Deal Making in an Era of Uncertainty

By Doug Mitman and Trent Myers
From The Business Journal: ACG Mergers and Acquisitions
August 2009

In an M&A review article from a year ago ("M&A in 2008: Strategic Buyers Emerge as Deal Activity Picks Up"), Steven Booth and Trisha Hansen of Robert W. Baird & Co. described how tight credit and bearish market sentiment had driven down both the dollar value and number of M&A transactions since the beginning of the year. Middle-market transactions – deals valued at $1 billion or less – were holding up better than one would have been expected from reading the headlines, with strategic buyers in particular picking up synergistic acquisitions at what appeared to be bargain values. The environment was challenging, but manageable, and there were signs that the second half of 2008 might be better than the first.

But all that occurred before the Lehman Brothers bankruptcy in mid-September, the first in a chain of events that led to the brink of a general loss in faith in the entire financial system. In the fourth quarter of 2008, there was literally no place to hide, as nearly ALL asset classes underwent significant declines in value. The M&A markets were no exception, and many deals already in progress were delayed, repriced, or in some cases cancelled outright. Many would-be sellers simply froze up, believing it was better to do nothing than risk bringing new assets to market in a period that many analysts were comparing to the opening phases of the Great Depression. Not that it would have made much difference, because credit for deals wasn’t just tight, it was unavailable, since banks – even those receiving cash infusions from the federal government’s TARP program – horded cash as a reserve against so-called “toxic” assets whose balance sheet values had become difficult, if not impossible, to determine.

Since then, the environment has improved. The stock market has rallied, and sellers have returned cautiously to the market. But, there’s no question that the M&A world has been fundamentally altered, and doing deals now is much more difficult than it was just a year or two ago. Both buyers and sellers accept that new economic realities have driven purchase price multiples lower, but significant challenges remain concerning other components of valuation, in particular the recovery and visibility of future earnings, and the availability and pricing of transaction financing.

The uncertain timing of earnings recovery from depressed levels appears to have caused many to delay taking companies to market. “Finding deals and getting them financed are the two major challenges,” says Paul Sweeney, Principal, PS Capital Partners, LLC. “With the exception of special circumstances, you do not see a lot of sellers who are desirous of getting liquidity at depressed valuations.” John Emory Jr., President and CEO, Emory & Co., agrees: “The price expectations of many sellers have come down somewhat over the past year. However, seller expectations are still generally higher than the market will bear, and most sellers realize this and have decided to wait until their earnings improve before trying to sell their companies.”

Depressed earnings are not the only factor impacting valuations in today’s market. Projecting financial performance, never easy even in good times, is especially difficult now given the fragile state of the economy and the extraordinary volatility in the stock market. Buyers and sellers have reacted to the uncertainty in different ways, with buyers wanting to mitigate their risk and sellers either factoring in a quick recovery in earnings or wanting to give more weight to average profitability over the past few years.

“The most significant challenge for buyers and sellers is the lack of revenue and earnings visibility,” according to Ron Miller, Managing Director, Cleary Gull Inc. “Many companies have very little perspective on either their near-term or long-term performance. As a result, it is more difficult to agree on a price and for lenders to agree to finance.”

“Buyers are focusing on future projections and visibility versus historical performance,” adds Linda Mertz, Managing Director, Mertz Associates, Inc. “And the general lack of good visibility is directly impacting a buyer's willingness to pony up cold hard cash today for something that may or may not happen tomorrow.”

Creative ways of structuring a deal and alternative financing have become more common as means to reconcile the diverging perspectives of buyers and sellers. Ron Miller comments: “To bridge valuation gaps, the use of seller notes and earn-outs is increasing. These tools are also being utilized to share economic risk in these uncertain times.” Stan Johnson, President, Anderson/Roethle, Inc., highlights the importance of buyers and sellers maintaining flexibility: “Being ‘creative’ means to us that both sides have to be willing to give and be flexible. We define a ‘fair’ deal as one in which each side gets ‘most’ of what they want.”

Beyond the issue of pricing and valuation, financing is cited by almost all advisors as a major obstacle to structuring and closing a deal. Until recently, the banking environment was so competitive that transaction financing of up to six times EBITDA, with relatively unrestrictive covenants, was not uncommon. Now, you are lucky if you can borrow two and half times EBITDA, and “covenant lite” is a thing of the past. Lou Banach, Managing Director, Schenk M&A Solutions, describes the new lending environment as one of new found discipline and risk aversion: “Finding the right senior lender for a deal is often paramount to leveraging a reasonable return to the buyer. Uncertainty surrounding asset values, regulatory concerns and liquidity at large financial institutions continues to limit their lending activity. Financing is available for smaller transactions and can be found in the community banks and super-community banks. These banks will exhibit discipline through an asset-based structure, lending as a percentage of assets rather than based on projected cash flows. Lending banks will expect an appropriate risk / reward trade-off or higher loan spreads with interest rate floors, real financial covenants and personal guaranties.”

The impact of more restrictive lending is felt most by private equity firms, whose business models are based on using leverage to magnify returns on equity. Prior to 2008, credit was cheap and plentiful, and private equity groups were competitive with strategic buyers for high quality acquisitions. That has now changed. Strategic buyers, especially those with strong balance sheets and a willingness to look for synergistic plays among distressed assets, have an advantage. As Linda Mertz states: “There is no question that corporations with a well developed strategy, money and management talent have an absolutely wonderful opportunity in today’s environment. Proactive buyers can generate very interesting deal flow and end up with interesting alternatives they never would have had just a year ago.” These views are echoed by Peter Kies, Managing Director, Robert W. Baird & Co.: “Changes in the financial world have shifted the relative buying power toward strategics. Credit market restrictions have had a bigger impact on financial buyers, which historically have used leverage to cover over half of total deal consideration. In addition, the amount of equity required by lending sources to fund leveraged transactions has increased from approximately 33% in 2008 to 40% - 45% in 2009. Furthermore, although private equity firms have a record amount of unallocated capital (estimated at $400 billion), the pace of investment has been slowed by the lack of high quality sell-side opportunities in the market, greater focus on portfolio companies, current challenges in fundraising, and concerns about the liquidity of limited partners during the economic crisis. By contrast, though M&A activity is also down among strategic buyers, companies with ample cash and strong balance sheets have been able to augment growth through acquisitions at lower multiples due to less competition from financial buyers.”

The recovery of M&A, in terms of valuation and the pace of activity, to the levels seen in 2007 will take significant time, and will depend on the sustainability of the economic recovery, continuing improvement in the credit markets, less volatility and a clearer direction in the public equity markets. And there are looming macro-economic issues that could negatively impact M&A activity: higher corporate and capital gains taxes, record government deficits, the strength of the dollar, and the future direction of interest rates, to name just a few.

Despite all this, now may not be such a bad time to sell a business. The opportunity to reinvest proceeds in the stock market at attractive price levels and potential tax savings may offset the benefits of waiting – perhaps for a long time – for market values to recover. According to Lou Banach, “The benefits of diversification and tax savings may make this a better time to sell than two years from now. Market timing is at best difficult, but over the next twelve months an opportunity exists to reinvest company sale proceeds and perhaps catch the stock market on the upswing. Many sellers expect capital gains taxes to increase in 2011, perhaps even higher than the currently scheduled increase to 20%.”

Banach goes on to say that closing deals today requires patience and flexibility: “The key to successful acquisitions now are well-capitalized buyers, prepared sellers with reasonable expectations of price, flexible terms and structures (which may include seller financing and earn-outs) and the right lenders for the opportunity. Successfully bringing these parties and elements together requires increased patience and skilled advisors to help structure and execute complex business transactions.” On that point, it appears that most of the M&A world agrees.