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No Big Deal

The credit crunch may have knocked the blockbuster out of favor, but middle-market M&A remains quite healthy.
Karen M. Kroll, CFO Magazine
October 1, 2007

When Citrix Systems Inc. announced its $500 million deal to buy XenSource Inc. in August, it seemed to be bucking a trend.

By most accounts, the merger-and-acquisition market had turned ice cold. After a superheated first half in which total North American deal values hit $1 trillion at the end of June, the subprime lending scandal suddenly dried up credit markets. The pace of M&A plunged from its weekly average of well over $50 billion; by the last week of August, not a single $2 billion deal had been announced.

But Citrix finance chief David Henshall wasn't deterred in his push to make his company a bigger player in desktop and server virtualization-software markets, which have doubled in each of the past two years. By buying XenSource, Citrix became the only vendor offering both datacenter and desktop virtualization software — and gained sharply on industry leader EMC Corp.

"It's an early, emerging market. We want to quickly become the number-two player," says Henshall. "When companies see a deal as highly strategic," he says, "short-term financial metrics tend to take a backseat to strategic importance."

A closer look at the deal numbers bears out that assessment. Despite the precipitous drop in blockbuster M&A and the near-disappearance of big private-equity buyers, middle-market deals show surprising strength. And if only one or two proposals worth $2 billion are now reported each week, transactions below that level have continued at a rate of just under 40 a week (see "Stronger in the Middle" at the end of this article).

Strategic acquirers in particular have continued to find and close attractive deals. "Strategic deals are less affected by the turbulent market, and more are proceeding on schedule," says Matthew Spain, managing director with UBS AG.

Cash Remains King
While private-equity buyers often depend on leveraged buyouts or complex syndications, midmarket strategic acquirers tend toward simpler, all-cash deals about 56 percent of the time, according to FactSet MergerStat LLC, which tracks global dealmaking. Some recent midmarket transactions have involved companies blessed with healthy cash positions or that prepared for deals by arranging for good financing terms. And stock-for-stock mergers remain an option.

"Strategic acquirers will clearly have an easier time than financial buyers in getting bank backing," says Bob Hotz, cochair of Houlihan Lokey and co-head of its corporate finance group. Companies can support their midmarket deals with evidence of revenue and cost synergies, he says, while financial buyers often can point only to anticipated cash-flow increases from the combined properties.

Midsize companies are also nimbler in adjusting to market conditions. In August, Darden Restaurants Inc., owner of Olive Garden, Red Lobster, and other chains, planned to buy Rare Hospitality International Inc., operator of LongHorn Steakhouse, for $1.4 billion in cash. By obtaining a $1.2 billion senior interim and $700 million senior revolving credit facility, says CFO Brad Richmond, "Darden had its interim financing in advance of the volatile market situation, which we anticipated to some degree."

As in the Citrix case, Darden provided compelling merger reasoning — at least to the bankers and companies involved. LongHorn Steakhouse and the other Rare brands provide Darden customers with additional casual-restaurant options to go with Red Lobster, Olive Garden, Bahama Breeze, and Smokey Bones. "They want variety," Richmond says, "and we're better able to capture growth opportunities in the casual-dining market." Currently, Darden estimates, customers visit one of its restaurants seven or eight times a year. And the company has gained a good reputation for brand building, especially at Olive Garden, where the theme of "When you're here, you're family" has caught on.

Darden, with more than 1,400 restaurants already, believes it can boost supply-chain management in the operations at Rare, which has about 300 restaurants. "We have expertise in meeting the logistical challenge of making sure frozen, refrigerated, and dry goods all arrive at the restaurant at the right time," says Richmond.

Caution: Problems Ahead
That's not to say that the sudden chill in the overall merger environment had no impact on midsize transactions. The Citrix-XenSource deal was done without bank financing and came together in a period of several weeks, says Henshall. But Citrix's stock price fluctuated with the rest of the market. Just a week before the announcement, for example, it fell 16 percent during one brief span. That made it challenging to set the number of shares needed to reach the $500 million deal consideration.

While Citrix gains valuable technology, XenSource gains immediate access to Citrix's 5,000 channel partners. "XenSource was small, with great technology," Henshall says. "It needed a way to get to market faster."

Similarly, RF Micro Devices Inc. had a relatively easy time of it with its purchase of Sirenza Microdevices for about $600 million in stock and $300 million in cash, also in August. RF Micro already had raised $375 million in low-coupon debt financing, giving it "the fire power" for the acquisition, says CFO Dean Priddy. As he watched the credit markets dry up, the company was able to speed up the acquisition, he adds.


The deal provides RF Micro access to a wider range of customers and markets for its radio-frequency products. Previously, the company's customer base consisted of the leading cellular-handset providers. Conversely, Sirenza supplies several thousand companies in both consumer and industrial markets, such as cable-television and aerospace firms. Priddy believes Sirenza can now leverage its stronger infrastructure and pull away from its competitors, most of which lack this scale in manufacturing and research.

Another factor aiding smaller deals is the drop in deal premiums resulting from the withdrawal of private equity from its dominant first-half position in M&A. On midmarket deals, now being done without private-equity competition, average premiums dropped from around 35 percent to 26 percent in the second quarter, according to MergerStat. Such reductions may be difficult for target companies to swallow. But they are a big attraction for midsize acquirers.

Citrix's Henshall believes that the credit crunch will affect midmarket deals more in the near future, although "the impact will be muted." UBS's Spain thinks that midmarket dealmaking will hold its own for a while — until another run by private equity reignites all of M&A. Financial buyers still have billions in their coffers and need to put it to work, he says.

For now, he suggests that corporate finance chiefs watch today's low valuations and stay aggressive. Says Spain: "Look for strategic opportunities presented by the current turmoil."

Karen M. Kroll is a freelance writer based in Minnetonka, Minnesota.





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