Volatile stockmarkets, depressing economic data and frigid credit conditions are not the best backdrop for mergers and acquisitions. It is hardly surprising, therefore, that M&A activity has come to a virtual standstill in recent weeks.
Private equity buyers, who were the mainstay of the M&A world for the best part of this century, have all but disappeared and corporates are deeply uncertain about the future.
As Gavin MacDonald, global head of M&A at Morgan Stanley, explains: “Markets are pretty glacial at the moment.”
Corporate financiers have no hesitation in explaining the slowdown.
“There are three key points at play in today’s marketplace. First, if you are thinking of selling, why would you do so now, unless you absolutely have to? Second, if you are looking to buy, why would you do so now, given the lack of clarity about business activity? And third, funding is almost completely unavailable, at least this side of Christmas. There is a premium on doing nothing,” says Robert Leitao, managing director at Rothschild.
The prevalence of private equity players in the M&A market had two important consequences. Transaction values were driven up because firms had plenty of access to cheap money so they could afford to offer generous prices for companies. And deals were primarily concluded for cash.
Now the situation is markedly different. Private equity buyers are conspicuous by their absence; credit is in desperately short supply and, even when it is available, it is a lot more expensive than a year ago.
“The days of accessing capital for 75 to 125 basis points over Libor are gone,” says Mr MacDonald.
Even A rated corporates are having to pay several hundred basis points over Libor for loan transactions, while B rated corporates and private equity firms are virtually barred from the debt markets.
“Corporates with access to funds do have to ask themselves if deals make sense when borrowing costs are at 7% to 8%,” says one corporate financier.
Club deals
Banks are also nervous of dishing out large sums of money. Syndicated transactions are rarely sighted and club deals have become the preferred form of lending.
“Banks are reluctant to lend more than £25m [$38m] to £50m each, which means that large deals are extremely difficult to do. Corporate credit is slightly more popular but even a well-rated corporate would struggle to do a deal of more than £1bn at the moment,” says Mr Leitao.
Falling equity prices do not help the situation either. Much like homeowners, many company boards grew used to believing their businesses were worth a certain sum. Now they are finding it hard to accept new, lower valuations.
“When the cycle turns, there is always a discrepancy between the expectations of buyers and sellers,” says Mr Leitao.
This is compounded by uncertainty about the future. Vendors find it hard to predict how their business will fare in 2009 and potential acquirers are reluctant to pounce, for two reasons: they hope to be able to offer less next year and they are unsure about their own prospects.
This does not mean, however, that M&A has gone into complete hibernation. Certain deals are being done, certain deals are in the pipeline and many more are under consideration.
The banking sector has been particularly active. Deals include the bailout of Wachovia by Wells Fargo in the US, the merger of Brazilian titans Itaú and Unibanco, and the proposed rescue of British bank HBoS by Lloyds TSB.
Many more transactions have either been completed or are under way in this industry but they all have one thing in common. Each deal is motivated by necessity. These banks need to club together because of the need for strength to the market place. Government money has been poured into the sector but it is not enough. In some cases, distressed banks are being supported by stronger peers. In other cases, banks are clubbing together in the hope that joining forces will deliver a larger balance sheet and a swathe of cost-cutting efficiencies.
Most corporate financers believe financial institutions will continue to provide them with a reason for getting up in the morning throughout 2009. And, as Sir Peter Burt and Sir George Mathewson’s bold proposal to keep HBoS independent makes plain, there are even remnants of audacity left in the market.
“The industry is going through a complete restructuring. We have seen the beginnings of it but we haven’t yet seen the end,” says one investment banker.
Reconfiguration
Where banking has led the way, others are expected to follow.
“M&A is likely to fall into three main categories over the next few months. Defensive mergers, sales of non-core assets and industry restructuring,” says Andy Ryde, partner at international law firm Slaughter and May.
“In defensive merger situations, vulnerable companies will try and be proactive by cuddling up to someone else rather than wait around like sitting ducks. Some may also hope that merging with another party will detract attention from any trading problems they may be experiencing,” he adds.
Sales of non-core assets are also expected, as a way of raising capital without having recourse to the lending market. And certain industries, of which banking is a prime example, may undergo radical restructuring.
“Many companies, particularly if they are highly leveraged, are thinking about how they will refinance their debt when it comes up for renewal. Even if their debt falls due in 2011, they will begin thinking about it next year and, if the economy is tough, they will want to plan well in advance. Banks are keen to delever, terms are tighter and companies are going to be thinking hard about how they will pull through. This could lead to takeovers or large equity injections,” says Nigel Meeks, head of M&A at Deutsche Bank.
Small and mid-cap companies have been particularly exposed to tumbling valuations and this could throw up a variety of opportunities (see Team of the Month, page 22).
“Small-cap valuations have fallen so much that in relation to mid-cap businesses, they look very attractive on a strategic basis,” says Graham Shore, chief executive of Shore Capital.
Liverpool Victoria, for instance, a British cash-rich mutual life assurer business, bought Highway Insurance for £150m. The price represented a 47% premium to Highway’s share price in August but the company’s stock had fallen sharply in the months leading up to the takeover.
“Deals that are half-way between M&A and recapitalisations are likely to be a feature of 2009 as well,” says Mr Shore.
If a company had a market capitalisation of £200m and borrowings of £500m last year, it may well find that it is worth a few million pounds on the stock market and the value of its debt has probably fallen to 80% or 90%. That means the enterprise value may have declined from £700m to £450m, which makes it a very attractive proposition, says Mr Shore.
“The need for cash may also drive smaller capital-intensive businesses into the arms of larger peers. Junior oil and gas businesses, and small miners may have great prospects, but they need money to fund exploration and production. If they can’t raise capital from the banking market, they may get taken out by larger businesses in their sector,” he adds.
Some bankers believe current conditions will pre-empt a return to more old-fashioned M&A methods.
Trade Buyers’ market
| “Over the past decade or so, the market has been dominated by financial buyers. In auctions, 80% of the bidders were private equity players. Now trade buyers are going to be more dominant and transactions will have more equity in them and less debt,” says John Llewellyn-Lloyd, chief executive of investment banking at Noble. |
“For vendors, this makes a lot more sense in this environment because it means even if they are selling at the bottom, they have the chance to share in any upside,” he adds.
Mr Llewellyn-Lloyd points out that market activity is constrained in most parts of the world, not just in the depressed economies of Europe and the US. But he cites the Gulf as one region where M&A could continue to take place. “There is huge liquidity in the Gulf and many industries are looking to consolidate so companies need to merge to create large, powerful corporations,” he says.
Several Asian and Middle Eastern sovereign wealth funds have had their fingers badly burned over the past year, buying stakes in Western banks whose share prices have subsequently plummeted. Nonetheless, they may still be on the look-out for interesting situations in the US and Europe.
“If they can see good opportunities, they will come in, as they did with Barclays, for example,” says Mr MacDonald.
In fact, the opportunistic approach is expected to prevail in every jurisdiction.
“Distressed M&A will become more prevalent over the next year, for sure. Also infrastructure, utilities and other industrials where there is good visibility are likely to attract interest, possibly from the Middle East or strong, local companies,” says Mr Ryde.
Private equity alive
Even private equity is not completely dead in the water. Paul Marson-Smith, chief executive of mid-market firm Gresham, suggests good deals with a strategic logic are still do-able.
He says: “Vendors think private equity is a busted flush but banks are still willing to make capital available. You just have to be more creative and less process-driven. You can’t just price off a book and a data room. You need to listen to all stakeholders and you need really strong banking relationships.
“But there are some fundamentally sound businesses around that happen to be in the wrong place, owned by cash-strapped parents, for example. These can provide excellent investments and banks will lend against them.
“The next few months are not going to be easy but caution and creativity are the key words.”
