M&A financing: Prudence takes a bow

According to a December 2009 survey by the Boston Consulting Group (BCG) and UBS, corporate appetite for mergers and acquisitions (M&A) is surprisingly healthy. One in five companies plans to buy a business with sales of more than €500m in 2010, including nearly one in two large companies with market capitalisation in excess of €20bn. Based on the overall results of the survey, BCG and UBS anticipate that M&A transaction values in 2010 will be about 20% higher than in 2009 - bringing the M&A market almost back to the level of activity in 2005. This implies a much faster recovery than in the early phases of the last M&A wave.

However, most transactions are likely to be 'horizontal' consolidation deals, says the report M&A: Ready for Liftoff? These are typically smaller, lower-risk acquisitions than the transformational deals the market had got used to in its heyday, evidence of a lingering caution about recovery and a hangover from the financial crisis.

And, while opportunism and the desire for growth will drive corporate deal volumes, prudence is also shaping financing structures. The survey revealed that 42% of companies preferred the idea of financing an acquisition out of existing cash or operating cash flow.

Equity is also playing a more prominent role. When cement company Holcim announced that it would acquire rival Cemex's Australian assets in mid-2009, the company's decision to fund the acquisition by raising additional equity capital was another clear example that conservatism is the name of the game in M&A.

In addition, Holcim - which has never before done a 100% equity-financed transaction - raised more money than it needed in order to preserve its liquidity and protect its credit rating. This is a sure sign that, right now, while such opportunistic acquisitions are increasingly likely, companies with more conservative capital structures and deals with less leveraged financing are more likely to get the go-ahead. Shareholders, instead of worrying about dilution, are participating.

"If an acquisition makes strategic sense, then shareholders are happy for the company to raise equity in order to finance it," says Peter Guenthardt, head of equity capital markets (ECM) EMEA at UBS.

Peter Guenthardt, head of equity capital markets (ECM) EMEA at UBS

Calculating costs

In addition to more cautious financing, the hurdle rate for what constitutes a good acquisition will also be higher. For the moment, valuation calculations will not be based on achieving synergies. If a transaction still adds up on that basis, then it will be judged to have a lot of upside built in. "Economic recovery is very patchy, and while there is still a lack of visibility - in terms of corporate order books and earnings, etc - most investors see it as too dangerous to go into a deal at 4x to 5x leverage with the promise to organically delever. If a deal only stacks up because of leverage, it is unlikely to get done," says Mr Guenthardt.

Berkshire Hathaway's loud criticism of Kraft's bid for Cadbury shows that investors are keeping a sharp eye on shareholder value. Led by Warren Buffett, Berkshire has made it plain that it believes the deal is a bad one - carrying high reorganisation costs and expensive deal fees, and forcing the sale of another business to pay for it.

Others, too, will be keen to make sure CEOs only pursue carefully financed deals.

In the wake of the financial crisis, there is much greater focus on the role of boards in tempering executive ambition - and this could put the brakes on pricing. Board members will be asking difficult questions before any acquisition gets approval. "Corporate executives will have to justify the price they're paying, the capital structure they want to put in place and the projections about the business going forward," says Marisa Drew, co-head of the global markets solutions group in EMEA and co-head of debt advisory and restructuring at Credit Suisse.

However, Holcim's 100% equity deal is unlikely to set the trend. "Deals will not be as equity heavy as we might have thought they would be three to six months ago," says Alasdair Warren, head of European ECM at Goldman Sachs. "While there will be many more cases where equity is a meaningful proportion of financing, very few will be 100% equity financed."

Indeed, more debt-financed deals, even in the non-investment grade sector, are already being done. For example, in November last year, US cable operator Liberty Global partly pre-funded its acquisition of German cable TV and radio company Unitymedia through a €2.5bn high-yield bond issue - using Unitymedia as the issuing vehicle; putting the proceeds into escrow until the deal got regulatory approval.

"The corporate world remains relatively cautious - with many expecting a bumpy ride in 2010 - but we are undoubtedly seeing the progressive return of risk appetite and innovative financing structures," says Paul Staples, head of corporate finance at BNP Paribas.

"We are experiencing a more benign borrowing environment, with clients now judging carefully what reliance to place upon the loan market as compared with capital markets-funded deals. Liberty Global's financing for the purchase of Unitymedia last November, while perhaps a one-off package, showed what could be done through the reopened high-yield market."

Leverage will be increasingly available - especially for the better credits - although most agree that it will remain relatively low. Market participants haven't yet forgotten the dark days of the financial crisis. When Liberty Global realised there was so much demand for its high-yield bond - the first major European deal where high-yield bonds have usurped bank loans to fund an acquisition - the company went back to underwriters to ask if the company could raise a little more debt in order to reduce its equity cheque. For investors, however, that was a step too far.

"In the Unity transaction, we experienced investors being very disciplined to hold the line on leverage," says Credit Suisse's Ms Drew.

But with private equity expected to return in 2010, leverage is on the rise. "As we progress through the first half of the year, we will see more private equity activity, including secondary buy-outs. The appetite by big banks to underwrite deals is coming back faster than many people anticipated - and while leverage will not be as aggressive as at the height of the market, it is returning," says Mr Warren, noting that Goldman has already underwritten three or four big leveraged buy-outs.

Marisa Drew, co-head of the global markets solutions group in EMEA and co-head of debt advisory and restructuring at Credit Suisse

Deal dynamics

Others agree that M&A financing will be shaped by private equity's return to the table. With funds replenished following the raft of exits anticipated from portfolio companies in Q1, market participants are waiting for financial sponsors to begin bidding for assets - and that could have a significant impact on deal dynamics.

"The big question is how the return of private equity will impact strategics' deal-making power and their approach to pricing," says UBS's Mr Guenthardt. "We are unlikely to see the same level of leverage that we did at the height of the markets any time soon, but when competition for assets heats up, it may force companies to rethink their conservatism on price and financing. Will they be forced to use more debt to be competitive on price to secure a deal? Strategic buyers may have to weigh up whether they are willing to lose an asset in order to maintain a conservative funding structure."

The predicted increase in private equity acquisitions is a signal that now may be the moment for corporates to step into the M&A market.

If sponsors can exit portfolio companies as expected in the first half of the year - and corporates look keen to take advantage of any reasonably priced assets that come to market - then the era of conservative financing could be over by the second half of 2010.