Now Is the Time for Corporate M&A
Global mergers and acquisitions hit a new high in 2006, with $3.79 trillion in deals. Even as late as the third quarter of 2007, Lehman Brothers’ revenue from mergers and acquisitions reached a record $425 million. But in the current economic environment, the deal flow is slowing. While that may sound like a bad thing, it actually means that corporate buyers may have less competition for acquisition targets.
"This may be the best time for corporates not to disappear from the M&A game," said Robert W. Holthausen, Nomura Securities Co. Professor, professor of accounting, finance, and management who serves as academic director of Wharton’s Mergers and Acquisitions program. "While companies may have been competing voraciously with private equity and other financial sponsors, the change in the credit markets has made valuations from highly leveraged deals smaller. When leveraged buyout (LBO) firms look at a potential acquisition, they are not likely to bid as high a price given the increase in credit spreads, such as the spread between the yields on U.S. government bonds and high yield issues. This is the time for corporate buyers to focus on their M&A activities to achieve their goals."
"This may be the best time for corporates not to disappear from the M&A game. … Credit markets have changed and this means changes for LBO firms. This makes it more likely that a corporate buyer can outbid a financial sponsor now than they were likely to in June." —Robert W. Holthausen, Nomura Securities Co. Professor, Professor of Accounting, Finance, and Management, The Wharton School
The favorable credit environment over the past few years meant that financial buyers were able and willing to finance deals with high levels of debt at very attractive terms — something most corporate buyers were unwilling to do. "Corporates don’t think about financing deals with 80 percent debt," he said. "It is not how they think. Because of the attractive debt terms that had been available, financial buyers were able to outbid corporate buyers. With the changes in the credit markets that have occurred since June, we expect to see that corporates will now account for a larger proportion of deals than in the year or two prior to June."
The increase in the credit spreads means that the playing field is tilting back in favor of corporate buyers. In addition, banks are tightening various credit requirements. In recent years, they had been lending without any performance requirements. Now, they are reinstating those requirements. Further, the amount of debt the banks are willing to lend relative to cash flows has declined since June as well. "Credit markets have changed and this means changes for LBO firms," Holthausen said. "This makes it more likely that a corporate buyer can outbid a financial sponsor now than they were likely to in June."
A Strategic Rationale
For corporate buyers, it is essential to have a strong strategic rationale for the deal. "You need to understand why this is going to create value," Holthausen said. "One of the things we focus on in the M&A program is identifying the strategic drivers of value."
This focus on strategy helps ensure the acquisition will actually generate value for the company and its shareholders. "People sometimes go out and acquire because everyone else is acquiring," he said. "They don’t know how it fits into their corporate strategy. Why are they doing it and what is its purpose?"
This strategic focus not only leads to better deal choices but also informs the entire process. In conducting due diligence for a deal, for example, managers could focus on countless issues. "No matter how hard you try, you can’t uncover every problem. If you have some strategy for why you are doing the deal, you can focus on that. If you expected to have some synergies in the product line, you can make sure that synergies are likely to be realized in the due diligence process. Rather than just look at 50,000 pieces of paper, you can look at the major value drivers in the deal. Obviously, there are many things that one has to investigate during the due diligence process, but staying focused on the value drivers of the deal is extremely important. The strategic focus affects the entire deal process — how you structure the deal, how you do due diligence, and how you think about integration."
Rigorous Valuation
Even with a strong strategic reason to acquire, there is a need for careful financial analysis to determine what the deal is worth to you. If you can’t make the acquisition at a price that is less than what it is worth to you, you have not created any value — no matter how compelling the strategic case for the acquisition may be.
But determining the value of a company is a very complex process. "In many cases, the analysis is not done very carefully," said Holthausen, who is completing a new textbook on valuation due out next year. "You need to think about the analysis in a rigorous way." There typically are wide ranges in valuations. "There is no one right answer, but you have to ensure that the analysis is reasonable."
Holthausen identified several pitfalls in the valuation process. One problem is creating a set of projections that are internally inconsistent. While developing realistic cash flow projections for the first five years is tricky, it is even harder to assess the "continuing value" or "terminal value" of the acquired firm. This is the value after the first five or ten years, extending out to 50 or 100 years, or even longer."
This terminal value can represent 40 to 70 percent of the total value of the deal, but most people spend three minutes on this," Holthausen said. "You need to figure out how you can use reasoned analysis to determine that continuing value."
Assessing cost of capital is another problem area. There are wide variations in the assessments of the cost of capital appropriate for valuing an acquisition. "People make a lot of mistakes in estimating the appropriate cost of capital number they use," he said. "It is very hard to get this right and there are huge differences of opinion about the correct way to do this."
Global Deals
The pace of global deals continues to be intense. That is unlikely to change, given the imperatives for companies to enter new markets and build global enterprises.
"Many companies are trying to become global powerhouses," Holthausen said. "There is still a tremendous amount of money, not just in the U.S. but all over the world. I don’t see anything that is going to cause the global push for deals to dissipate. The proportion of deals that are U.S.-centric is much smaller than it was ten years ago. There has been a great deal of deregulation around the world, which means that the climate is more favorable for M&A transactions."
The Mergers and Acquisitions program attracts a high percentage of international participants — usually around 30 to 40 percent. Insights from these managers, as well as participants from diverse areas and industries, add to the depth of the discussions.
Creating a Rigorous Process
While it may be a more favorable environment for corporate buyers, deals still need to be well managed. The 5-day Wharton program covers key areas such as integration, valuation, negotiation, due diligence, and structuring the deal.
Mergers and Acquisitions is designed to give managers who are involved in designing or executing mergers and acquisitions the knowledge they need to put together better deals. It helps them identify the key areas for attention, ask the right questions, and ensure all aspects of the process are addressed. "This is what a generalist needs to know," Holthausen said. "If you take the elective section on taxes, for example, you won’t become an expert in an hour or two. You will still need someone with tax expertise, but you will have some idea of the tradeoffs involved in the different tax structures."
He noted that CEOs of two private companies involved in a merger or acquisition will sometimes believe they have nailed down an agreement without discussing tax implications. "They agree on price but never talk about the tax structure," he said. "If you agree on price and have not discussed the tax structure, you have not agreed on price."
© 2007 The Wharton School, University of Pennsylvania
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