Congress is close to taxing “carried-interest” income on fund managers at 30% in 2011 from the current 15% capital gains rate. The rate is likely to go to 33% in 2013. Congress may exclude the first 25% of income from this higher tax rate (which doesn’t really make sense to me) but the real story is the opportunity this presents for strategic buyers.
First, private equity firms are now motivated to divest businesses in 2010 to preempt the higher taxes – look for companies they acquired pre-2006 or post 2008 as more likely candidates. Second, I believe these fund managers will find a way to structure deals to avoid the higher taxes, for example using calls and puts. In the meantime this distraction will limit their deal making. So once again strategic buyers have an advantage over financial buyers.
The long-term question is: how will this change impact investments in growing companies? I don’t see how it helps.
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Nothing like today’s considerable drop in the market to remind everyone that the economy remains on shaky ground. I stand by my past prediction that the market will not improve dramatically for another 12 months.
This turmoil does two things. It makes sellers more fearful that the bottom could fall out again and it may be time to hitch their wagon to another team of horses. It also adds fear to buyers who aren’t convinced they want to plunk down a bunch of dough when the market may not make it rise and bake into something meaningful.
So I contend we continue to have parity among buyers and sellers, but I also contend for those with strong stomachs and solid strategic plans, this could turn out to be a great time to be a bold buyer. Remember the adage “buy low, sell high.” The market is low for many buyers. So do you really believe the saying or it just sounds nice for other people?
H-P is acquiring Palm for $1B and they say it is to position them further into the smartphone market which reportedly grew by over 60% last year. H-P’s head of strategy, Shane Robison said “It’s an opportunity for us to get into a very big market”. Understandable? It is to me. I’m not saying it’s a good strategy, but they have ONE reason for the acquisition and from my experience H-P is more likely to be successful because people get it.
Although it almost dipped back below today, the Dow broke the 11,000 mark earlier this week. This psychological barrier will impact the M&A market since there is a strong correlation between the equities market and M&A, with M&A lagging a bit.
I continue to expect an increase in deal making, with the biggest growth to be hitting in mid-2011. Companies are now gearing up for deals which take some time to get into place, but with a strong stock market, burgeoning balance sheets, and historically low costs for debt, I see the market starting to brew. I still maintain you should keep your seat belt on because I fully expected non-participants of the M&A market are going to be shocked at how their competitors radically change over the next 12-24 months. Many companies will be left eating dust while others blaze a new growth path.
Cerberus Capital Management agreed to acquire DynCorp for $1 Billion on April 12. DynCorp is a Virginia-based defense contractor who focuses on low-technology, high people-centric government contracts in hostile areas like Afghanistan. Cerberus, probably best known for its acquisition of Chrysler, sees this as a way to expand its government business. There were four things that I found interesting about this acquisition:
This takes a public company private which should provide savings, but also means it will likely go public again in a few years when Cerberus wants a liquidity event
The deal is a leveraged buyout (LBO) and a big one. The WSJ reports the structure will be 2/3 debt and 1/3 equity, which is much lower than the more recent levels of 50% equity.
There is a “go-shop” clause. This provision gives DynCorp a month to find a better deal, which should quash a shareholders suits that it wasn’t a fair price.
This is essentially one private equity firm selling to another. So this is financial engineering more than strategic fit.
All in all this deal is another sign of the thaw of the investment communities involvement in M&A deals. I still contend there is about another 12 months of unique balance in the market between buyers and sellers and I still expect a frothy M&A market starting in mid-2011.
PWC reported recently that 46% of CEO’s in their survey indicate they plan to sell their company, and of these 66% said they plan to sell within the next five years. The primary reason cited in the report is to diversify and create liquidity.
My experience with CEO’s of privately held firms is they typically have most of their net worth in tied up in their company. They’ve seen the drastic drop in their stock portfolios, missed opportunities to sell at the market peak in 2007 and are getting closer to retirement age. I had one CEO tell me he didn’t think he could last until the next big upturn in the M&A market and he can’t chance more downturns.
I think you will see a record number of owners looking to sell starting in the next 12 months (perhaps sooner if the capital gains tax debate resurfaces) and you have record amounts of cash sitting on the sidelines which will start moving into the market in the next 12-15 months. Put on your seatbelt because I think we are preparing for a very exciting ride in the M&A market.
I just spoke at the Wisconsin Institute of Certified Public Accountants Spring Conference and the general sentiment was cautious optimism for the next 12 months. Several attendees mentioned they only see distressed companies selling and at 0.5x revenues. Another mentioned his firm has lots of cash and no debt but they are hesitant to part with it. All-in-all I think many are taking a wait and see attitude – which for the middle is okay, but the strong companies and weak companies may wait too long. Long enough that their moment will have passed.
On this blog previously, David discussed some of the issues surrounding the AOL-Time Warner merger. Given that the ten year anniversary of the merger was recently marked, I wanted to re-visit the ill-fated deal to explore it a little more in-depth.
AOL and Time Warner merged to create the “world’s first Internet-age media and communications company” for an all-stock combined value of $350 billion. The merger announcement stated that the new company “will be uniquely positioned to speed the development of the interactive medium and the growth of all its businesses. It will provide an important new broadband distribution platform for AOL’s interactive services and drive subscriber growth through cross-marketing with Time Warner’s pre-eminent brands”… which doesn’t include the laundry list of growth opportunities captured in the remainder of the announcement covering everything from music to telephony.
Instead of delivering on these ambitious promises, the merger imploded, translating into about $100B in lost shareholder value. The new company was plagued by many issues such as: short-term thinking, bad technology, bungled product development, and a risk-averse culture more prone to imitation than innovation. Most importantly the vision and passion the deal champions Jerry Levin and Steve Case established in 2000 were not effectively translated and executed by their people.
Yes, there were external pressures such as regulators and Wall street that increased merger difficulties – but I believe it all comes back to a clear vision that sets the strategic direction that the rest of the organization can understand and execute against. To that point – AOL’s original vision was “to build a global medium as central to people’s lives as the telephone or television… and even more valuable”. The company accomplished this vision prior to the merger. Eventually they replaced the statement in 2006: “to serve the world’s most engaged community”, which is nondescript and applicable to many businesses.
Recently, Jerry Levin, former CEO of AOL-Time Warner, and Steve Case, co-founder of AOL were on CNBC reflecting on the merger (see the video below). Levin apologized for the merger, “I presided over the worst deal of the century… I’m really very sorry about the pain and suffering and loss this has caused.” Levin and Case’s observations included:
Leaders need to be compassionate and understanding of the significant tension due to a merger’s disruptive nature and cultural differences
AOL TW was to be a ‘supermarket’ but instead was a ‘mall’
Vision is nothing without execution in which people are key
Too much focus on internal politics and wall street instead of customer needs
According to the Wall Street Journal, November 2009 was the biggest month in over a year for deals involving consumer products and food and drinks firms, with $12.54 billion in acquisitions. And it doesn’t look like this momentum will be stopped. Kettle Chips, Just for Men and Grecian Formula hair-coloring products, Aqua Velva cologne, Brylcreem hair gel, Vagisil feminine products and Ambi Pur brand are all reported to be on the block. It is interesting to me that such well known brand name companies would sell in a down market. I believe the consumer product industry continues to have seismic changes as younger people are less tied to brands, while at the same time distribution channels like Wal-Mart have strengthening power over their suppliers and continue to expand their private label products. I anticipate more product consolidation as companies like P&G have to remain relevant to their customers and maintain some economies of scale. Perhaps at the end we will have some consumer product companies “too big to fail.”
Our buy-side clients at Capstone are seeing the same trend that a recent Reuters article reported: “Companies are making moves to divest assets that are not essential to their operations, while stronger firms, nudged on by their boards and shareholders, are looking to grow and position themselves for the recovery.” This leads to numerous “orphan” non-core product lines and/or business units. This is resulting in increased deal flow, with more silent auctions and calls coming in from around the globe. Further, JPMorgan noted: “We are seeing a pickup in serious strategic discussions that would give us more optimism for 2010.” Capstone’s pipeline is strong and growing as proactive external growth requirements are driving leaders to “come out of the woodwork” looking for strategic assets that will offset their deficits on the organic growth side as they refine their 2010 budget forecasts. Do you need to fill a gap? Consider that technologies and product lines are “on the market”.
The M&A statistics for the third quarter of 2009 are in and show the vast majority of the deals getting done are strategic. The economic crisis and concerns over deal financing continued to significantly hold down the number and value of deals when compared to the same period last year. Today, a Wall Street Journal article by Peter Lattman reports that leverage is out and equity is in. Although these numbers are grim, there is reason for hope. A number of big name deals, such as Kraft-Cadbury and Disney-Marvel, have injected the market with some much needed optimism. These types of deals are evidence that strategic deals are going to lead the way to recovery with private equity to follow – not the other way around.
A story in the news last week caught my eye – U.S. antitrust enforcers are planning to revamp merger guidelines. This isn’t surprising news – there have been expectations for quite awhile that the Obama administration was going to take a closer look at large corporate mergers. It also won’t affect the vast majority of you (or our clients) – antitrust enforcement generally only relates to the biggest of the deals (like the potential Kraft – Cadbury transaction mentioned in the article). What stood out to me, though, was at the bottom of the page:
The move to revamp the guidelines… comes as tentative signs emerge that the mergers and acquisitions market is recovering… In the three months from June to August, global M&A rose 29 percent compared to the preceding three months. In the second quarter, M&A was up 15.2 percent compared with the first quarter…
This has been exactly what we have been seeing with our clients in recent months. Deals are getting done in new ways: more creative deal structures are being used and more options are on the table. Deals are viewed as strategic partnerships to make two companies stronger and help them weather the storm together. Is increased government scrutiny actually an indication that we are finally starting to see clear skies in the distance?
Three recent deals are being heralded as “the revival” of the M&A market. Although the linked article captures some of the larger buy-side deals (for example Disney’s $4 billion purchase of Marvel) that are now beginning to emerge, we here at Capstone are seeing a similar trend in the area of the market where we mainly focus: smaller to mid-size ($25 to $200 million) transactions. Firms are beginning to react to the apparent improvement in economic conditions (according to some indicators, but not all – see today’s unemployment numbers), and wish to capitalize on lower prices and expectations before a full recovery occurs.
PWC released its second quarter report on M&A activity in the industrial products sector. Two items from the report stood out for me. First, M&A activity in the second quarter actually rose compared to the first quarter of 2009 (although still down significantly compared to last year). This could be a sign that some of the fear that has gripped the marketplace is beginning to subside. Second, the following quote struck me:
Strategic buyers continued to act as the main investors in the majority of deals in all segments of the industrial products industry as financial investors remained on the sidelines because of continued tight credit markets and a lack of liquidity.
Cash continues to be king. Companies that have cash are using it to snap up weak competition and make strategic moves to strengthen themselves for the future. They are making small, targeted acquisitions to calibrate their business.
At Capstone, we are continuing to push our clients to be active buyers in this market. Our mantra remains: “If not now, when?”
There was an excellent profile in last weekend’s Wall Street Journal of Cisco Systems and its CEO, John Chambers. Cisco is a company that “gets it”. In some of the most difficult economic conditions of our lifetime, Cisco is not hiding its head in the sand. Here is Chambers’ philosophy:
Even in this downturn, we intend to be the most aggressive we’ve ever been.
That is saying something for Cisco. Since Chambers took over as CEO in 1995, Cisco has been a bold acquirer. As the article says:
Cisco’s growth plan has combined audacity in acquisitions and attacking new markets with strict, even ruthless control over costs.
The result of this growth plan? I could lay it out in words, but you know that a picture says it better – look at Cisco’s performance against the major stock indices since 1990:
Cisco is represented by the blue line.
Pretty impressive. Being aggressive during down times and constantly calibrating with targeted acquisitions have paid off big time for Cisco and its investors.
It seems that in the world of private equity, middle-market funds are enjoying the greatest success in this bleak deal-making landscape. The main reason given:
…small and middle-market firms are getting the attention of the PE shops because they can be had without piling on gobs of debt
Right now, they are also considered a relative “bargain” in the marketplace. Despite the uncertainty surrounding the economy, there are still deals to be had. PE funds with cash and who deal with smaller to mid-size banks not burdened by the troubles of the larger institutions are see opportunity – and are pouncing.
Back in December, I noted (and agreed with) one author’s proclamation that in the current economy, the balance of power in M&A has shifted from sellers to buyers. The main reason: With the credit market in a crunch, cash is king, and cash-rich companies hold a distinct advantage.
As these survey results show, this trend is continuing. I believe this is true in the US as well. Buyers are looking to protect themselves from a sour deal by adding in more escrows and earn-outs, along with more items covered in reps and warranties. Due diligence has become more thorough.
Good companies are choosing to sit on the sidelines rather than risk a bad deal. Grade ‘A’ sellers are also waiting for better days, if they can, or aren’t compromising. Cash is king and the king makes the rules.
I recently read an article through DealBook indicating that the Obama administration will increase antitrust enforcement during its tenure, raising the anxieties of many on Wall Street.
In the big picture, I don’t think this increased oversight will have much impact on middle-market deals – after all, it’s usually only the really big deals that could have monopoly implications.
What stuck out for me in the article, though, was the following statement:
Economic downturns tend to force executives to find ways to reduce costs…
Merging with a rival, and reaping the synergies that come from eliminating duplicative functions, is a crucial component of any manager’s recession survival tool kit…
It’s my belief that while cost-cutting is one way to deal with a tough economic situation, it can only help you tread water for so long.
Proactive growth proponents look at a complementary acquisition or new market entry opportunity as a chance to increase revenue and cross-sell – leading to more significant growth in the long run.
I often find that the cost-cutting aspects of these deals are a way to get more conservative finance colleagues to sign off on the deal. The benefits are real and helpful, but cannot by themselves lead to sustainable growth.
Although many executives are just trying to weather the current storm, I believe that those that are bold with their growth moves will come out significantly stronger once it passes.