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Down but Not Out

M&A activity has plunged in 2009, but recent deals suggest it may be poised for a comeback.
Russ Banham, CFO Magazine
October 1, 2009

In August, Beckman Coulter Inc. pulled off a minor miracle: it acquired another company. The $3.6 billion maker of biomedical testing equipment completed the $780 million acquisition of the lab-based diagnostic business of camera maker Olympus, which wanted out of the life-sciences space. Even more amazing than the fact of the deal was how it was structured. "We were able to finance the whole deal, which is unusual in the current economic environment," says Beckman Coulter senior vice president and CFO Charlie Slacik.

Far more typical these days is Inovis, an Atlanta-based B2B software provider that racked up four acquisitions prior to the recession and none since. "Without an equity infusion from the two private-equity funds that own us, we cannot make an acquisition off our own balance sheet," acknowledges Inovis CFO Ken Williams. "While they still have ample funds to lend and invest, they've increased their target internal rate of return to 30% and higher. Sellers, meanwhile, are holding to very high sell points. The combination is just killing deals."

Inovis is just one of many wallflowers at what used to be the biggest party in business. Globally, total merger-and-acquisition transaction volume was down 47.4% in the first half of the year compared with the same period in 2008, while corresponding deal values were down 43.6%, to $705.7 billion, according to Mergermarket. Deal values declined by an even sharper margin in the United States, a stunning 85% dip from July 2008 to July 2009 (to $23 billion), notes Dealogic.

Although the economy shows signs of improvement — slowing unemployment numbers, increasing manufacturing output, a rising stock market — M&A activity remains lackluster. In July, Goldman Sachs CFO David Viniar predicted transactions would increase in the second half of 2009, but as of September, a boom had yet to manifest itself. (Viniar was unavailable for comment.) "No one wants to buy a company when the bottom still isn't clear, and no one wants to sell a company for less than they think it is worth," notes David Hinkel, senior consultant at Towers Perrin, where he is a member of its senior leadership team for corporate transactions.

Still, like Beckman Coulter, some well-funded companies are finding deals that are too good to pass up — Disney's $4 billion acquisition of Marvel Entertainment and Baker Hughes's $5.5 billion merger with BJ Services closed August on a note of deal-making optimism, and September saw Kraft mulling a hostile bid for Cadbury. Some companies have been able to make acquisitions that bolster their product lines and market presence while more-cautious competitors remain on the sidelines, waiting for a rebound in the economy and the credit markets.

Massive Debt Coming Due
The dearth of credit, of course, has been a deal killer for many companies, and for private-equity firms in particular. Private-equity firms typically leverage their acquisitions, and right now prevailing credit terms, conditions, and covenants don't favor a deal. "The private, classic leveraged buyout won't come back until the credit markets come back," says James Rosener, managing partner at New York–based law firm Pepper Hamilton and a member of its international M&A transactions team.

Private equity alone is shouldering more than $400 billion of debt that needs to be paid off before 2014, money borrowed to buy companies in the M&A heyday of 2005–2007. In just the next two years, $21 billion of this debt will mature, according to Standard & Poor's. "Debts done with 'covenants lite' two years ago will be financed with a lot tougher terms when the markets reopen," predicts Rosener. That may make private-equity firms — the gorger at the last M&A feast — more choosy about what they put on their plates, if not keep them away from the table altogether. (U.S. private-equity firms still have plenty of "dry powder" or uncommitted capital at their disposal, more than $600 billion by one recent reckoning.)

This leaves the pickings to strategic dealmakers, companies that buy other companies for complementary or synergistic reasons. But the credit squeeze is pinching them, too. "Liquidity is a major issue for many companies," says Ronald Basso, partner and co-chair of the corporate finance group at law firm Buchanan Ingersoll & Rooney. "They may need to amend their credit agreement with a bank, and, for companies that already have good pricing in their agreements, this is a risk. If they go forward they risk being criticized — doing a deal when they needed to conserve cash to last out the recession."

Is the Price Right?
Uncertainty about deal prices is also keeping otherwise acquisitive companies from shopping. "The issue is valuations — the confidence that you're getting what you think you're getting," says Matt Toole, director of the deals intelligence group in the investment banking division of Thomson Reuters.

Buyers "want to be sure they acquire companies that provide a return to shareholders, and they can't predict that now," notes Adena Friedman, CFO and executive vice president of corporate strategy at Nasdaq OMX Group, where she rode herd on the stock exchange's mergers with OMX and INET. "We don't know when the recession will end, what will happen to inflation or pricing, or when demand will come back. If you can't model these things, it is hard to determine the right price for the asset you want to buy."


The uncertainty is afflicting sellers, too. "Unless a target is deemed to be truly distressed and therefore literally has to sell, most companies are reluctant to sell because they believe the valuations on their current and future earnings are too low," says Basso.

"Sellers are holding on to assets in the hopes they'll be worth more once the recession ends," agrees Chris Gaffney, managing partner at private-equity firm Great Hill Partners. "It's the same thing we saw in 1991 and 2001, where the values had declined and companies were reluctant to part with [the assets] until the values returned."

Gaffney adds that the postrecession "new economy" is making would-be acquirers cautious. "Buyers are trying to figure out what the new game is — where they should park their money in the new economy from an acquisition standpoint," he says. "They're still trying to sort this out." Toole adds: "Companies are asking, 'Will this business model work in the new economy?' Since they can't decide one way or the other, it's a game of wait-and-see."

Still another reason why potential buyers are hesitating may be FAS 141(R), a new merger-accounting rule that may require ongoing fair-value testing of acquired assets and liabilities, and disclosure of the findings. Forty-four percent of executives polled in a recent Deloitte Webcast say they have changed their M&A deal strategies in response to the new rule.

Too Tempting to Resist
Yet some companies are making deals despite the recession — and profiting from them. In a Towers Perrin study of 204 global deals from September 2008 to the end of May 2009 having a transaction value of $100 million or more, three-quarters of the acquirers have since outperformed their nonacquisitive peers by an aggregate 6.3%. Defying the conventional wisdom that mergers destroy shareholder value, "the study indicates that companies forging ahead with transactions have picked up bargains and seen better returns than those not doing deals at all," Hinkel says.

In the case of Beckman Coulter, Tokyo-based Olympus made an offer that the U.S. company couldn't refuse. "We weren't looking to make a transaction to spur our growth, but Olympus came to us with a wonderful synergistic business at a great price," says Slacik. "To shore up their balance sheet, they made the proactive decision to get out of the health-care business and to focus on consumer electronics. Hospital diagnostics is all we do, so it was a great fit."

Beckman Coulter financed the deal through the issuance of two $250 million senior note offerings and a $260 million common stock offering. "It took a lot of work with the rating agencies, and I was on the road for many weeks visiting with potential bondholders and stockholders," the CFO says. "I was able to demonstrate the synergistic nature of the deal, that it wasn't a risky game-changer, just basic blocking and tackling — two consolidating businesses that would take cost out. That got them comfortable. On the day the stock was issued, our stock price went up and has held steady since."

Buyers with cash to spare can also gobble up weaker players. Publicly traded Radware's acquisition of Alteon is a case in point. The Tel Aviv–based integrated application delivery provider purchased the application-networking unit from Nortel for $18 million, a distant cry from the $7.8 billion Nortel originally paid for Alteon in 2000. "We've been cash-flow positive quarter after quarter and still have another $150 million to make more acquisitions," says Radware CFO Meir Moshe.

Radware was focused on a synergistic acquisition that "wouldn't require us to adopt a different business, appeal to new customers outside our comfort zone, or train new employees," Moshe says. "We wanted to buy someone in our own space to drive shareholder value through increased sales." Buying Alteon effectively doubles Radware's client base to more than 10,000 customers — not bad for a trifling $18 million.

Like Radware, Corning has built up a sizable cash war chest to invest in acquisitions. "In our businesses we have either hit bottom or are rising from it, giving us confidence in our outlook, unlike others that are waiting out deals because they face huge economic uncertainty," says Jim Flaws, CFO of the specialty glass and ceramics manufacturer ($5.6 billion in 2008 revenues). "We have a reasonable handle on the economy and where we're going. Every one of our businesses had a sales increase in the second quarter."

Corning's cash position makes the company less dependent on the credit markets for midsize deals. It also learned valuable lessons from the previous downturn in 2002, when the telecom bubble burst. "We decided then that we wanted to be prepared for the next downturn, whenever it came, by building up a significant amount of cash," Flaws explains. "We've done that, and have almost no debt coming due short-term. We're prepared to do deals now and we have the money to do them."

So what is he waiting for? "The valuations are higher than we think they should be," he says. "There were some companies we were interested in acquiring a few months ago, but the valuations were more than what we thought appropriate. Now they're lower and likely to get lower still."

In his sights are life-sciences companies that manufacture disposable products for general drug testing, as well as organizations with complementary product lines like optical fiber, hardware, and equipment. "I just asked our board this morning for its approval to make an offer," Flaws said in August, declining to divulge the company's name. "They approved the deal. Now I have to find out if the seller likes the offer."


A Confidence Game
What will it take for other companies to start shopping again? A revival of the credit markets is essential. "Lenders have to come back into the market deep enough to create a vibrant trend," says Hiter Harris, co-founder and managing director of Harris Williams & Co., a midmarket investment bank in Richmond, Virginia.

Rosener of Pepper Hamilton concurs: "There is still a tremendous amount of private-equity money out there. When the credit markets rebound, they'll be back in the game. They need to grow, too."

More-practical valuations of seller properties would be another plus. "Most deals never get better than the first offer, because sellers are holding on to sell points that are too high," says Inovis CFO Williams. "Even if the debt markets come back, there is still a significant overvaluation of companies. Sellers need to have more-realistic exit valuations."

Acquisitions remain key to Nasdaq OMX's long-term growth, says finance chief Friedman, and the less uncertainty involved, the better. "As future income streams become more predictable across our industry," the company will be better able "to model out potential strategic combinations," she says.

Perhaps the biggest icebreaker is buyer confidence. Consultant Hinkel says two more quarters of positive earnings by large companies, in addition to continuing good news about employment and manufacturing output, will thaw the market. Attorney Basso agrees, while cautioning, "One quarter of solid earnings does not a recovery make."

"People need to feel there are no more shoes about to drop, and that we've hit bottom and are climbing out," says Duff Meyercord, partner at merchant bank Carl Marks Advisory Group. "Only then will potential buyers have the confidence to move forward."

Russ Banham is a contributing editor of CFO.




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