Lessons from Adversity

The split personality of 2007 dealmaking, with its dramatic highs and lows, could teach a few things about M&A in the year ahead.
Avital Louria HahnJanuary 1, 2008

When London-based National Grid agreed in 2006 to a $12 billion deal for East Coast energy giant KeySpan, National Grid CFO Steve Lucas couldn’t have known that lending markets would collapse in mid-2007 — just a few months before his merger closed. But the design of the terms proved so prescient that he could be credited with a hint of omniscience.

As a hedge against the evaporation of then-prevailing easy credit, Lucas skipped the customary financing for such all-cash deals, which involves using bank credit facilities and issuing long-term debt to pay them off after the close. Instead, National Grid issued $7.5 billion in bonds ahead of time. “Not only did we minimize our risk, we also saved a ton of money,” says Lucas, estimating that between $300 million and $500 million was sliced from its interest rates and bank fees. Even now, he adds, “National Grid would like to do further value-enhancing deals in the U.S.”

Of course, deals did unravel — something that was sure to happen as the M&A landscape took acquirers “from Goldilocks to The Perfect Storm,” in the words of Lee LeBrun, co-head of M&A in the Americas at UBS Securities. If the confluence of problems started with the subprime-mortgage crisis and resulting tumble in credit availability, he says, the stock-market correction and the plunge in the dollar’s value quickly compounded the problem.

But in some ways the experience of buyers during the challenging 2007 M&A market — superheated at first, then severely chilled at midyear — bolsters the argument that many companies are doing deals better even as they face adversity. Through November, U.S. deals approached $1.5 trillion, leading some experts to suggest that when the economy slips, companies step up the quality of dealmaking. That could augur well.

“What we tend to see with the M&A market is higher returns for deals done in down markets,” says Jeff Gell, co-head of M&A for The Boston Consulting Group (BCG). Even LeBrun expects overall deal activity to fall less than 20 percent from last year, mostly reflecting the squeeze on private equity that won’t ease until the more than $200 billion in leveraged-buyout debt is sold. The heightened activity by cash-paying U.S. strategic buyers will continue to be augmented, he says, by foreign investors drawn to the weak dollar.

Indeed, a recent UBS report declared: “The current M&A wave is far from over,” as cash-paying strategic buyers step up, replacing some of the dealmaking done last year by private-equity players.

The New Advisers

The volume achieved in such a tumultuous year confirms that M&A has become an accepted tool for corporate growth. Such acceptance may have been in doubt as recently as 2000, when the AOL/Time Warner miscalculations and WorldCom and Tyco International scandals, among others, gave acquisitiveness a bad rap.

With improvements in corporate governance, though, certain “serial shoppers” — General Electric, Cisco Systems, and Oracle among them — have enhanced their reputations for doing value-producing deals. And internationally, companies like National Grid, which counted KeySpan as its sixth U.S. acquisition since 1999, refined systems for valuing deals, completing them cost-efficiently and integrating targets effectively.

The success has shown up in value-creation measurements. Management consulting firm McKinsey & Co. used a “deal value added” index to compare market capitalization immediately before and after an announced transaction, and found that — to Wall Street, anyway — the increase in value has been steadily climbing to a current level of 10.6 percent last year, from 2.1 percent when the research started in 1997.

Some credit may go to two relatively new variables in the M&A equation: the elevated oversight of boards in corporate decision-making and the greater influence of shareholder groups that have value-creation as their central goal.

“You see a noticeable change in the role of boards,” says Bob Filek, head of transaction services at PricewaterhouseCoopers (PwC). Directors these days often hire their own M&A advisers to get a view independent of management. And certainly the ousting of Merrill Lynch CEO Stan O’Neal for unilaterally exploring a deal with Wachovia is a prime example of boards’ rising power.

As for pressure from investors, that’s seen in the thousands of hedge funds, pension funds, and private individuals that have sought to influence managements — especially in encouraging a deal, or objecting to one that has been proposed. As 2007 was ending, hedge fund Pardus Capital Management, for example, was making headway in pressing Delta Air Lines and United Air Lines to create the world’s largest carrier by merging, in one of the more visible examples of the trend. While activists may seem like flies in the ointment, evidence suggests that their positions enhance M&A value, in addition to ratcheting up dividends and squeezing executive compensation, according to a recent BCG report.

Further, says PwC’s Filek, companies have been performing more-thorough due diligence, and starting the process earlier. In fact, these days due diligence often begins well before signing the letter of intent. New technology tools for valuing, analyzing, and integrating deals also are helping companies improve their acquisition record, he says.

Cash and Consolidation

The continuing movement toward cash-only deals in 2007 was also a positive trend in the eyes of M&A advisers because of the higher return compared with stock deals; cash is also associated with lower premiums. According to research by UBS, most deals in 2000 were for stock, and the price paid above actual market capitalization was 35 percent on average. In the first three quarters of last year, meanwhile, premiums held below 25 percent, according to Thomson Financial.

In the current economic environment, companies almost certainly will use cash for acquisitions more often, although they will probably also tap the stock they’ve built up during the massive buybacks in recent months. Studies have determined that in the recent period of low capital spending, larger companies have accumulated cash on their balance sheets to the tune of $800 billion — equal to 10 percent of their market cap and about twice the historic rate. “Corporate-side [M&A] should stay strong, if not get stronger,” says BCG’s Gell. “And over the next 5 to 10 years, the companies that [spend] the most [in buying companies] are the ones that will grow the most.”

With PE deals having sharply receded in last year’s second half, strategic buyers may find a relatively open field for deals that advance the consolidation of their industries. Globally, Gell finds the regulatory environment more conducive to allowing such combinations, with antitrust concerns fading somewhat. And, he notes, industry-consolidating deals tend to generate substantial cost savings.

Certainly, global consolidation has been a theme in the natural resources sector. Fueled by an insatiable demand in China for raw materials, a range of commodities are now trading at all-time high prices. As 2007 ended, the world’s biggest M&A drama involved Australian mining concern BHP Billiton’s hostile $140 billion bid for London-based Rio Tinto, which itself had snapped up Canadian aluminum-maker Alcan for $43 billion during the year. (Experts suggest, by the way, that the larger the size differential between buyer and seller, the more the potential cost savings, but the harder the integration. That would augur less well for a BHP-Rio transaction, because the two companies have market caps of $206 billion and $136 billion, respectively.)

As 2008 unfolds, bankers also see more consolidation ahead for energy, financial, health care, information technology, and consumer-products companies. And much of it could involve overseas companies buying U.S. firms. “With the dollar down and the euro up, many of the large European players think power plants in Europe are overvalued. They see opportunity in the U.S.,” says Dean Maschoff, vice president at CRA International’s energy and environmental practice. Foreign acquirers like Iberdrola likely will compete with private-equity competitors for deals, he says.

For now, private-equity players are hampered by overhang of unsold LBO debt, which in addition to the weak credit markets is keeping them on the sidelines. If private buyers do regain their strength, they could target the utilities sector. Last year’s $44.4 billion purchase of Texas utility TXU by a Goldman Sachs–led investor group proved that such deals can be successful — if the buyer engages in early negotiations with legislators and environmental groups to bridge any divides that arise. Private buyers are likely to remain keenly interested. Indeed, private equity’s war chest is still enormous, at about $250 billion, according to some estimates.

In the near term, though, strategic buyers will continue to face less competition from financial players for targets, even if the amount of foreign money flooding into U.S. deals increases. Last year’s retreat by private equity was dramatic indeed. Because private investors left the field, deal volume fell 68 percent in the third quarter compared with the second quarter. But select fourth-quarter deals like IBM’s $5 billion purchase of Cognos suggested a renewed interest in software consolidation among cash-rich acquirers, and could kick off similar deals.

Says PwC’s Filek: “Sophisticated corporate buyers see this as a relatively limited time frame, when there are probably fewer competitors for properties, and they can make sensible, strategic acquisitions.”

Avital Louria Hahn is a senior editor at CFO.

Breaking Up Was Easy to Do

If private-equity buyers seemed to attack their acquisition prey with abandon as 2007 began, the midyear retreat from the market revealed evidence of a distinctly more cautious side: the low “reverse” breakup fees they wrote into their deals.

When Cerberus Capital Management withdrew its $4 billion buyout bid for United Rentals, for example, the target lost 37 percent of its stock value. Cerberus, meanwhile, was tagged with a $100 million fee that was a mere 2.5 percent of the deal’s value. If J.C. Flowers & Co. and the private-equity group it leads are allowed to withdraw from their deal with SLM Corp., as the private-equity firms propose, their payment to the Sallie Mae college lending operation would be $900 million — representing less than 4 percent of that $25 billion transaction. In the months after the bidders said they wanted to pull out, SLM lost 36 percent of its market capitalization.

The low breakup fees to the jilted target — called “reverse” because the normal fee is designed to remunerate the suitor when a target withdraws — were designed that way to allow an easy escape for conservative private-equity players.

But unhappy targets may have learned from these expensive withdrawals. Going forward, “reverse breakup fees may be larger because there is more downside for the public company to not get acquired than [for] the buyer being topped,” says Lee LeBrun, co-head of M&A, Americas, at UBS. — A.L.H.

To see a list of the top 20 deals of 2007 that targeted U.S. companies, click here.

U.S. M&A approaches record levels, 1998–2007