The Great M&A Rebound

Over the last several years, merger and acquisition (M&A) volumes have declined at a precipitous rate. Scores of investment bankers have lost their jobs and recent history is littered with failed and under-performing transactions that have tarnished M&A as a viable strategy.

But looking ahead, multiple trends are in play and will serve as a foundation for a rebound in M&A activity during the next six to 12 months.

Increased Capital Markets Liquidity

Junk-bond financings have increased sharply as issuers look to take advantage of historically low interest rates and investors seek out higher yields. Through May, $44 billion of below-investment grade debt has been issued. This is the highest year-to-date (YTD) issuance since 1999 when $47.8 billion was issued over the same time frame.

For 2003, full-year issuance volume could be $100 billion and best 1999’s record of $87 billion.

The evidence to date has been that most of the junk-bond financing proceeds have been used to repay bank debt or extend maturities of existing facilities. These bank-loan pay-downs will eventually trigger a loosening of the overly tight credit underwriting standards as banks need to grow loan assets to maintain their own top-line revenue growth.

The increases in capital markets liquidity and bank lending will provide support for greater deal activity by facilitating, rather than impeding, in those cases where sellers insist on cash over stock as the sales consideration. Buyers will have greater flexibility on pricing transactions.

Currently, banks are reluctant to lend more than 2.5 to 2.75 times trailing EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). In order to fund the total purchase price, buyers have been faced with increasing their equity contributions or seeking out higher-priced mezzanine debt, which can negatively impact buyer returns.

Lenders’ willingness to fund higher levels of senior debt will help close the gap on pricing as tight credit underwriting standards have made it difficult for buyers and sellers to reach agreement on price.

Sarbanes-Oxley

Most of the attention generated by the Sarbanes-Oxley law has been focused on the burdens and complexity that the law adds to the overall corporate governance process. One less noted effect is the law’s impact on owners of private companies formulating an exit strategy.

These owners are increasingly skeptical about the feasibility of an initial public offering (IPO) as an exit vehicle since an IPO exit strategy by definition includes compliance with Sarbanes-Oxley provisions. Public companies face increased investor scrutiny, difficulty in finding directors and higher compliance costs that provide no bottom-line benefit.

The attractiveness of being a public company is further undermined by the substantial cutback in research coverage for small cap stocks. Therefore, owners contemplating an exit strategy for their business will be more inclined to favor an M&A transaction over an IPO.

Reinvestment Opportunities Under the New Tax Law

The cut in the capital gains rate will have some marginal impact on seller decisions. However, the larger opportunity is created by the reduction in the tax rate on dividends. Private company owners will have the ability to sell their company and reinvest the after-tax sale proceeds in a diverse basket of dividend paying stocks.

The dividends received will only be taxed at 15 percent instead of the ordinary income rates. The seller diversifies its investment risk across a broader portfolio and achieves a greater after-tax income stream due to this reduction in the tax rate on dividends.

The combination of a cut in the capital gains tax rate and the lower tax rate on dividends will be a tipping point for many sellers.

Supply and Demand

These three trends will serve as a foundation for increased M&A activity but increases in transaction volumes will require a rebalancing of the transaction demand and supply. On the demand side, private equity firms are estimated to have $100 billion to $125 billion on the sidelines ready to invest.

The tightening of bank underwriting standards over the last several years has impacted these buyers. However, the primary constraint has been the lack of a supply of good quality companies. The supply has been constrained by sellers’ reluctance to accept lower valuations and desire to avoid the appearance of having to sell.

The supply side of the equation will come into balance over the next six to12 months. The increased supply will be driven by a number of factors. Private company owners will increasingly favor an M&A transaction as the primary exit vehicle and the recent rebound in the stock market puts some upward pressure on valuations.

The increased scrutiny of corporate governance practices and the transparency of financial reporting are causing larger complex companies to reconsider their overly expansive business operations. These actions will precipitate further sales of business units as these larger companies look to pare down their diverse operations to support a more investor friendly image.

Additional supply will be driven by private equity firms looking to exit pre-1999 vintage investments. Longer hold times will negatively impact general partner and limited partner returns. Private equity firms need to create exits to generate cash returns to limited partner investors.

On the demand side, strategic buyers need to buy revenue growth and make smaller strategic acquisitions to fill in gaps in product lines or geographic coverage. After spending the last several year’s reducing expenses in response to revenue declines, there is little left to cut and well-executed acquisitions can augment weak organic growth. Companies are reluctant to add expenses without better assurance of the durability of the revenue.

A strategic acquisition provides a more certain means to increase top line revenues. This added demand from strategic buyers would also put upward pressure on valuations as financial and strategic buyers compete for acquisition targets.

Over the long term, M&A will continue to be a viable business strategy and an important element in reallocating capital. Sophisticated buyers and sellers have learned from the excesses of several years ago and will identify, structure and close better deals premised on detailed and not cursory due diligence.

For those companies contemplating the development of an M&A strategy whether as an expansion strategy of an exit vehicle, this is an excellent time to start developing the strategy and best position your company to take advantage of the underlying changes that will lead to increased transaction volume in the near term.

Jack Bradley is president of Bingham Strategic Advisors LLC, a subsidiary of Bingham McCutchen LLP in Boston. Bingham Strategic Advisors provides M&A advisory services. Jack has more than 23 years experience in commercial and investment banking. He has advised clients in various industries and has consulted clients on numerous cross-border transactions.