M&A Trends in Today’s Turbulent Credit and Economic Market
Corporate & Finance Alert
December 2, 2008
The recent credit bubble with easy access to cheap credit and excessive debt leverage produced a robust Seller’s M&A market with Seller friendly M&A agreements and premium prices for targets. These market conditions fueled the M&A market to historically lofty levels in terms of volume and number of transactions and peaked in the third quarter of 2007. The credit-crunch (which began during the third quarter of 2007) and the current worldwide economic downturn has dramatically impacted the M&A landscape. This article will summarize the market trends resulting from this reversal and identify M&A paradigm changes and preemptory actions which may be necessary for Buyers and Sellers to effectively close M&A transactions in today’s turbulent credit and economic market.
Overall M&A statistics for the initial nine months of 2008 as compared with the end of the third quarter of 2007 show a dramatic decline of roughly 40% in the number of completed transactions. Large public company leveraged buyouts sponsored by private equity firms (LBO) declined from 26.2% of total M&A deal value to 6.5% which is directly attributable to systemic credit issues limiting the ability of large institutional lenders to move LBO loans off their balance sheets to the secondary market. As a result, lenders have imposed stricter leverage ratios with total debt to EBITDA ratios declining to 4.1 down from 5.2 for the third quarter of 2007 with a corresponding increase in average equity contribution per transaction to 44% as compared with 33% for the same prior period. Strategic acquisitions by well capitalized companies, mid market deals (under $250 million) and cross border transactions with US targets showed greater resilience with declines less than the declines in the overall M&A and LBO market. However, the deteriorating stock market and credit issues in October and November, 2008 has produced only 139 M&A deals in November, of which 129 were strategic acquisitions, as compared to a monthly average of 250 total acquisitions for the rest of 2008. This trend is likely to continue well into 2009.
Today’s tight credit markets require deal sponsors to invest more equity per transaction with less borrowed capital. This has caused a rationalization of target valuations and expectations of Sellers with average enterprise value (purchase price/adjusted EBITDA multiples) showing a decline of 10% from the third quarter of 2007. This market adjustment, coupled with the frozen credit markets, has shifted deal and negotiating leverage from Sellers to Buyers with the following M&A market trends likely to occur:
- Greater percentage of purchase price consideration paid in cash/stock of Buyer rather than from proceeds of debt financing.
- More Seller take-back financing, retained equity or purchase price earn-outs to satisfy declining lender leverage ratios and to bridge Seller valuation/purchase price expectations.
- Post closing purchase price adjustments to reflect adverse changes in pre-closing net working capital or post closing EBITDA results secured by post closing escrows.
- Extended due diligence periods to enable Buyers and lenders to “drill down” for unforeseen effects of the current economic slowdown.
- Return of traditional “financing out” condition to Buyers based on credit market turmoil with fewer “reverse breakup fees” for middle market transactions.
- Specific quantitative material adverse change benchmarks to enable Buyer to “walk” from transaction without liability in the event financial and business conditions of Seller deteriorate after signing M&A agreement.
- As the result of recently litigated deals, clarity in drafting M&A agreements to provide certainty on the remedies of the parties if the deal is terminated, eg., no specific performance rights for failure to close for any reason. Litigation may increase for busted deals or closed deals that do not perform to Buyer expectations.
- Tighter Seller representations and warranties subject to qualifications, based on quantitative criteria rather than subjective “materiality” exceptions and longer survival periods for Seller indemnifications, reduced “baskets”, “caps” and “collars” on indemnity claims and escrows or other security devices to secure Sellers’ indemnification obligations.
- Acquisition debt financing based on reduced leverage ratios, rigorous underwriting requirements and strict financial loan covenants. Lender imposed re-pricing of loans or other economic considerations in exchange for covenant waivers and a flight to quality by lenders in terms of collateral with less cash flow and more asset based lending. Sub-debt lenders may seek to fill the void left by senior lenders by requesting partial security with traditional higher sub-debt pricing.
- Decreased opportunities for Bankruptcy acquisitions pursuant to a reorganization plan due to scarcity of debtor-in-possession financing which will result in more piecemeal liquidations rather than sales as a going concern. More opportunistic minority equity investments in distressed companies to cure loan covenant defaults (eg., net working capital, fixed charge coverage ratios and other financial covenants) without triggering a change of control event of default in lieu of an acquisition of a target with replacement credit facility due to the uncertainty of credit markets, risks of likely re-pricing and more stringent credit terms. Also, increased opportunities for secured party UCC sales of troubled company assets by secured lenders as alternative to time consuming and costly stalking horse bankruptcy sales.
Since large public company LBO’s and certain strategic acquisitions requiring substantial debt financing may be limited under current market conditions, unprecedented opportunities for middle market M&A transactions may exist provided Sellers and Buyers recognize that historical M&A “market” and deal structure models may require modification. With the credit-crunch and economic slowdown expected to continue through 2009, successful M&A transactions will depend on creativity in structuring the acquisition and locating acquisition financing and the reasonable economic expectations and risk allocation of Sellers and Buyers. Blind adherence to historic M&A models will be counter productive in the current M&A market where flexibility and a willingness to “change the model” may be necessary to attract the abundant amount of un-invested equity capital available from strategic Buyers, private equity funds and sovereign wealth funds and an appropriate amount of leverage through debt financing provided by a limited number of credit providers. Successfully navigating an M&A transaction in today’s turbulent credit and economic market will require advance preparation, sound professional advice, patience and an extended time period to complete the due diligence process and closing. Sellers planning a sale for family succession, strategic or other sound business reasons should start early on a reverse due diligence process to assure their records, financials and other internal matters are in order. Further, voluntary compliance with “best practices” such as Sarbanes Oxley policies and procedures, Audit and Compensation Committees and independent directors will validate a Seller’s internal policies and controls in advance of the rigorous due diligence review which will be conducted by Buyers and their lenders. Research on valuation expectations, deal structure and financing alternatives in a creative and thoughtful manner in advance of the acquisition process will allow sufficient time to make an informed and prudent evaluation of acquisition proposals based on new, evolving M&A market models and trends.