Wednesday, June 23, 2010

While Large Cap Transactions Remain Challenged for Second Half, Looming Tax Increases Will Light Fire Under Middle Market Merger & Acquisition Activity, According to PricewaterhouseCoopers

/PRNewswire/ -- Despite earlier improvements in credit and equity markets and corporate balance sheets, U.S. merger and acquisition (M&A) activity remained sluggish in the first half of 2010. Unforeseen economic events in the last two months triggered a global ripple effect reviving sentiments of uncertainty -- setting the stage for a challenging M&A environment for large cap transactions in the second half, according to the Transaction Services practice at PricewaterhouseCoopers, LLP (PwC). However, PwC contends that the middle market may be a different story.

"Going into the second half, record dry powder in the private equity space and unprecedented cash levels on the balance sheets of corporate America will combine with the desire of family held businesses and private equity backed management teams to sell prior to looming tax increases," says Bob Filek, partner with PricewaterhouseCoopers' Transaction Services.

U.S. M&A activity was down three percent compared with the same period in 2009. The number of closed deals in the first half of 2010 represents the lowest deal volume this decade, according to PwC. For the first five months of 2010, there were 2,969 closed deals representing $317 billion, compared with 3,065 deals valued at $323 billion in the same period of 2009.

While deal value and volume are down, willing lenders and open credits markets are available for transactions, according to PwC. "Banks and institutions are providing capital to execute deals," says Greg Peterson, partner with PricewaterhouseCoopers' Transaction Services. "They are lending more conservatively, but credit is available from a variety of sources and in a variety of types -- including traditional leveraged loans."

Corporate buyers continue to employ strategic deal making, pursing attractively valued companies and seeking out 'mergers of productivity' as a means to capture benefits of scale and cost savings, maintains Filek. "Companies are taking advantage of depressed valuations -- looking for deals to grow and diversify at discounted prices. Even with the uncertainty in Europe, a hesitant consumer and volatile markets, it's still an attractive time to buy."

The median deal size in the first half was $107 million, indicating that smaller, middle market deals have become the new 'normal.' "While there is still ambition to complete mega deals, the 'hit rate' will be low. The sweet spot for deals will be one to five billion dollars and below, with a mega deal or two sprinkled in," says PwC's Peterson.

PwC expects divestitures, carve-outs and spin-offs to continue to contribute to deal activity as companies separate certain assets and operations no longer seen as core to the business. The likely candidates to acquire these assets are private equity players who have strong relationships with large corporations that may be interested in selling certain assets. Business units within the industrial products and technology sectors are among the industries where PwC expects to see increased divestiture activity.

"Private equity players will also remain active in the distressed area, using their debt, hedge and distressed funds to find deals in untraditional ways," continues Peterson. "While there are concerns about stricter regulation for certain alternative investment classes, private equity is a resilient and innovative business run by sophisticated investors who will still get deals done, regardless of what transpires in Washington."

The current private equity overhang at nearly $850 billion (three and a half times the overhang in 2000) represents 54% of all capital commitments made between 2004 and 2009. Over 85% of the $850 billion is in funds larger than $1 billion, including 48% in funds larger than $5 billion, according to Cambridge Associates.

Declining values of the Euro and Pound are also providing a strong backdrop for cross-border deals, particularly in Europe. "Typically, during U.S. downturns, European companies take advantage of a poor U.S. economy, but this time, foreign buyers have to deal with issues at home, including a challenging financing market, reduced demand and declining currency values," according to PwC's Filek. "As a result, we expect the inverse to occur. U.S. corporates are going to see good opportunities to acquire high quality franchises and brands in Europe."

Sectors ripe for consolidation include:

-- Aerospace & Defense - Activity in the security, surveillance and
homeland security sectors are expected to continue as suppliers seek
to diversify their offerings and seek growth areas away from
traditional defense budgets. Look for organizational conflict of
interest concerns to drive some activity, with A&D companies
evaluating options to exit such activities through a sales process.
-- Automotive -- With crashing 2009 assembly volumes in the rear-view
mirror, companies with strong balance sheets and access to capital are
poised to re-enter the deal market. Over the next three to five
years, M&A will be driven by new technologies, regulations and
consumer requirements. Tier one suppliers will work to realign their
product portfolios to take advantage of the restructured industry.
Developed markets will focus on fuel economy, hybrid and electric
vehicles and infotainment and communications in vehicles, while
developing markets will focus on delivering low cost vehicles and
acquiring technologies.
-- Entertainment, Media & Communications -- Private equity interest
remains strong with new investment in and through platform companies.
High-profile acquisitions over the past several years, as well as
numerous middle-market acquisitions, have led private equity's
interest and influence via platform investments to expand across the
E&M landscape. As private equity investors continue to assess the
cyclical and structural issues within certain E&M subsectors, PwC
expects that interest to permeate even further via bolt-on
acquisitions as well as new platform company investments.
Additionally, more traditional, well-capitalized corporates in this
space appear to be stabilizing and interested in potential M&A
-- Financial Services -- Until the impact of U.S. financial regulation is
fully realized, uncertainty will be cause for continued stagnation of
deals in the sector, other than some continuing interest in FDIC
supported takeovers. However, opportunities exist for companies to
divest non-core assets and consider capital raising alternatives such
as debt or equity raises. Consolidation in the property and casualty
insurance is still expected in light of continued soft premium pricing
and desire to maximize scale, while life insurance consolidations will
likely continue to be a less active space given returning investment
portfolio valuations and focus on product redesign.
-- Healthcare -- As the full impact of U.S. healthcare reform becomes
better understood, look for increased industry M&A and joint venture
activity. Consolidation will accelerate in the services and health
insurance/managed care sectors, driven by the need to reduce costs,
increase productivity and develop more integrated business models.
Technology will play an even larger role; and leaders will embrace
strategies and innovations that will lead to more collaboration across
all health industry sectors.
-- Oil & Gas -- Oil & gas commodity price differential will drive
companies to increase their oil positions through acquisitions.
Equipment and service companies will expand their product and
geographic footprint through transactions. The offshore drilling
moratorium will be an obstacle for those highly levered to Gulf of
Mexico E&P projects but will likely not dampen the growing level of
transactions in the sector.
-- Power & Utilities -- Despite uncertainty surrounding energy policy and
regulatory changes, M&A activity in the sector has been a pleasant
surprise, as significant regulated and merchant company transactions
have been announced in the first two quarters of 2010. PwC expects
this trend to continue, with a cautious eye towards regulatory
approvals of the announced transactions. IOUs continue to shed
non-core assets and M&A activity remains strong in the renewable
space. Expect to see continued sales of merchant power plants,
particularly driven by the current and projected commodity prices.
-- Retail/Consumer Products -- Watch for the strongest sectors to lead
the way in accelerated activity focused on growth. Food and household
products companies will look to expand portfolios and enter emerging
markets as a way to boost revenue growth. Retailers faced with a
lackluster U.S. consumer will be focused on business models that make
sense for them in emerging markets. European specialty companies
depressed by the recent downturn could be attractive to opportunistic
U.S. buyers.
-- Technology -- Record profits and favorable revisions in investors'
expectations will drive M&A as a means of accelerating innovation
cycles. The 'new R&D' will continue to drive mid-market transactions.
PwC expects software incumbents to round-out offerings or acquire
industry-specific applications and as major hardware players expand
into end-to-end solutions. Look for semiconductor deals to come to
the fore as the long-awaited cyclical rebound begins to take hold.
Consumer technology and Internet majors will continue to work their
way along the value chain to capture market and mindshare as mobile
computing, entertainment and communications markets converge on
intelligent and user-friendly devices.

According to PwC, the wild card in the second half will be just how much incentive looming tax increases give buyers to sell. "The economics could be compelling enough to drive a rush to exit by December 31, which could mean a busy holiday season for deal makers," says Filek.

*The accuracy of our previous forecasts does not guarantee future accuracy.

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