When it comes to funding acquisitions, banks are still holding tight to their money — unless you count the special case of banks buying other banks, which is causing quite a stir in the wake of the government bailout. The fact is, this is still a tough time for M&A, especially in what I have called “the wedge”: M&A transactions between $1bn and $10bn. Smaller deals continue under the radar, and the mating season of the behemoths never ends. Witness the prospect of GM and Chrysler merging.

In the wedge, a huge area of M&A activity, private equity is being told to wait. Banks aren’t playing and neither are the battered hedge funds. So we can expect a hold on most LBOs (leveraged buyouts) until at least the early part of next year. However, not all private equity firms are taking this lying down. They are turning away from traditional sources and seeking capital elsewhere — specifically, the public markets.

The result: we’re seeing renewed interest in SPACs, or Special Purpose Acquisition Companies. These are basically IPOs launched purely for the purpose of buying companies. How quickly this trend will increase is an open question, but it’s certainly a development to watch over the coming months.

Watch out for one defensive M&A strategy in times of financial stress. Instead of selling, weaker companies under threat may seek mergers with other victims of the crisis. Expect to see quiet talks between struggling competitors, looking for ways to wring out the costs and create a new, stronger entity.

A short while ago, banks were pressuring struggling companies and seemed only too eager to move them into the “distressed” category, or effectively force them to sell. Recently, there’s been a dramatic reversal of attitude. The last things banks want on their hands is a host of collapsing companies. So you’ll find a very liberal attitude right now. That doesn’t mean that new credit is easy to come by, of course. As we all know that’s as rare as the unicorn right now. But if you have existing obligations to your bank, you may find new ways to work with them. They want you to stay in business, and you can use that need to your advantage.

What does this mean for mergers and acquisitions? What does this mean for buyers? For those with a strong balance sheet, there are opportunities to work effectively not only with troubled sellers but also with the banks that service them.

I’ve noticed some company buyers willfully slowing down the acquisition process at this time. Why? They smell bankruptcy in the air. The longer they can string out the negotiations, the more desperate the seller’s condition and the lower the price. It’s tough for sellers to defend themselves in this environment. I’ve noticed some company buyers willfully slowing down the acquisition process at this time.

Best thing to do: let your buyer know there are other, more attractive suitors knocking at your door.

What I called “the wedge” in my post, The Wedge: M&A from $1B – $10B, is the natural hunting ground of private equity. And this is where we can expect the least activity during a crisis of credit. These buyers hate to put in 100% equity. They like a good measure of debt in the purchase, so this isn’t their time for Mergers and Acquisitions. And what is private equity doing, meanwhile? The short answer is: hoarding cash in unprecedented amounts. The last month has seen record accumulations of private equity funds. That money represents a potent resource for future activity, and we should be prepared to see a resurgence of private equity activity the moment the financial environment shifts in their favor.

In every crisis there are winners as well as losers. Today companies seeking growth through acquisition can pick up bargains — if they have the cash. Small, over-leveraged companies are choosing to sell rather than go to the wall. As for the publicly traded corporations, they are under pressure from shareholders to get out of business units that don’t make business sense. So there may be some attractive divisions up for grabs — the unwanted stepchildren of major corporations. From the buyer’s perspective the key is to come to market with a strong balance sheet. This isn’t the time for highly leveraged acquisitions. Cash is king and the buyer with dollars to spend can not only pay less but also command favorable terms like a quicker closer or more reps and warranties. I talk more about this in my post The Return of Simplicity in M&A.

That doesn’t mean we should expect a huge volume of mergers and acquisitions right now. There will be a slowdown in the coming months while the current financial turbulence plays out. But watch the beginning of 2009. I have clients right now engaged in intensive planning for acquisitions early in the New Year.

A common error in the M&A game is to over-delegate the process to the financial team. I had a highly successful client who put an entire acquisition in the hands of his CFO. Like many (but not all) of his kind, this financial executive could only see or understand spreadsheets. He had zero patience for the “soft” side of M&A, which turns out not to be so soft when it sabotages the deal.

In dealing with the seller, our hard nosed CFO had just one focus: beating down the other side to the lowest possible price. There is one situation where this approach is legitimate – when you plan to close your acquisition and sell the assets. But more often than not, you are seeking to buy a going concern that you intend to expand after the purchase. That means you will be working side-by-side with the people that face you around the negotiating table. They will remember how you treated them once integration begins, and you will pay for your miscalculations – very likely in hard dollars. Buying a company is not like buying a car where you walk away and never see the seller again. It is more like buying a car with the driver thrown in.

In the case of my client, the transaction never even reached a conclusion.

The refusal to accommodate the human dimension is the root cause of many, if not most, M&A failures. Obsessive focus on negotiated wins and financial engineering can deliver you a pyrrhic victory. You get what you ask for, but not what you need.

To be clear here, I am all in favor of vigorous negotiation and taking a stand for your goals. But in addition, you need to cultivate a breadth of awareness, and an informed understanding of the many dimensions of M&A.

There is an old way and a new way to go about the M&A process, and it’s essential to know the difference.

I had a client that perfectly exemplified the old way. She would be regularly approached by investment bankers hawking “the book” on a company they had for sale. She would listen to the pitch, peruse the documentation and try to figure whether the purchase was a good idea. Eventually she allowed herself to be sold on the acquisition of a small operation. The target company was losing money, but she was persuaded that she would easily be able to turn it around and generate a profit.

Twelve months later, her acquisition was not only losing money but distracting her management team from the core business.

What was missing here can be summed up in one word: strategy. It’s amazing to me how common this deficiency is. Many sophisticated people drift into a purely reactive relationship to growth. They talk to whoever comes to lunch. They size up whatever opportunity comes across their desk. And they do their best to match what’s new with what they already have.

It’s to counter this tendency that I’ve developed my 14-stage “Road Map” approach to buying companies. Whether you use my approach or someone else’s, be sure of one thing: before you set out on the journey of acquisition, get yourself a map.

The right acquisition can dramatically accelerate your company’s growth. Sadly, great opportunities are widely missed, especially in the mid-market. Many companies shy away because the whole field of M&A seems too intimidating. There are others who attempt acquisitions and are disappointed by the outcome, often because they try to follow a rote system overly focused on the numbers. What’s missing is an approach that is tightly disciplined on the one hand, and sufficiently holistic on the other.

When I say “holistic” I mean you have to go beyond the numbers. The finances are an essential dimension of the M&A picture. But they are only one dimension. For success in this field, you must open your eyes to many other potential benefits.

A good acquisition might bring you a technology that you couldn’t otherwise obtain. It could bring you to a market sector that has been out of reach. It might win you exceptionally talented people. It could subtly but significantly enhance your brand and reputation, making you more attractive to customers and high-value employees. Or your acquisition could be simply defensive, blocking a competitor from obtaining the same assets.

All these and more benefits will certainly show up on the bottom line, sooner or later. However, they represent values that may not be subject to instant financial calculation.

Often the single most important benefit of a judicious acquisition can be to “recalibrate” your business. What I mean is that every healthy business has to redefine itself over and over again to flourish in a changing world. Acquisitions – and divestitures – can be a swift and powerful way to positively reinvent your company to meet new pressures and leverage new opportunities.

This isn’t the time to be down on private equity. They aren’t the bad guys and they brought a lot of value to companies in recent years. But the growth economics have changed. Private equity buyers have wrung out much of the financial value from these companies. When it comes to business acquisitions, it’s time to start building strategically. Now we’re going to see combinations that really make strategic sense, not just financial sense. And that’s going to make companies stronger.

Private equity is here to stay. They have got lots of cash, and in time they will come back in and make deals. Right now, there’s no doubt they are sitting on the sidelines. Their models are changing because they cannot access the amount of debt that they used to. So they will have to pay less for companies or take lower returns — that’s the choice they face. Naturally, they will prefer to pay less and get the same returns. A good result is that prices will normalize. For sellers, of course, that doesn’t look so positive, but the overall change is for the good.

Weaker, smaller companies, whether in the financial, manufacturing or service industries are experiencing some healthy fear right now. They recognize the potential value of being aligned with other companies, but just being the small independent standalone isn’t enough to make an acquisition attractive. Unless they have something unique to offer a buyer, they realize they will have to act to enhance their business model. That’s the positive effect.

So there are going to be some motivated sellers — not fire sales, but motivated sellers who see value in being part of a strategic partnership, just as Merrill Lynch realized that becoming part of Bank of America would produce a worthwhile combination. We’ll see players in many different industries that will be more receptive to a corporate acquisition of this kind. What we won’t see for some time is the highly leveraged market. Instead, we can anticipate much more equity in M&A transactions. It’s back to cash is king and the Golden Rule!

Much of the buildup that’s been happening over recent years in the residential mortgage market is similar to what has been going on in the commercial market. It’s all about financial engineering. Typically, the financial investor looks at an acquisition and says: “Let’s restructure the balance sheet so that the company doesn’t fundamentally change. We get a higher return because we’re using debt as opposed to equity.”

Because of the current crisis, we are moving away from this financial emphasis and into a strategic model where an acquisition must bring real value to the business. The focus now will be external growth for tangible results, and truly effective integration. That’s to say, the newly combined entity will be able to do things in the real world that weren’t possible for the two separate companies. It can get better purchasing power. It can consolidate sales and marketing efforts. It can make cost savings, for example, in the usage of facilities. These improvements in capacity or utilization are not what a financial investor brings to the table — they are unique to strategic buyers. This is the type of acquisition that will now come into vogue.

Here we see the upside of the current crisis. Long term, the M&A markets will become more solid and stable. In recent years, too many companies have been so worried about covering the financial cost of doing business —the interest payments on debt — that they have not been reinvesting in the fundamentals of their business. We will begin to see more investment in people and technology — the things that make the companies profitable. Long term this will be very good for U.S. businesses because it will make us more competitive and more globally focused.

When the smoke clears and the dust settles, what does the Wall Street meltdown mean?

We’re back to cash is king. The Golden Rule has been restored: he who has the gold, makes the rules. It’s a return to old-fashioned investing. Companies with strong balance sheets and lots of cash are moving in to make acquisitions. In some cases they are paying 100% equity — no money down, no debt whatsoever, a completely unleveraged transaction. And they’re able to really have an impact on businesses that they weren’t necessarily able to touch before.

We certainly saw that with Warren Buffett. He had the gold, and he set the rules. He got a real sweetheart deal with Goldman Sachs. Granted he has money at risk, but he was able to get a highly preferential deal structure that a year ago he wouldn’t have been possible. It’s all about the cash position. The people that have dry gunpowder right now will do very well. Companies with little debt and good fundamental financials have the opportunity right now to really make a move and become even stronger.

A few things are going to follow. First, valuations will fall — it will be interesting to see how valuation companies (the experts who calculate what a company is worth) adjust to the new climate. Second, cash-rich buyers will be able to acquire companies that others cannot. And there is a third consequence to this whole upheaval: we will see a new layer of transparency and simplicity in the markets. Acquisitions in recent years have been largely driven by financial engineering. Now we’ll see a change in acquisition strategy. Today, the question hanging over possible transactions will be: “Does this make good business sense?” That’s a sea change in the M&A world.

In the current crisis, people are rightly concerned about a declining dollar and its impact on all aspects of business, including Mergers and Acquisitions.

Outbound, the weaker dollar is making it more difficult for US companies to make acquisitions abroad, because they’re now more expensive. On the inbound side the impact has been positive. We’ve seen a strong increase in foreign investments in the US. With a weak dollar, many foreign players see an opportunity to buy companies at a discount.

The US firm seeking growth through acquisition might assume that this means increased competition, because that attractive competitor you want to buy is also being courted by cash-rich foreign buyers.

In reality, you’re seeing not more competition but different competition. In the past, competition came largely from private equity or hedge funds — and that was a very difficult competitor. These were sophisticated buyers, with a low weighted average cost of capital because they had good access to cheap debt. they understood capital asset pricing models, and they were tough people to compete against.

Now the scene has changed. The private equity players have withdrawn and the foreign buyers are stepping in. But these foreign competitors may not know the US market as well. They will tend to be strategic buyers, looking to improve their business or marketing picture, rather than purely financial buyers aiming to turn a quick profit, and as such they may prove far less sophisticated.Right now, it’s a little premature to determine exactly how they will behave. My sense is they will tend to be fairly cash rich because the dollar is weak. That means that in some cases they are likely to overpay. So from a seller’s perspective, we see strong activity right now by US companies looking to divest. They’re eager to accept inquiries at this point, especially from foreign buyers because they spot an opportunity to get a high price for their business.

I was asked the other day about the meaning of “enterprise value”. We have two different terminologies that are used in the marketplace: enterprise value and equity value. Enterprise value is the value of a business including its debt. Equity value is the value of the business debt free.

In some situations, you might be buying a company while also assuming its debt. That would be its enterprise value. Equity value says: “I’m going to pay you a price, but I want it debt free. You pay off the debt, do whatever you want with it, but I want to buy your company debt free.”

In today’s M&A markets, the predominant transaction type is equity value. The exception would be if a company has a capital structure that is very favorable, and the seller therefore has reason to assume it. This is not a whole lot different from buying a house and assuming someone else’s mortgage. There aren’t a lot of fees associated with it — you just slip right in. Sign a few papers and you’re done!

In the commercial world, if I can buy a company and they have very good debt I might be glad to take it on. A common example is an industrial development bond from the local government that is on very favorable terms. As a buyer, that’s most likely something that I’m going to want to keep in place. Why would we want a low-cost loan paid off? On the contrary, we could use that as part of the deal structure. So, the primary reason for selecting enterprise value would be if the buyer can secure a deal structure that’s such that the existing debt provides a benefit. If the debit is not favorable, then as a buyer I would probably opt for equity value and bring in my own debt structure.

There’s some confusion around about the direction of the M&A market, and it comes from seeing the market as an undifferentiated whole. For example, a recent article in the New York Sun predicts a comeback in M&A activity after a year in the doldrums. 

The article is generally correct and I do see a strong emanating market. However I question their premise that the comeback is widespread over the whole market. There’s going to be a divide. At the high end — which I characterize as transactions of $10B and up — we’ll continue to see a healthy amount of activity. It’s Hewlett Packard buying EDS. It’s Anheuser-Busch getting bought by Inbev. It’s Microsoft trying to buy Yahoo.  Many of those big companies recognize that they will only continue to grow by adding strategic components to their business. They’re looking to get immediate expansion in either brands or — even more important — global penetration, which is partly what we saw on the Inbev deal. 

The other area where we will see continued growth is at the lower end of the market. These are transactions under $1B in size. Here people are trying to fill their market gaps, buying competitors that have gotten weaker. In particular within that sector, watch for transactions under $100m  — I predict the strongest activity within this range. The primary reason is their access to credit, or perhaps more significantly their ability to do without it.  In many cases privately held companies of this size can buy for cash out of their operating income. Or they can use equity positions they’re going to put into the business. Either way, the transactions are proving much easier to get financed.

So this is what I see as the major divide — greater than $10B, less than a billion. In my next post I’ll talk about the missing middle: transactions from $1B to $10B.