PwC: Sour Economy Sparks Divestitures

Companies will soon spin off and carve out more pieces of their empires, finance execs say.
Marie LeoneOctober 20, 2009

Each of the Big Four accounting firms has scrutinized the corporate divestiture market over the past three quarters and has come up with largely the same conclusions. The divestiture market, they say, is outpacing the mergers and acquisitions market in general. More distressed businesses are on the block. Deals are more complex, and therefore take longer to complete. And the woefully stagnant global economy has created a corporate buyer’s market, at least for now.

The most recent survey from the Big Four came Tuesday from PricewaterhouseCoopers. PwC reports that 60% of the 215 C-suite executives it polled say that a slowdown in divestiture activity over the past 12 months may lead to a “pent-up need to divest” assets as the economy improves over the coming year. Further, the same percentage of executives conclude that current economic conditions “clearly” make it a buyer’s market — with an equal number of public- and private-company executives thinking that way.

Completed in September, the PwC survey includes CFOs and investment-firm partners of both public and private companies. In general, the survey indicates that the future of the economy’s anemic condition and tight credit conditions “remain significant unknowns” for executives involved in the divestiture market. But 69% of them plan for either a similar or increased level of buying or selling activity in the coming year in comparison to the past 12 months.

Another 30% see a turnaround coming and note that a seller’s market isn’t far off. Still, PwC says the results should be viewed with “cautious optimism,” because difficulties in the divestiture market persist. Valuations remain “a moving target” and therefore will continue to constrain mergers and acquisitions, according to the firm.

In fact, 90% of the respondents place the value-expectation gap between buyers and sellers in 2009 as between 0 and 4 turns of EBITDA (earnings before interest, taxes, depreciation, and amortization). With a turn representing 1 multiple of EBITDA, the value-expectation gap represents the disparity between what buyers and sellers calculate as the value of a business. For example, if a business is valued by a seller at 8 times EBITDA based on prior market conditions and current buyers value the same business at only 4 times EBITDA, the disparity between the buyer’s and seller’s valuation would be 4 EBITDA turns, or a 50% value gap.

PwC officials assert that as long as the M&A market stays stagnant, “getting deals done will likely remain a challenge,” adding that “there is no debate that a valuation expectation difference of potentially 50% will likely be a deal breaker for most transactions.”

Overall, 35% of the respondents say they delayed or deferred divestitures this year because of economic conditions. Similarly, 26% of those polled report reduced divestiture activity. Many respondents blame the delays on the increased complexity of the divestiture process, with 51% of respondents reporting that it took 20% longer to close a deal this year than last.

The slower closes were caused by potential buyers’ demands for more information before inking a deal. Indeed, buyers have more leverage in deal negotiations in a sagging economic climate, but protracted deal making is also a result of lenders imposing stricter — and therefore more time-consuming — lending requirements on transactions. What’s more, buyers likely are performing more in-depth due-diligence checks because of the added risk brought on by underperforming businesses that are up for sale.

Private-company executives claim that finding a buyer is their most difficult divestiture task, while their public-company counterparts say executing a separation is their number-one snag. To be sure, in a stagnant economy the burden is on the seller to illustrate how the carve-out is likely to operate independently from its corporate parent before buyers will agree to a deal.

Nevertheless, 18% of the executives report an increase in divestiture activities, with more public-company executives saying they were buying and selling businesses than private company executives. PwC says this trend may suggest that public companies are more likely to continue making decisions regarding business strategy despite tough economic cycles because they are spurred on by shareholder demands and available capital.

Looking ahead, a robust 69% of the executives either expect to increase divestiture activities (39%) or forecast activity to remain the same (30%) in 2010. Less than one-third of the respondents expect to reduce or defer activity next year. Executives say that behind the increase in divestiture activity is “the desire to sell off noncore or non-performing business,” which is consistent with what PwC found when working with clients who were revaluating the efficacy of acquisitions made in the past decade.

However, an increase in divestitures depends on economic recovery, according to 87% of the executives polled. Further, U.S.-based corporate buyers are expected to be the main participants in the 2010 market, according to 56% of the respondents. Based on PwC field experience and the survey results, the buying activity is likely to be strategic, to help companies fill in business gaps, suggesting that private equity will not play as big a role in acquisitions as it has in the past, given the continued tight credit markets, adds PwC.

In its August report on divestiture activity for the first half of the year, Deloitte notes that “unlike the overall M&A market, divestiture volumes have remained strong in 2009.” For example, divestitures in the first two quarters of the year accounted for more than 30% of all M&A volume, compared with 27% during the same period in 2008. That deal volume, according to Deloitte, was driven by asset sell-offs to “help stabilize balance sheets,” as well as a move to jettison noncore businesses.

But the size and relative value of the deals in 2009 have decreased. For the 12-month period ending June 30, global divestiture volume reached 12,000 deals, and was consistent with 2008 numbers. But while deal volumes were down about 5% in Q2 of 2009 compared with Q2 of 2008, deal values were down 50%. However, Deloitte points out, both volume and value are strengthening if Q2 2009 is compared with the first quarter of the year.

Deloitte also reports that distressed divestiture volumes hit new highs during the first half of the year, reaching a historic 81 distressed divestitures, an 80% increase over the first half of 2008. Deals contributing to that record-breaking six months included Fiat SpA’s acquisition of Chrysler, Systemax Inc.’s acquisition of Circuit City, and Farmer’s Insurance Group’s acquisition of AIG’s personal auto-insurance unit.

The financial sector drove much of the distressed divestiture activity, coming in at nearly 700 deals — a 50% increase over the first half of 2008. During that spurt, OneWest Bank Group acquired the banking operations of IndyMac Federal Bank from the government, and UBS Investment Bank picked up AIG’s Commodity Index Business.

In April KPMG released details of a survey it conducted in conjunction with The Deal that polled 270 M&A professionals. According to that report, 50% of the respondents claim they were currently “in the market for distressed businesses or assets,” with 12% noting they would be potential sellers.

But more than half of those polled say they didn’t plan to complete any divestitures this year, while 33% planned between one and two divestitures, and 9% expected to complete three or four divestitures before the year is out. What’s more, the enterprise value of the divestitures was also expected to be small, with 79% of the KPMG respondents figuring the average value of their 2009 divestitures to be $250 million or less.

During the first quarter, Ernst & Young released its M&A report, a survey produced with the Economist Intelligence Unit, a sister company of CFO.com. That report polled 360 senior executives, who say the sour market conditions would prompt more divestitures than last year. The divestitures, according to E&Y, were being driven by the need to raise cash “either for defensive reasons or to redeploy capital to acquisitions.” Either way, buyers with cash had a “rare opportunity” to acquire businesses that would not normally be on the auction block, and grab the assets at lower prices than in recent years.

Sellers, on the other hand, will become more innovative, E&Y predicted then. With acquisition funding scarce and private-equity buyers waiting for the market to stabilize, sellers will choose to become more creative and seek out joint ventures, partial sales, and earnouts and fund them with alternative-financing arrangements involving equity, debt, and vendor arrangements. In fact, the E&Y report predicted sellers would probably need to pursue several divestment options at once in order to have “the greatest chance of achieving their objectives.”