Although strongly affected by the financial and economic crisis, mergers and acquisitions (M&A) still presented cash-rich companies with the opportunity to benefit from depressed asset prices during the past two years. However, the period of heavily undervalued assets has come to an end. As a result acquirers will have to refocus even more strongly on fundamental value drivers and their own business strategy in any deal. This month we look at the effects of the crisis on M&A and the importance of identifying the right target for a transaction.
How the crisis has impacted M&A
The Organisation for Economic Cooperation and Development (OECD) noted in its March 2010 investment newsletter that the past two years have seen a collapse in the average monthly M&A activity. Year-on-year global M&A activity was at its lowest level since the global economic crisis began, hovering at around 35% of the activity in 2007. Although 5,800 deals totalling $2.3 trillion were announced in 2009, M&A volumes were at their lowest level since 2004.
Consultancy firm McKinsey, however, evaluated the past two years with less gloom. Much of the pre-crisis M&A boom was driven by private equity buyers and cheap financing, the management consultants noted, and most of the reduction during the past two years was the result of a 29% decline in market capitalisation. When adjusted for market capitalisation M&A activity was stable in 2009, following the drop in 2008.
The OECD found that the general decline was more pronounced in the OECD countries than in the rest of the world. While the global economic crisis has caused a decline of international M&A activity, it has not substantially altered the geographic distribution of international investment flows between the OECD and the rest of the world, which stayed at a ratio of 80/20 during this time, the organisation said.
However, developing nations have reached a much higher share as the originator of international M&A activity. In 2000, only 4% of all M&A investment came from non-OECD countries. This share increased to 16% by 2007 and 25% in 2009.
Activity shifts to emerging markets
Given the recession and the slow economic recovery of developed nations in Europe, the US and Japan, growth in M&A deals has mainly come from Asia-Pacific and African markets in 2010.
Overall, the focus of M&A deals in 2010 has shifted to developing nations. According to data provider Dealogic, cross-border acquisitions in emerging economies have already totalled $137 billion this year, compared with a total of $179 billion for all of 2009.
Planned cross-border acquisitions of companies in emerging countries have increased to a share of 40% of the global cross-border M&A activity. This trend is also expected to continue with local companies in China and India driving the deals. As at April 2010, companies in emerging markets had already generated $44.2 billion in M&A deal values, Dealogic data showed. This compared to $92.3 billion of acquisitions in emerging markets made by companies from developed economies.
Brazil, China, India, Indonesia, Russia and South Africa have emerged as major players in M&A deals over the past decade. But not all countries were equally affected by the crisis, as in particular China was able to grow its share among these countries to 60%, by becoming the most popular target market in 2009 and 2010.
Despite the wider collapse of M&A activity in 2008 and 2009, a number of companies that had accumulated excess cash during the boom years were able to make acquisitions on favourable terms.
While in the past companies with strong cash positions often saw their share price penalised, because they were not regarded as sufficiently leveraged, this was no longer the case during the economic downturn. Higher market premiums for cash-rich companies and lack of funding for rivals led to some strategic acquisitions of target companies whose balance sheet and market valuations were not as strong.
Another beneficial factor was that corporate acquirers did not face competition from private equity buyers, as buyout firms were no longer able to secure leveraged financing for their deals.
However, with stock markets recovering the period of highly undervalued assets is over, which means that acquirers have to focus even more strongly on the fundamental value drivers in any deal.
A survey of 360 M&A professionals, including public companies, private companies and private equity funds conducted by KPMG and The Deal found that the majority of M&A dealmakers were more upbeat about 2010 both with regard to the economic and the deal environment.
The respondents expect to see most of the deal activity this year in those industries that were subject to the greatest turmoil, such as banking, healthcare – due to the healthcare legislation in the US – and financial services. Other industries that would witness above average deal activity were IT, energy, real estate and retail according to the respondents.
Consultancy firm McKinsey believes that large public companies that have accumulated cash reserves, and on average outperformed the share price of smaller companies over the past three years, are in the best position to benefit from a wider pick-up in M&A activity.
Deals of 2010
Prudential’s (now aborted) acquisition of AIG’s Asian life insurance unit for $35.5 billion was going to be the largest deal of the year, followed by Swiss pharmaceuticals company Novartis, which paid $28 billion to acquire a majority stake in eye care company Alcon. In the UK, the acquisition of Cadbury by Kraft for $19.7 billion made the headlines after the chocolate maker and parts of the British media and public had initially fiercely resisted the take-over offer.
The treasurer’s involvement
Corporate treasurers have assumed a more pivotal role in the M&A process in recent years and are more than ever in a position to ensure that a deal generates the desired value. The greater importance of cash flow and balance-sheet strength for both acquirers and targets in M&A deals has meant that treasurers, together with their CFOs, have been sought out as the best people to quantify cash resources and capital expenditure as well as forecast the overall financial position of the merged company.
Treasurers are also able to help when assessing a target’s balance sheet for strengths and liabilities and will ensure that a deal is structured efficiently from a cash flow and tax perspective. As a result, the treasury team is nowadays involved in everything from target identification and due diligence to post-merger integration.
Financial analysis of the target company
The treasury and finance departments are likely to carry out an analysis of the target company’s financial statements. This analysis is part of the wider evaluation of the target and generally encompasses the accuracy of performance forecasts, debt service ability, historic capital expenditure, working capital, debt facilities, obligations, contingencies and existing bank relationships.
Hidden issues, such as pension or healthcare liabilities, need to be identified and fully examined, as they are a major factor affecting the value that is generated through an M&A transaction. How a target company uses and values derivatives is another potential risk factor that must be taken into account.
Arguably the most important element in an acquisition is the purchase or sales price. While the acquirer has to ensure not to overpay and endanger the success of the transaction, the seller is naturally interested in pushing the sales price as high as possible. The valuation of the target company is therefore critical.
Different methodologies and metrics can be employed to calculate the value of a company from discounted cash flow analysis to asset-based valuation methods. Comparative studies tend to use share-based metrics such as price earnings ratio or total enterprise value, which adds a company’s interest-bearing debt to the total market capitalisation and preferred shares before subtracting cash in order to compare companies with varying levels of debt. Total enterprise value is then often divided by sales or earnings. Valuations tend to differ between industries, but irrespective of the methodology other factors have to be taken into account.
Any changes to the operating environment, factors impacting on the sustainability of earnings or other potential threats must be considered. The same applies to potential opportunities such as assets for disposal or one-off exceptional gains (and losses).
Another area in which the treasury department will be involved is the financing of the transaction. The questions that are raised are similar to general funding issues, including whether debt or equity is used, the potential dilution of earnings per share, the impact on existing facilities and lender relationships as well as the prevailing market and liquidity conditions for both debt and equity.
Treasury due diligence
The impact of a transaction on the treasury department must also be evaluated. The treasurer will naturally be involved in the analysis of the target company’s cash management structure, interest rate and foreign exchange hedging, debt facilities and banking relationships as well as any opportunities for or obstacles to a successful integration. The debt and structured finance arrangements that will be inherited are of particular importance and will need to be managed.
Reminding yourself again of the deal rationale
The ultimate objective of mergers and acquisitions is to grow a business in order to generate shareholder value:
One plus one equals three?
The goal is to bring two companies together, which combined are worth more than individually. The hope is to take advantage of greater economies of scale, achieve a larger market share, higher competitiveness, more cost-efficiency and revenue increases, for example due to cross-selling, as well as to better utilise assets and capacities.
Larger companies may believe that they can grow quicker through M&A, whereas smaller companies may realise that they cannot survive on their own. However, the identification of the right target and the implications of the transaction itself are very complex and mean that more than half of all mergers fail to produce the expected value growth in value. In addition, the global financial and economic crisis has altered the market for mergers and acquisitions, making it more difficult to obtain financing and putting companies’ available resources under stress.
The reasons for failure can range from a flawed corporate strategy and a lack of due diligence to an overestimation of synergies and an underestimation of cultural and integration issues.
Although seemingly trivial, the large share of failed mergers and acquisitions indicates that many deals already go wrong at the inception stage when suitable targets are identified.
M&A is essentially a strategy for growth. The decision to acquire a firm or not is always part of the wider question of whether to grow organically or to expand through a merger or an acquisition. The motivation for a merger should therefore derive naturally from the company’s overall strategy.
Mergers and acquisitions are rarely successful only because an opportunity suddenly presents itself, for example when a competitor struggles and appears currently undervalued or a new start-up company has launched the product the company had planned to develop internally.
No matter what the opportunities are, the transaction has to fit into the general corporate strategy and should not just attempt to grow the business for growth’s sake. Within each corporate strategy there are several reasons why a merger or an acquisition may make sense.
Grow market share.
Buying another firm can increase a company’s finances faster than organic growth would, but each acquisition also represents considerable cost and risks which can lead to failure.
Entering new markets.
Instead of having to build a new business from scratch, mergers and acquisitions enable companies to enter untapped markets immediately. However, new markets bring new complexity and additional challenges.
Access to new products and services.
If a target company has products that complement the acquirer’s product range an acquisition could generate immediate value, but there should not be too much overlap with the acquiring company’s offering.
Better use of cash reserves.
Investors tend to believe that unused cash reserves are a missed opportunity to grow shareholder value. An acquisition may therefore make better use of the cash, but alternatives such as share buy-backs or increased dividends also exist.
Mergers and acquisitions are one way to attract talented personnel. However, the transaction and the new corporate environment have to be attractive to the acquired company to retain the staff.
Identifying a target
To ensure that a target company matches the acquirer’s strategic objectives, it is important to build a target profile, including all publicly available information on the business.
One way to tackle the complexity of M&A deals is to bring as many different people from the acquirer’s team together to analyse the data. This can include external legal advice and financial consultants as well as human resources and IT.
All parts of a prospective target must be investigated from financial, technical and legal to management and personnel. The team will analyse the target company’s organisational structure, customers and markets and test its products to obtain a full picture of the entire business.
An essential part of this due diligence process is the search for potential deal breakers and obstacles, such as regulatory restrictions, looming law suits or the target management’s reluctance to strike a deal. This is important because not only should the target be right for the acquirer, but the acquirer should also be right for the target company. Successful mergers always allow the acquired company to thrive within the new corporate environment.
Once a target has been identified it is a good time to once again verify the rationale for the deal. Too many mergers have failed because CEOs and investment bankers have overestimated the potential for enhanced value, perhaps blinded by the immediate benefits that a deal meant for themselves.