Mergers and Acquisitions

The overall M&A deal market was seriously impacted by the recession. According to Mergerstat, calendar year 2009 U.S. deal dollar volume was 19% lower than calendar year 2008. Similarly, the number of deals dropped 15% in 2009 from the prior year. While the 2009 numbers were down, clearly reflecting the weakness in the deal market, the M&A market seemed to turn a corner in the fourth quarter of 2009 as the data showed more than double the M&A deal dollar volume than the fourth quarter of 2008.

The 2009 recession year was problematic for all participants in the deal business. Private equity funds focused on their portfolios, commercial bankers focused on their problem loans and how to work within with the new regulatory climate while investment bankers focused on survival in a deal market with little activity.

At this point in 2010, participants in the deal market are guardedly optimistic. Continuing doubts and concerns about the economy’s ability to create jobs, growing federal and state budget deficits, the continuing limited, although modestly improving, availability of debt capital, lagging consumer spending and the small
number of other early signs of a recovery are all serving to restrain market optimism.

This market restraint is reflected in the early 2010 deal data. According to Dealogic, M&A deal activity for January 2010 was down 7% from the first month of 2009. This continued decline, albeit somewhat smaller, still reflects weakness in the M&A market. This is definitely a buyer’s market, if only we had the buyers.

M&A deal valuations also suffered in 2009. According to Mergerstat, median implied enterprise valuation multiples declined from the peak valuations achieved in 2006/2007 to an average of 6.3x EBITDA, on par with the depressed valuations of the post 2001 “tech bubble” correction. Recession, economy induced lower corporate earnings, scarce debt capital, and reduced visibility of future earnings all served to produce these lower valuation metrics. Further, according to GF Data Resources, the equity contribution in private equity acquisitions has increased dramatically, averaging almost 60% of the capital structure.

Despite these negative statistics, what do deal practitioners think of the current market? According to a recent study conducted by Thompson Reuters, the following was observed:

• 82% of dealmakers expect a jump in M&A activity in the next six months, up from 56% six months ago.

Strategic investor purchasers and distressed asset buyers are expected to lead the way.

• 80% of surveyed dealmakers identified the current environment as a buyer’s market.
• “Credit Crunch” has decreased in importance as the biggest obstacle to M&A activity, moving from 43% of respondents surveyed last year to 29% today.

A Bain & Company analysis of more than 24,000 transactions between 1996 and 2006 shows that acquisitions completed during or just after the 2001/2002 recession generated almost triple the returns of acquisitions made during the preceding boom years. This held true regardless of industry or the size of the deal.
Private equity funds, strategic buyers, and other investors know this as well, which might be the most positive early indicator of 2010 deal activity.

The 2010 M&A market may be far better than 2009 due to the following reasons;

• A continued gradual improvement in credit availability and stronger lending behavior by banks;
• Continued improvement in corporate earnings. Trailing 12 month corporate earnings will improve as companies drop off poor performance months of 2009 and replace them with better performance months of 2010;
• Better visibility of future revenue growth and input costs;
• Ample supply of private equity funds and an increasing urgency to deploy those funds;
• A significant number of strategic buyers with large cash positions, a strong capital base and a desire to increase earnings;
• Concern over the increase in capital gains taxes and the top marginal tax rate; and n A large number of “older vintage” private equity fund portfolio companies that need liquidity events.

All of these factors could make 2010 a pretty good year in the M&A business.

Financing Market

The credit markets, while showing positive trends for larger middle market borrowers, continue to constrain transaction activity. We expect modest, but favorable, progress in lender and investor appetite for the balance of 2010. We are seeing material improvement in pricing for solid borrowers and a modest relaxation in credit metrics for borrowers with greater than $15 million in EBITDA.

We believe that as consensus grows with respect to the recession bottoming out and even modest economic growth resuming, mezzanine investors will begin actively considering investments in cyclical issuers. Further, we expect the modest relaxation in credit metrics to migrate to the below $15 million in EBITDA borrower market, assuming continued comfort with overall economic progress. We believe these trends will emerge over the next three to six months.

Senior Bank Debt - Middle market loan issuance was $25.8 billion in the fourth quarter of 2009, the highest quarterly volume since the third quarter of 2008. For the full year, volume came in at approximately $71 billion, down 30% from 2008 volume. According to Reuters Loan Pricing Corporation, a majority of the loan issuance was driven by amendment activity. As was the case in 2008, market conditions were characterized by higher pricing, more conservative structures, lower leverage multiples, and tighter covenants. As the credit markets continue to thaw, we expect issuance to increase gradually in 2010.

Private Placements - Traditional private placement volume for 2009 came in at $29.3 billion, down slightly from the 2008 total of $29.4 billion. Approximately 98% of issuance was NAIC2 (BBB-
or better).

Mezzanine – Only $3.0 billion of mezzanine funds were raised in 2009, down significantly from the $26.1 billion collected in 2008. The decrease in fundraising activity can be attributed to fewer M&A transactions to finance as well as a number of companies that are over-levered with few recapitalization alternatives. Return requirements remain at a level of 18% to 22% but investors are reluctant to invest in cyclical issuers. As the credit markets continue to loosen and M&A activity picks up steam, we expect mezzanine transaction activity and fundraising to increase.

Investment Grade Bonds - According to Thomson Reuters, investment grade volume increased to $712 billion in 2009, a 10% increase from the $647 billion issued in 2008. The number of issues increased 11% to 789 in 2009 from 712 in 2008.

High Yield Bonds - High yield debt issuance increased substantially versus 2008 volume. Issuance totaled $146 billion in 2009, quadrupling the $37 billion in volume completed in 2008.

Private Equity - According to Buyouts, there were 530 control-stake private equity transactions in 2009, a decrease of 37% versus the 872 transactions completed in 2008. Total reported deal value was $34 billion, substantially lower than the total of $137 billion in 2008. These decreases are due to a variety of factors, including decreased availability of financing, more conservative deal structures, tighter financial covenants, and an increased focus on current portfolio companies. Although fundraising slowed down in 2009, with only $64.5 billion raised, private equity firms continue to have a healthy amount of capital to put to work in 2010.

Initial Public Offerings - The U.S. IPO market has been weak since early 2008. According to Renaissance Capital, 63 IPOs priced in 2009 (49 in the second half), up nearly 50% from the 43 IPOs priced in 2008. Total proceeds came in at $21.9 billion, down 22% from $28 billion in 2008. Although the market has been relatively weak compared to prior years, the pipeline of companies filing and preparing to file has steadily increased in early 2010.

Economic Conditions

• Fed keeps interest rates at historic lows
• Unemployment remains around 10%
• Mixed views on near-term outlook for overall economy

Since December 2008, the Federal Reserve has kept interest rates at historic lows as concerns about ongoing economic weakness continue to outweigh any fears regarding future inflation. The National Association for Business Economics has indicated that it expects the U.S. economy to grow by 3.2% in 2010 and the unemployment rate will decrease slightly throughout the year, down to around 9.6%. While this view keeps us optimistic, the many differing views from leading economists keep us skeptical that we will see major improvements in the economy in 2010.

Conclusion

On balance, we are guardedly optimistic that the M&A and financing markets will show steady (although modest) improvement as we move through 2010. Activity levels in 2010 should increase as year-over-year performance comparisons turn positive and investor psychology improves with what is hopefully more economic stability.