The New M&A Ecology

Business Finance: How is the deal landscape looking these days?

Jeff Gell: It's a tale of two markets right now, and has been for the past two years, but the trends are different by segment. One segment that really drove quite a bit of market growth over the past couple of years and came to a halt last summer is the private equity [PE] segment, where large pools of equity capital -- combined with the ability to lever that up into large pools of deal capital with relatively low rate-of-return hurdle requirements on the debt side -- made a number of deals possible.

The drying up of the liquidity side has closed a large piece of that market, and you see that equity being used in very different ways now. You see higher equity percents in deals, which means the deals are getting smaller and the deals that get done need more operational transformation profit improvement to justify the returns that the PE funds need.

The other half of the deal market is corporate buyers. They've been complaining over the past couple of years that despite the strong synergy potentials they would have in buying a company that a private equity fund wouldn't have, they were finding deals too expensive and getting outbid by the PE firms. Part of it is the higher return requirement that the corporate guys have because they're less heavily levered and not putting as much cheap debt into the deal. Part of it is that they look at synergies, but they don't look at base operating performance improvements in the same way that the private equity investors would.

But corporate buyers are sitting on very large pools of cash; they generate more cash from operations than they can put against organic growth opportunities. So they face a choice: "Do I give this cash back to my investors in the form of stock buybacks or dividends, or do I use it to buy companies?" That trend has continued despite the credit crunch, and in a number of industries people are looking for a great place to put the cash. From that perspective the corporate market is still active, and the corporate market is what's driving the M&A market today.

BF: So is now a good time to buy?

JG: In a down market, not everybody is in a position to buy. You've got companies that are stronger operating performers, and others that are weaker operating performers. Weak earnings and a weak multiple create great buying opportunities for the good managers. We've found empirically that in down markets like we're in today, the deals that get done are much more likely to generate positive returns for the buyer than deals done at other times. It's a function of price of deal and quality of company that actually has the wherewithal to buy at this time. Better companies and better operators are buying companies at cheaper prices than they would otherwise.

What we see is companies with relatively high profitability buying companies that have relatively low profitability but are not in financial distress. The assets have good underlying earnings power; they just happen to be underperforming. The reason why these deals create a lot of value is that the buyer, which has higher profitability -- and you would assume, good operating practices -- is able to get more out of those assets than the prior owner was and actually improve the operating performance as a result.

BF: BCG research suggests that the size of the target relative to the size of the buyer is often a key factor in the success or failure of an acquisition. Why is that?

JG: Generally what you see is that smaller deals, less than 10 percent of market cap, tend to outperform. But there's always an underlying distribution, and the averages are misleading. So [the research] doesn't say that you shouldn't do a large deal; it says there are more bad large deals than good large deals because people underestimate the complexity of what goes into managing the base business (for both buyer and seller) and actually driving those synergies. The sheer number of resources that you need to drive a large-scale integration can be overwhelming, and it's very tempting to under-resource that.

That being said, if you do it well you can create a lot of value. It's not as though no big deals create value.

BF: What tips do you have for companies that are considering a deal in this environment?

JG: The first thing I'd want to know is what my base-case outlook for my business looks like. If I don't buy this company, what kind of returns will I deliver to my shareholders? What's my forecast over the next five years? How much cash am I going to generate? How do I plan on deploying that cash in terms of dividends, stock buybacks, and paying down debt, with some reasonable assumptions around my valuation multiple, either rule-of-thumb or some much more sophisticated modeling? What do I think my return to shareholders could be?

Lay out the pro forma of what the two companies look like together. Over three to five years, is it many more dollars of shareholder value that I create if I'm successful? Limited shareholder value? Or does it actually destroy shareholder value in the near term if I'm successful? You need to be very crisp and clear in understanding that.

That being said, that's just a purely financial look at things. You need to have a very clear view of the operating model under the deal, the strategic rationale for doing the deal, where you think the sources of value are and how that actually translates into the pro forma. If I think a combined deal gives me access to new markets that I wouldn't have otherwise, how much revenue and profits does access to those new markets actually generate in my pro forma for the next one, three, five years?

With a clear strategy that's translated into the operating and financial model, once I'm ready to announce the deal I have a blueprint of the relatively short list of actions that I need to take to deliver on that financial pro forma. I've already started integration planning, and I'm ready to go full steam ahead on that from the day of the announcement. There's no delay; there's no "I can't think about planning until close is over because I don't want to be gun-jumping". Get the planning done quickly so that you're implementing, not planning, when you own this asset, because every day you delay is millions of dollars that you're leaving on the table.

See BCG's "The Return of the Strategist: Creating Value With M&A in the Downturn" here.