on a shopping spree, making sure they can fund their operations even if traditional financing becomes difficulty to find, warns Jeff Horwitz, partner at law firm Proskauer Rose LLP. "Liquidity is king now," he says.
As any savvy shopper knows, just because something is cheap doesn't mean it's a worthy purchase. A target's strategic fit with the acquirer is as important as ever, says J.D. Sherman, CFO of Akamai Technologies, a Cambridge, Massachusetts-based Web infrastructure company. "Don't let bargain-basement prices change the fundamentals of your acquisition strategy," he says.
"The trick is in understanding what you need, and at what price you will walk away," says S.L. Narayanan, finance chief at Symphony Services, a provider of software engineering services based in Palo Alto, California. This may be standard advice, but it is particularly germane now, he says, because "when valuations are down, it can be especially tempting to look around."
Thorough due diligence and rigorous downside-scenario planning are also critical in a market where some sectors have yet to touch bottom. "CFOs have to be prepared for a deeper downturn than they may currently be expecting," says Robert Filek of PricewaterhouseCoopers's transaction-services group. "You don't want to make a major strategic move and be surprised by a worse short-term economic picture than anyone expects." Given the dwindling competition for deals, acquirers may be able to negotiate longer time frames for due diligence than before, when auctions dictated strict timetables.
In their due diligence, finance teams should put assumptions about synergies to the test and understand the target business from an operational perspective, not just from a financial viewpoint, says David Williams of Deloitte's Financial Advisory Services practice. "Many companies approach due diligence by dotting the i's and crossing the t's," he says. "Instead, I would focus all of my time making sure the strategic value is there."
Tough market conditions will be unforgiving of deals that are a bad strategic fit, making it hard for buyers to successfully integrate them or realize the projected benefits. As an extra precaution against an ongoing down market, Narayanan suggests building in a "margin of safety": a 3 to 5 percent premium over the target hurdle rate.
Holding Out for More
Despite the severity of the downturn, not all industries are witnessing sinking valuations. In some, like health care and energy, deal multiples are still climbing. Chini cites a recent deal in the energy business that closed at a multiple of nine and a half times earnings before interest, taxes, depreciation, and amortization (EBITDA); a year ago, he says, it would have sold at eight or nine times EBITDA.
Richard Arnold, chief operating officer and CFO at Phoenix Technologies, says the portable-computer market, which is the company's largest customer segment, is growing at a compound annual rate of 30 percent. "We don't see any weakness at all in our market," he says. Still, Phoenix was recently able to buy a portfolio company from a venture-capital firm even as the target was in the middle of raising a new round of financing from its backer.
"Three or four years ago, those VCs would never have let go of this asset," says Arnold. "In today's environment, they are just a little more willing to take the risk out of their portfolio by cashing out." Indeed, strategic buyers might consider approaching attractive targets that have turned down offers in the past; this time around, they could receive a warmer reception.
But many prospective sellers, conditioned by years of deal mania, haven't adjusted their valuations to the new market conditions, observes Akamai's Sherman. Indeed, some may decide to hold out for a higher price when the market improves, says Narayanan. "I think you'll see a lot of overtures by potential buyers," he says. "But what is realistic and what is doable is driven by the seller's level of desperation — or the lack of it."
Although many private-equity buyers have moved to the sidelines, U.S. companies face competition from overseas. Spurred on by the dollar's weakness, many international companies are looking to expand their stateside presence through acquisitions. "Foreign buyers are saying, 'Hey, the United States is on sale,'" says attorney Horwitz of Proskauer Rose.
Some foreign companies are getting what amounts to a 10 to 20 percent discount on deals simply because of their currency's relative strength against the dollar, which has sunk to record lows against the euro in recent months. Bainbridge's Chini says he has seen numerous Indian and Chinese companies enter the market for U.S. deals, particularly in the technology and health-care sectors. Sovereign wealth funds, pools of investment capital managed by governments, could also play a role, although they typically tend to focus on large targets, according to Chini.
Tight credit, shaky markets, and new competitors notwithstanding, the current M&A market may provide companies with an opportunity to emerge from the downturn stronger than before, particularly if they focus on less-risky small and midsize deals that build on their core businesses. "There are hidden gems out there that they can get on the cheap," says Deloitte's Williams.
Finally, a silver lining.
Kate O'Sullivan is a senior writer at CFO.
Tips for doing a deal in a down market
Look for bargains, but maintain discipline on strategic fit. In today's uncertain environment, CFOs should look to build on their core business with well-priced acquisitions of close competitors or complementary businesses, not unplanned expansions into new areas.
Do more due diligence than ever before. "In this economy, you really have to understand the health of the companies you're looking at," says Robert Filek of PricewaterhouseCoopers.
Model downside scenarios carefully. Forecast results based on a recession that lasts even longer than you expect.
Be aware of your own liquidity needs before you start pursuing deals. As the credit crisis continues to unfold, bank financing could be hard to come by.
Know your market sector. Some industries are still pricey and will require strong bids. "Some sectors are continuing to climb as if there were no credit crisis at all," says Nick Chini, managing principal at Bainbridge. — K.O'S.