After an M&A boom which took global deal volumes to record highs in 2006 and 2007, the financial crisis has hit M&A markets extremely hard. While 2009 was a good year for investors in the stock markets and many other markets, M&A activity was very negatively affected by the credit crunch its various consequences.
Many observers expect a modest recovery in 2010, but the markets remain volatile and any prediction for the M&A market must be seen as an attempt to gaze into the crystal ball. Any prognosis made at the time of writing in February 2010 may be obsolete when this article is published.
M&A Cycle and Current M&A Sentiment
Deal volumes in 2006 and 2007 were higher than those in 1999 and 2000, when the M&A markets were benefiting from the extremes of the dotcom bubble. Figures in 2009 are similar to those in 1997, 2001 and 2004. While cheap debt was a key driver of the recent M&A boom, the credit crunch and the difficulties in obtaining acquisition financing are responsible for the current problems. As the bond market, which provided liquidity at least for some time, shows signs of drying up again, the situation may even become worse before it gets better.
The markets continue to be disturbed by new problems like the Dubai crisis and the Greek crisis. While at the end of 2009 most market participants would have expected an upswing of the equity capital markets and a wave of IPOs in 2010, the mood has recently changed in Germany and other European markets. A number of German IPOs which were expected in 2010 are now rumoured to have been cancelled. On the other hand, one major German company which pursued a dual-track strategy for the exit of its private equity owner recently announced that the offers received from trade buyers for a M&A exit were so insufficient that it will instead continue with the envisaged IPO. Some of the other auctions for major assets which are underway indicate that both strategic buyers and private equity buyers are reluctant (or unable) to offer attractive prices which meet the expectations of the sellers. Therefore, it is certainly possible that some of these processes will be stopped, at least by those sellers that are not forced to complete a transaction this year. Therefore, there is a high likelihood that the same kind of deals will dominate in 2010 as in 2009: less cyclical industries with typically strong balance sheets (energy; pharmaceuticals; health care) on the one side and distressed sellers on the other side. Of course, we all hope not to see another bank deal which must be financed with taxpayers’ money.
Distressed M&A and Reorganisations
The number of insolvencies has risen dramatically. Therefore, it is not surprising that distressed situations account for a large part of current M&A activity. We see transactions occurring after insolvency proceedings have started, transactions to avoid insolvency in a distressed situation and bailout transactions into which investors inject fresh capital.
In many situations, it is no longer the shareholders or the management who control the process; rather, it is the lenders that “call the shots”, particularly if the company is in such a financial situation that, taking into account the enterprise value and the debt of the company, its equity is already wiped out. The “lenders” group often includes hedge funds and other aggressive players who have acquired debt at a considerable discount. In jurisdictions that do not provide for a reorganisation procedure comparable to the US Bankruptcy Code’s Chapter 11, which allows the debtor some breathing time and interim protection from its creditors, it is more difficult to restructure the company prior to the onset of insolvency proceedings. It must be noted, however, that many European jurisdictions have made considerable progress in providing adequate and efficient procedures for this eventuality in the last decade.
When the companies are sold, the creditors may take a leading role in organising the process as well. In some cases, a trustee is chosen to hold the shares in the target company and to run the sale process. For potential buyers, it is important not only to analyse the financial status of the target but also to understand the situation of the lenders, who may have different capital ratios and write-off statuses. They must also understand which formal consent requirements of the creditors and the shareholders exist and how the interplay is to work. In extreme cases, they may find out after lengthy negotiations that they have spoken to the wrong party.
In the banking sector, Hypo Real Estate and WestLB have formed the first of the German “bad banks”. It is difficult to predict whether other banks will be forced to implement similar solutions. It is also possible that the crisis will force further consolidation and M&A activity in this sector.
Sovereign Wealth Funds
Sovereign wealth funds have made some notable investments in banks and major industrial companies during the crisis. Although the Dubai crisis shows that the Arabic region has some problems of its own, we expect further activities from sovereign wealth funds in Europe in the years to come.
As a result of concerns relating to the politically motivated influence that such investors could exercise in strategically important industries, the restrictions of the German Foreign Trade Act – which traditionally only applied to arms and defence-related industries – have been extended to other industries as well. Acquisitions of German companies by buyers that come from regions outside the EU and countries associated with the EU (Iceland, Liechtenstein, Norway and Switzerland) may become subject to review provided that at least 25 per cent of the voting rights are acquired and that the acquisition “endangers the public order or security of the Federal Republic of Germany”. This is meant to be a very high threshold and there is widespread opinion that only a few cases will be affected. Nevertheless, the potential for intervention creates unwelcome uncertainty which could in auctions work to the disadvantage of a non-EU potential acquirer. For this reason, the new law has introduced the possibility for each acquirer to apply for a preliminary clearance certificate.
The Return of the Private Equity Buyer
As in other jurisdictions around the world, the lack of acquisition financing was particularly dramatic for private equity buyers traditionally relying on debt financing in leveraged transactions. While there was some activity in the mid-cap sector, there were hardly any major transactions in 2009. The major funds which usually engage in transactions with a volume of €500 million or more have mostly concentrated on their existing portfolio companies and their refinancing and recapitalisation. In some cases, the funds have provided fresh equity. However, there were also some significant cases from the automotive supply industry to real estate in which portfolio companies became insolvent or were ultimately acquired by the creditors.
Where major transactions were completed (eg, Springer Science+Business Media), this was usually possible when the companies were already indebted to a large extent and such gearing could be preserved by involving the existing lenders in a refinancing in a change of control transaction, often combined with the injection of fresh capital.
Although the circumstances and market conditions have been extremely difficult, the private equity industry has proven that it can survive even in an extreme financial crisis.
We expect, therefore, something of a private equity renaissance once the market conditions improve. Of course, we should not expect a return to market conditions like in 2006-07, and features such as covenant-light and accrued interest will not return in the same way for a long time.
In earlier M&A and stock-market cycles, we have seen hostile takeovers in the first stages of recovery after a stock-market crash as those players with a strong balance sheet take advantage of the depressed share prices of their weaker competitors. This time around, this has not happened in Germany so far. The main reasons for this are that acquisition financing has been extremely difficult to obtain even for blue-chip borrowers, and that there has been great uncertainty as to the right valuation in an economy that could be subject to downturn. Furthermore, some potential acquirers were concerned about their own businesses and felt more comfortable maintaining a strong liquidity position than spending the money on acquisitions.
Due to the financing constraints which may continue, we expect more share-for-share offers or combined cash-and-share offers with a substantial share component. If German acquirers offer shares, they can use authorised capital if such capital is large enough. There is a trend, however, whereby institutional investors are trying to restrict such authorisations. Therefore, consent by the shareholders’ meeting may be required to increase the capital. In this context, it is noteworthy that recent amendments to the German Stock Corporation Act have significantly increased the likelihood of companies obtaining a speedy capital increase clearance in a preliminary court proceeding, in spite of pending shareholder litigation.
With respect to cash-settled total return equity swaps which were used in Porsche/VW and Schaeffler/Continental to prepare a takeover and which are not subject to disclosure requirements in Germany, there is an ongoing debate as to whether the example of other jurisdictions should be followed, with the disclosure rules extended to cover such derivatives.
Deal Terms and Deal Protection
While in the “golden days” of the M&A boom in 2006-07 many transactions were done on the basis of “historic” effective date accounts without a post-closing price adjustment (a “locked box” arrangement) and on the basis of limited representations and warranties combined with low liability caps and high de minimis thresholds, there is now a trend towards more buyer-friendly share-purchase agreements.
The difficulties in properly evaluating a business with an unclear future due to the crisis, while at the same time matching the buyer’s careful evaluation and the seller’s expectations, result in the search for intelligent purchase-price formulas, in particular earn-out mechanisms. While very sophisticated clauses have been developed, there is considerable scepticism as to whether they will work in practice, in particular if the buyer plans to extract synergies by merging the target with its own business.
Material adverse change (MAC) clauses have become increasingly important after several major transactions were not closed due to the effects of the crisis. We see a trend to clearly defined MAC clauses (threshold amounts, measurement periods, carve-outs, etc), close alignment with MAC clauses in the financing documentation and an increase in use of market MAC clauses.