What to expect in today's M&A market

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© 2010 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com).DOI 10.1002/jcaf.20557

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Bill Venema

The merger-and-ac-quisition (M&A) market during

the last year has been dismal. The credit crisis and the global recession that followed caused most sellers to hunker down and wait for bet-ter days. On the buy side, most potential buyers have wanted to avoid grabbing a falling knife and have chosen to wait until they are sure it’s on the floor.

THE STATISTICS ON THE CURRENT M&A MARKET

The number of M&A trans-actions has fallen dramatically since 2007, and valuations have fallen as well. During the third quarter of 2009, M&A activ-ity across all industry sectors was uninspiring, although an improvement over the second quarter of 2009. Compared to the third quarter of 2008, fewer buy-ers focused on smaller transac-tions in the third quarter of 2009, so that both the number of trans-actions and the value of transac-tions declined significantly.

As reflected in Exhibit 1, the number and value of deals in the third quarter of 2009 increased from the second quarter of 2009.1 Specifically, the number of deals increased 6 percent from

An attorney and merger-and-acquisition deal-maker reveals what to expect in today’s market.

© 2010 Wiley Periodicals, Inc.

What to Expect in Today’s M&A Market

the second quarter of 2009 to the third, and the value of the deals increased 38 percent, although the increase in the value of the deals was largely attributable to a greater number of transactions over $1 billion.2 Nevertheless, when compared to the third quarter of 2008, the number of transactions is down 27 percent, and the value of transactions is down 55 percent. Compared to the results of the recent past, the trend looks bleak, as shown in Exhibit 2.

For deals announced in the first six months of 2009, the median ratio of enterprise value to trailing 12 months earnings before interest, taxes, deprecia-tion, and amortization (EBITDA) was lower than it was during the last six months of 2008 and during all of 2008 and 2007 (see Exhibit 3).3 The decline in EBITDA multiples has not affected every industry sector, however. Some sectors are faring better than others, particularly those with stable cash flows and good growth prospects. For example, the health care

and technology sec-tors have fared better than deals involving consumer-related com-panies or industrials.4 Exhibit 4 sets forth the

multiples for various sectors for the first half of 2009.

Are There Reasons to Hope?

As bleak as things might seem, there are reasons to hope. Note that I use the word hope. Although the discussion that follows addresses some positive developments in the M&A mar-ketplace, these developments are insufficient to guarantee that the dark days are behind us. There is no way to be sure that the market has turned around until after it has done so, because recessions do not end all at once. Instead, they fade away, as the positive forces in the economy overtake the negative. With the foregoing as a caveat, let’s turn to a discussion of these positive developments.

The chart in Exhibit 5 is from August 2009, and it shows that the yield on junk bonds dropped significantly to a level that was 835 basis points more than comparable Treasuries.5 (As a point of reference, note that the spread was 854 on

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12 The Journal of Corporate Accounting & Finance / January/February 2010

DOI 10.1002/jcaf © 2010 Wiley Periodicals, Inc.

and other purposes increased by 74.4 percent in the second quarter of 2009, compared to the first quarter of 2009.8

The second reason to hope that M&A market activity might be coming back is the rally in the equity markets. As of late September 2009, the S&P 500 index has risen 57 percent since early March, according to Bloomberg.9 The rise in the value of publicly traded equi-ties will also improve M&A valuations, even among private companies, because public-company comparables are a key factor in determining the value of a private company. Moreover, improving valuations will com-fort business owners who stub-bornly cling to the valuations of the heady days of 2006.

Although the economy con-tinues to send mixed signals, such as high unemployment num-bers, a third reason for hope is the renewal of optimism among businesspeople. On September 1, 2009, Tatum, LLC, the largest executive services firm in the country, published its monthly

rates, which makes it difficult to finance M&A transactions. When the spread between junk bonds and comparable Treasuries is below the historical average, banks consider the climate for lending to be good. Consequently, they charge lower interest rates, thereby making it easier to finance deals. Although a spread of 758 basis points is still above the average of 590 basis points, it is a vast improvement over the spreads of the past year, when the spread hit 2,180 basis points.7 This drop also helps to explain why, according to Thomson Reuters LPC, total debt issuances for working capital, M&As,

September 12, 2008, which was the Friday before the Lehman Brothers filed for bankruptcy protection.) As of October 16, 2009, the spread has dropped to a level that was only 758 basis points more than comparable Treasuries.6

This decline is good news, because the spread between junk bond interest rates and compara-ble Treasuries is a good barom-eter for predicting a rebound in M&A market activity. If the spread is higher than the histori-cal average of 590 basis points, then banks consider the risk of lending to be above average and, therefore, charge higher interest

Number and Value of M&A Transactions in Recent Past

Q3 2008 Q2 2009 Q3 2009

Number of Transactions 2,575 2,012 2,141

Value of Transactions $317 billion $104 billion $144 billion

Exhibit 1

Number and Value of M&A Transactions This Decade

Exhibit 2


The Journal of Corporate Accounting & Finance / January/February 2010 13

© 2010 Wiley Periodicals, Inc. DOI 10.1002/jcaf

In the current M&A market, for example, sellers might find that the issue of valuation—often the principal determining factor in good economic times—has been replaced by concerns over a potential buyer’s ability to finance the transaction. Sellers should carefully avoid becom-ing tied up in a transaction that a potential buyer might be unable to finance. Getting out of a transaction after it starts is fraught with risks, because (among other reasons) suppli-ers, customers, and employees can become uneasy if they think the company is up for sale. In addition, they often wonder why a transaction failed to close, regardless of the explanation offered by the seller.

From the buyer’s perspec-tive, financing the transaction is not the only concern. Funda-mentally, M&A transactions take place because the buyer thinks that it can do more with the business or its assets than the owner can. In other words, the buyer values the business at a level that is, at least to some extent, higher than the value the seller places on it. Accord-ingly, the buyer will want to have a clear idea about what will happen with the business fol-lowing the closing. If the future is cloudy, it is difficult for buy-ers to project what will happen following the closing, thereby adding to the buyer’s uncertainty that is already present in any deal. Added uncertainty means greater risk, which quickly trans-lates into a lower offering price. Unfortunately for buyers, own-ers of privately held businesses are unlikely to be sympathetic with a buyer’s concern over the future. Owners often view their businesses not as investments, but rather as lifestyles, jobs, and/or measures of their social

Survey of Business Conditions, which is based on the views of executives and consulting pro-fessionals across the country concerning current business and economic conditions. The report revealed that the business index moved up from 2.9 to 4.2 and that the three-month moving average rose for the eighth con-secutive month, thereby indicat-ing that those surveyed believe a business recovery is under way.10

Finally, there is a virtual arsenal of cash on the balance sheets of corporate America. The credit crisis and economic slowdown caused them to hoard their cash. S&P analyst Howard Silverblatt estimates that the amount of corporate cash avail-able is around $700 billion, not counting the financial, utilities, and transportation sectors, which carry large cash balances as a normal part of doing business.11 In addition, private equity funds are estimated to be sitting on

$1.02 trillion of cash, accord-ing to Preqin, a London-based research service. Almost half of that amount—around $472 bil-lion—is held by buyout funds.12 That amount of uninvested capi-tal will not sit idle for long, espe-cially when it’s earning a mere 1 percent in a bank account.

It’s too early to tell whether the dark days are truly over. Nevertheless, there are reasons to hope. If the credit and equity markets continue to improve, and business optimism holds up, then we could be in store for a true rally of M&A activity.

DIFFERING PERSPECTIVES IN UNCERTAIN ECONOMIC TIMES

When it is difficult to find credit and the economy’s health is uncertain, the rules of the game change, and the par-ticipants in M&A transactions must be flexible enough to respond.

Median Ratio of Enterprise Value to Trailing 12 Months EBITDA

by Various Sectors

Health

Care Technology Consumer Industrials

EV/TTM EBITDA 9.0 8.2 6.3 6.8

Exhibit 4

Median Ratio of Enterprise Value to Trailing 12 Months EBITDA

in Recent Past

2007 2008 H2 2008 H1 2009

EV/TTM EBITDA 10.7 9.3 8.5 7.1

Exhibit 3




storms, because consumers need their goods and services despite the condition of the economy. Health care services and food fall into this category.

There are also businesses that sell during bad economic times, because the owners believe they must. For example, if a business has reached a plateau, cannot move to the next level without further financing or help, and will lose ground in the marketplace if it fails to move forward, then a sale might make sense. In other words, if the business is unable to obtain equity or debt financing to enable it to move to the next level, then selling the business might be the best alternative, even during bad economic times. Other businesses that fall into the category of needing to sell include those in which the owners and/or executives want to retire or have developed health issues that prevent them from continuing to work in the way the business requires.

WHAT INDUSTRIES ARE LIKELY TO SEE THE MOST ACTIVITY?

The answer to the question of which industries are likely to see the most activity has two sides, and each side has the word “opportunity” printed on it. On one side, there are those industries that are doing very well and for whom the near term looks prom-ising. On the other side, there are those industries whose businesses have been devastated in the reces-sion and must be consolidated to survive at all. In the first category are industries such as health care and technology. In the latter category are industries such as financial services and automotive.

According to Duff & Phelps, a leading independent provider of financial advisory and invest-ment banking services, health

Some businesses sell during bad economic times, because they are performing well, despite the condition of the overall econ-omy. Consequently, buyers and sellers are more likely to come to a meeting of the minds on the value of the business. Almost every industry seems to have a superstar that has found a way to prosper, even in bad economic times. Google is an example of such a business. In addition, there are counter-cyclical busi-nesses, such as repair shops and discount stores like Wal-Mart that do well in a poor economy, precisely because consumers are being careful with their spend-ing. Finally, there are other busi-nesses that weather economic

status. Therefore, reaching a “meeting of the minds” on price will be difficult in uncertain economic times, unless the busi-ness needs to be sold for some reason.

WHO ARE THE LIKELY SELLERS IN THIS MARKET?

There are some potential sellers for whom the uncertain economy is not an impediment to sale. If a business is doing well despite the economy, then they will be highly sought after by buyers, and valuation will not be an issue, despite the uncertain economy. That, of course, begs the question: What businesses do well, despite the economy?

Number and Value of Health Care M&A Transactions in 2009

Q1 2009

Q1 2009 w/o

2 Largest Q2 2009

Number of Transactions 203 201 228

Value of Transactions $127.5 billion $16.5 billion $27.9 billion

Exhibit 6

Exhibit 5

Junk Bond Yields




Obviously, one way buyers attempt to achieve premium rates of return is to offer lower pur-chase prices. In the face of resis-tance to lower valuations, poten-tial buyers can resort to several different tools to bridge the gap with the seller on the valuation of the business, including:

seller financing,• earnout provisions, and• seller participation in owner-• ship following closing.

Each technique has its challenges. Nevertheless, given the current economic landscape, one or more of them are likely to be a part of most M&A transac-tions for some time to come.

Seller Financing

Because the credit crunch has made it difficult for buyers to obtain suf-ficient leverage to finance their acquisitions, as they have in the recent past, they are increasingly call-ing upon sellers to finance a portion of the purchase price. This tactic is espe-cially prevalent among smaller transactions involv-ing private sellers. Seller

financing decreases the amount of equity that the buyer must provide and reduces the amount of senior debt that the buyer must obtain. In addition, the promissory note that the buyer delivers to the seller is usually subject to a right of setoff (if the buyer has a claim against the seller, the buyer can “set it off ” against what the buyer would otherwise owe the seller) for any breaches of the acquisi-tion agreement by the seller, thereby providing the buyer with additional recourse for indemni-fication, if the seller breaches the acquisition agreement.

the automotive industry, buy-ers are typically looking for bargains. Sometimes, the prices are negotiated at arm’s length, while at other times buyers wait and buy companies out of bankruptcy. Although overall transaction volume and value might decline in these depressed industries, there will be forced consolidations, which will create acquisition targets for opportunistic buyers.

HOW WILL DEALS GET DONE IN THE CURRENT ECONOMIC CLIMATE?

Once again, “cash is king.” Those who have cash, such as the strategic buyers mentioned above, are likely buyers. Although private

equity funds also have a lot of cash to invest, they might be slow to adjust to a new marketplace where debt to finance deals is more difficult to obtain. Private equity funds have to return a high rate of return to their investors, which is difficult to do without leverage. Consequently, when dealing with private equity firms, sellers should carefully review any financing conditions and other provisions of the purchase agree-ment that are designed to assist the private equity fund in realizing the premium rates of return their investors demand.

care M&A activity increased in Q2 2009. As displayed in Exhibit 6, there were 228 health care transactions announced in Q2 2009 compared to 203 announced in the first quarter.13 Although the total deal value declined from $127.5 billion in the first quarter to $27.9 billion in the second, one should note that the first-quarter figure includes Pfizer’s $64 billion acquisition of Wyeth and Merck’s $47 billion acquisition of Schering-Plough (i.e., a total of $111 billion). If one were to exclude those transactions, then the total in Q1 2009 is only $16.5 billion, and so, the deal value would have increased almost 70 percent.14

Another industry that typically has a strong M&A market is the technology industry. The second quarter of 2009 was no exception. According to the international invest-ment bank Houlihan Lokey, the value of M&A trans-actions in the technology sector during Q2 2009 was $16.3 billion, compared to $9.9 billion in Q1 2009.15

The higher rates of growth associated with businesses in the techno-logy industry make them attractive acquisition targets. In addition, there are many strate-gic buyers that are active in the M&A marketplace, because they believe that it is easier to “buy rather than to build” technology. Given the extremely rapid pace of change, buyers want to invest in proven technologies, not research and development. In addition, the technology indus-try is highly fragmented, and so there are many privately held businesses that are attractive takeover targets.

In depressed industries, such as financial services and

When dealing with private equity firms, sellers should carefully review any financing conditions and other provisions of the purchase agree-ment that are designed to assist the private equity fund in realizing the premium rates of return their investors demand.




There are several common features of seller financing. First, it is usually structured so that it qualifies for installment sale treatment, thereby allowing the seller to recognize the gain from the sale over several years, as it receives payments on the debt. Second, it usually bears interest at a rate that is similar to a high-yield security, although the prin-cipal does not amortize during the term of the note. Instead, the principal amount of the note is payable in full at maturity. Third, the note is usually an unse-cured obligation of the buyer and is subordinated to the other indebtedness of the buyer. Con-sequently, the seller should pay very close attention to the terms of the inter-creditor agreement with the other lenders. Fourth, many sellers insist on provisions in the note that require the buyer to prepay it under certain circumstances. These circumstances include (1) a change of control, (2) an initial public offering, and (3) the arrival of a specified future date, although in each case the buyer might try to include the right to convert the note into company stock, if the buyer is unable to arrange for substitute financing in a timely manner.

Earnout Provisions

Another way in which buy-ers and sellers attempt to bridge the valuation gap is by making a portion of the purchase price contingent upon the target com-pany’s achievement of certain specified performance targets. As with any such technique, there are pros and cons.

Normally, buyers like earn-out provisions. If a buyer intends to retain some of the selling

the seller, who will insist on hav-ing some authority with respect to the operation of the business following the closing because part of the seller’s consideration depends on achieving the speci-fied performance targets.

Because of these complexi-ties, the negotiation of the pur-chase agreement will probably take more time if it includes an earnout provision. Moreover, even with a well-crafted earnout provision, there is a good chance that the seller and buyer will find themselves in a protracted dispute following the closing, concerning whether the specified performance targets have been

achieved. To structure an earnout provision properly, therefore, there are numer-ous issues for the parties to consider.

The parties should ensure that there is a true “meeting of the minds” concerning what account-ing principles the acquired company will use follow-ing the closing, because these accounting principles can affect whether the

company achieves the specified performance targets. Another accounting issue concerns how the acquiring company accounts for the earnout payments. Under Financial Accounting Standard (FAS) 141R, which became effective in 2009, any future earnout payments that the acquiring company will make in cash (other than those treated as employee compensation) must be assigned a fair value at the time of closing and fully recognized as a liability of the acquiring company at that time.16 There-after, the acquiring company must re-evaluate the value of the earnout payments upon each reporting date, which can affect the earnings in that period if the

company’s owners as employees of the target company follow-ing the closing, then an earnout provision will not only address the valuation gap, but it will also provide an incentive for these employees to work toward reach-ing the specified performance targets following the closing, thereby enhancing the company’s value. Alternatively, however, if a buyer intends to bring in new management or make other improvements to the company, it might not want to share the ben-efits of that effort with the seller. Another reason that buyers like earnout provisions is that they reduce the amount of considera-

tion that the buyer must deliver at closing, thereby reducing—and, in some instances, elimi-nating—the need for acquisition financing.

Sellers typically do not like earnout provisions. Such provi-sions are extremely difficult to structure and draft into the acqui-sition agreement. In addition, they are difficult to administer following the closing, especially if the buyer intends to integrate the target company into an exist-ing business, rather than keeping it as a wholly owned subsidiary. Earnout provisions must deal with the tension between the buyer, who will want to have complete control over the com-pany following the closing, and

Even with a well-crafted earnout provision, there is a good chance that the seller and buyer will find themselves in a protracted dispute following the closing, concerning whether the specified performance targets have been achieved.




Seller Participation in Ownership Following Closing

Another tool that parties use to bridge the gap on valuation is to have the seller participate in the ownership following the closing. This ownership could be in the company that was sold (if the transaction is structured as a stock sale) or it could be in the acquisition entity (if the transaction is structured as an asset sale or merger). By using this structure, the buyer does not have to come up with purchase consideration equal to 100 percent of the value

of the target company. The stock that the seller holds is rarely the same as that which the seller held before closing. Even if the seller is holding a portion of the shares held before closing, the trans-action is likely to layer on significant restrictions by means of a shareholder agreement or revisions to the articles of incorpora-tion. The seller might also receive new shares, rang-

ing from common stock with few rights to preferred stock with a special dividend rate and other preferences. If the seller’s ownership interest following closing is substantial (i.e., 15 percent or more), then the seller will probably insist upon various governance rights, such as a board seat and super major-ity voting provisions on certain transactions.

If the seller participates in the ownership following the closing, the tax planning is cru-cial. If the transaction fails to qualify for tax-free reorganiza-tion treatment, then the sellers would normally be subject to tax on the shares they receive, even though the shares may be

to the achievement of the targets. The buyer will resist limiting its control of the business following the closing, especially if it wants to integrate the target company into its other businesses or change the company’s strategy or operations. The result of these negotiations can range from nar-row covenants or veto rights on relatively “big” issues to com-plicated provisions that allow the seller to be involved in the details of managing the business following the closing.

There are tax implications associated with earnout provi-sions, as well. If the owners

will be working in the company following the closing, there is a danger that the IRS will char-acterize the earnout payments as employment income, which would subject them to ordinary income tax rates. One way to avoid that characterization is to provide that the earnout payments are not subject to forfeiture if the seller’s employ-ment is terminated. If the earn-out payments are treated as deferred purchase price, then the earnout payment (aside from an imputed interest component) will normally be taxed at capital gains rates rather than as ordi-nary income. Consequently, it would not be deductible by the buyer.

estimated value of the earnout payments changes. Under the old accounting rules, earnout payments were not recognized until the contingency was resolved, and there was generally no interim effect on the com-pany’s earnings or liabilities.

The specified performance targets comprise the heart of the earnout provision. Sellers usu-ally prefer metrics that are high on the income statement, such as revenues or receipts, because they are less prone to manipula-tion by the buyer. Conversely, buyers prefer metrics that more accurately reflect value, such as earnings per share or EBITDA. Even if a metric such as revenue or receipts is used, buyers should consider the seasonality of sales or collections and, in the case of receipts, how fast they will be collected. The seasonality of reve-nues and the length of the collections cycle can be addressed in drafting the time period of the earn-out provision. The overall duration of an earnout provision is also the subject of considerable negotiation, with buyers typically preferring peri-ods as long as three years.

The issue of controlling the business following the closing is always a point of contention during the negotiation of the earnout provision. Sellers will want to ensure that the business is conducted in a way that achieves the specified perfor-mance targets. Accordingly, the seller will want to have some sort of recourse if the company is deprived of resources follow-ing the closing that are needed in order to meet the specified performance targets or if the company is managed in a way that the seller believes is counter

The issue of controlling the busi-ness following the closing is always a point of contention during the negotiation of the earnout provision. Sellers will want to ensure that the business is conducted in a way that achieves the specified performance targets.




7. “The M&A Market: When This Number Falls, Expect the Takeovers to Heat Up,” Investment U, published by The Oxford Club (August 12, 2009).

8. “Market Conditions Improve, More Is Necessary for a Full Recovery,” Middle Market M&A News, published by Deloitte Corporate Finance LLC (August 2009).

9. “Bullish Estimates Fail to Keep Up With S&P Gain,” Bloomberg.com (September 23, 2009).

10. The Tatum Survey of Business Condi-tions, published by Tatum LLC (September 1, 2009).

11. http://blogs.businessweek.com/mt/mt-tb.cgi/ 15281.1259314643.

12. See note 5. 13. Healthcare Industry Insights Q2 2009,

published by Duff & Phelps Global Healthcare Investment Banking Group (September 2009) at p. 8.

14. Ibid. 15. Technology Quarterly Newsletter,

Houlihan Lokey Publications (Second Quarter 2009) at p. 2.

16. Business Combinations and Consolida-tions . . . The New Accounting Stand-ards, published by Pricewaterhouse-Coopers (July 24, 2009).

meantime, while the economy is attempting to recover, those who want or need to engage in M&A transactions will need to be flex-ible and to structure transactions that creatively bridge the valu-ation gap between buyers and sellers.

NOTES

1. Software Industry Equity Report, Q2 2009, published by Software Equity Group, LLC, at p. 10.

2. Ibid. 3. “In Search of Deal Value,” The Deal

Magazine (September 4, 2009) at p. 1. 4. Ibid. 5. “High Yield Spreads Fall Below Pre-

Lehman Levels,” Think Big, published by Bespoke Investment Group (September 16, 2009).

6. “Junk Bonds Still Cheap Even After Record Rally, JPMorgan Says,” Bloomberg.com (http://www.bloomberg.com/apps/news?pid=20670001&sid=aS_7g9RmqicA).

illiquid or subject to transfer restrictions. Moreover, any tax-able gain that is triggered by the receipt of such considera-tion would not be eligible for deferral under the installment method. Consequently, most sellers will insist that whatever structure is used qualifies for tax-free treatment, although doing so might run counter to the buyer’s tax objectives. Therefore, the issue is yet another negotiating point.

FLEXIBILITY IS KEY

Obviously, no one knows for sure what the future holds. It is tough to say whether credit and equity markets will continue to improve, so that both the number and value of M&A transactions can increase. In the

Bill Venema is an experienced business lawyer in the Houston office of Epstein Becker & Green, P.C., a national law firm. His practice focuses on mergers and acquisitions, IT contracts, outsourcing, licensing, joint ventures, and private equity. He is the author of The Strategic Guide to Selling Your Software Company: Essential Advice From a Veteran Deal Warrior, as well as numerous articles on a variety of business law topics. He also maintains a Web site for entrepreneurs at www.TheVenemaReport.com.


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What to expect in today's M&A market