The Market for Deals

Big deals – mergers, acquisitions, takeovers – are not being announced at a significant rate of late.  This has prompted some people to ask whether the deal market is dead or dying.  Others ask what the future holds for private equity.  Still others wonder whether we have seen the end of M&A as we knew it.

These questions are regularly raised in the media, and I am often asked whether I buy into the “gloom and doom” stories told by others.  I do not.

The reality is that a depressed economy and a tight capital market do not automatically bode ill for the long term deal market.  A depressed market can often present significant buying opportunities for hungry acquirors.  Buyers who are looking for targets to acquire can find bargains, with some targets teetering on the verge of bankruptcy, for example, and boards of the targets wanting to avoid dooming their shareholders to such a fate.  (As we know, shareholders of a company that goes bankrupt usually lose the totality of their investment.  Contrariwise, if an almost bankrupt company is acquired at a bargain price prior to bankruptcy, the target shareholders usually get at least something in the buyout.)

The caveat is that buyers tend to abhor an uncertain market.  If it is unclear whether we are close to the bottom of the market, or if the market is materially volatile, buyers tend to wait things out, to avoid overpaying or to avoid using stock in the acquisition in an unfavorable manner or to avoid taking on needlessly expensive debt to fund the acquisition.

Naysayers might then ask how deals can possibly get funded in this tight credit market.  Even assuming there are buyers who are gutsy enough to make bids for targets in this tumultuous economy, some question whether struggling banks will really fund deals in this “credit crisis.”

There are two responses to this funding issue:
First, some deals are not funded with borrowed cash.  In strategic deals, for example, where Widget Producing Company (“WPC”) acquires Widget Development Company (“WDC”), the deal is often funded with the stock of the acquiror.  WPC pays for its acquisition of WDC with WPC stock.  Instead of WPC writing a check to WDC to acquire WDC, WPC compiles a big pile of WPC stock to turn over to WDC and its shareholders.
Second, the fact that the credit market is tight and some banks are struggling does not mean that banks are not lending.  Quite the contrary – banks make money by lending.  When banks are struggling, banks will want to lend money for conservative, qualified deals in order to MAKE money from interest and fees.  That is not to say that the turbulent market and rough banking situation has not impacted the deal market – it has.  Banks are far less willing now to fund every possible deal than they were a few years ago.  Banks are more stringently judging the quality and risk-exposure of the deals that are presented for funding.  Five years ago, lenders asked fewer questions and asked for much less in terms of guarantees before lending money to finance acquisitions.  Now, however, bankers (and their lawyers) want to know more about the deals and are demanding more in terms of guarantees before agreeing to lend.

Indeed, the issue of guarantees is a thorny one in the private equity market.  Big private equity firms are usually founded by a few wealthy players or their affiliated entities, who then raise capital from other investors.  When these private equity firms make an acquisition of another company, the PE firm usually first creates a “shell” acquisition company to make the actual acquisition.  So if Nowicki Private Equity Firm (“NPEF”) wants to acquire Wal-Mart, NPEF would first create a shell company that is wholly owned by NPEF, and the shell company would then be the company to borrow money and itself acquire Wal-Mart.  By creating a shell company to actually acquire Wal-Mart, NPEF insulates itself to a degree from liability for borrowing money and engaging in the acquisition.  If the shell backs out of the acquisition or fails to honor the loan, recourse to NPEF would be limited (historically).  I say “historically” because this is one aspect of the deal market that has changed a bit in the recent credit crunch.  These days, if a private equity firm wants a bank or third party to fund the private equity firm’s shell to conduct an acquisition, lenders are asking for more demanding guarantees from the private equity firm itself.  Lenders are realizing that they need an entity with money/assets – as opposed to a shell – to be fully on the hook for the deal.

So, back to my point about lending:  Money is there, banks and others are lending, but they are being more conservative in evaluating the deals that they will fund, and they are being more demanding in terms of the guarantees that they require.  This means that fewer deals are getting funded, and this means, therefore, that fewer deals are getting done.

I do not see this as a negative, however, nor do I see this as presenting a gloom and doom scenario indicating that the deal markets are dead if not mortally wounded.  Rather, there were deals done in 2005 or 2006, for example, that never should have been done.  Lenders offered funding that they never should have offered, and they agreed to terms that were not particularly compelling.  A contraction in the deal market is perfectly appropriate, and the fact that a tight credit market is allowing (if not forcing) banks and other lenders to think harder about how they lend money and to whom is a very good thing, in my view.

While it is curious to have so few big deals announced each week in the WSJ or on Bloomberg, the reality is that this slow-down and the resultant reexamination of how deals are funded makes sense.  I imagine the past 15 months and the next 9 months will be significant in terms of molding the new parameters for the deal market.

To that end, I am co-teaching a Deals class at Boston University this spring, and it will be interesting to see how, if at all, the course changes in response to the changing deals market.  (The class involves a good number of guest teachers who are practitioners at various Boston firms, so the course will necessarily morph a bit in response to the current market for deals.)

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