M&A Report: Deal or No Deal?

Talk about a drop-off. Merger and acquisition activity came to a screeching halt late this summer when concerns in the credit market made financing for large deals all but impossible, especially for private-equity blockbusters that had been fueling the M&A boom.

In fact, deal volume dropped to just $54 billion in August from more than $192 billion in July, according to Thomson Financial’s Richard Peterson, director of capital markets. He confirmed that August was the largest month-over-month decline in deal activity by dollar value in more than 20 years. And September volume is on par with the slow pace of August. “It was on track to be a record year with more than $2 trillion in activity,” says Peterson. “Now, it will be tough to get back to 2006 numbers. It could be a down year.” In fact, the number of merger transactions was down only slightly, from 900 in July to 842 in August, suggesting that smaller deals are dominating.

The big change, of course, is difficulty in the private-equity leveraged finance realm. Peterson says that private-equity managers are preoccupied with securing financing for the deals that they have already announced. Bankers were looking to tighten the terms on that credit as fears of a downturn sent shivers through the market. The test case seems to be First Data Corp., which announced in April that it was going private in a $26.4-billion leveraged buyout by Kohlberg Kravis Roberts & Co. But the ensuing credit crunch put the deal in jeopardy, as bankers sought better terms or a higher rate of interest on the $24 billion of debt the deal requires. In late September, it appeared that KKR was close to reaching an agreement with bankers, providing a sign of hope that financing for large deals is available, albeit at costlier terms.

“Terms on financing will not be nearly as favorable going forward,” says Philip Richter, a partner in the corporate department of law firm Fried, Frank, Harris, Shriver & Jacobson. “You’re not going to see some of the things you were seeing like PIK-toggle bonds and covenant-light agreements. Banks are going to want better terms on these loans.”

Richter and others say that difficulties in the credit market for private-equity firms could open the door for strategic buyers. “Private-equity firms may have a harder time competing in those deals because the financing terms are less favorable,” he says. The two largest deals announced in August and the first half of September were strategic acquisitions: MetroPCS launched an unsolicited $5-billion bid for Leap Wireless in early September, which looked to be on the verge of falling through, and Medco Health Solutions said it would buy PolyMedica for $1.5 billion. The size of these transactions is a far cry from the blockbuster deals PE firms were announcing earlier this year.

“Companies that were sitting on the sidelines because they didn’t want to compete with private equity may now be looking for deals,” says John Graham, a finance professor at Duke University’s Fuqua School of Business. “There may be good opportunities to pick off some undervalued assets.” Fried Frank’s Richter says strategic buyers can bypass problems in the credit market by offering mostly stock in the deals. Some of the industries where Richter expects to see some modest activity are energy, technology, and retail. He expects buyers to remain interested in companies that service the oil industry. “When oil is over $80 a barrel, you are likely to see some M&A activity in areas such as drilling equipment and other companies that support the oil industry.” If the holiday shopping season turns out to be a bust, he says, corporate bargain hunters could look to scoop up retail companies hit with declining stock prices. Bargain hunting is likely to be a recurring theme in M&A through the rest of the year. Thomson’s Peterson expects financial services companies to remain targets, especially those that have been hit by the turbulence in the home-lending arena.

Point of No Return?

The question going forward is: Will a healthy level of M&A activity return before the end of the year? The answer depends somewhat on how the credit market shakes out. “I think companies are worried about the credit situation and they are taking a step back to see how that resolves itself,” says Graham. “That could take a while, but I doubt, even then, it would jump back to the level that we have seen in the last few years.”

Peterson agrees that M&A activity is likely to remain depressed for the rest of the year. He points out, however, that M&A activity has generally been more robust in the early part of the year, which could mean a return to a healthier volume in the first part of 2008. By then, says Peterson, there could be some cuts in the federal funds rate, which could fuel increased buying, and executives will have a clearer picture of what’s happing in the credit market and the economy as a whole. “There will also still be PE deals, just on a smaller scale,” he says. Bankers will also likely favor underleveraged deals.