Long Live M&A

In the summer of 2007, levels of mergers & acquisitions (M&A) activity took a drastic downturn. In 2006, and early 2007, we witnessed record levels of strategic M&A and private equity buyout transactions. Flush with cash due, in part, to the collateralized lending obligations market, lenders backing private equity sponsors loosened traditional credit standards and adopted modified lending products to accommodate their needs.

"Covenant lite" deals involved few, if any, of the traditional obligations of borrowers to maintain financial condition or meet other requirements. "PIK" or "toggle" loans allowed borrowers to pay interest in kind rather than in cash. Levels of leverage that in retrospect seem excessive were commonplace.

The correction began with the widespread defaults on subprime mortgages and the resulting reassessment of credit across virtually all industries. As markets tightened, some of the largest and most publicized private equity deals began to fall through as nervous lenders financing the deals backed out. Private equity giant KKR's proposed $8 billion acquisition of Harman International was unable to close. The acquisition of the wholesale supply business of Home Depot by a consortium of private equity firms, including Bain Capital and Carlyle Group, could only be completed after major alteration of deal terms, including a significant decrease in purchase price and an increase in the amount of equity in the deal. To date, private equity and buyout activity are down significantly from their 2006 and first half of 2007 levels.

So, what does this mean for the typical middle market (between $10 million and $500 million) transaction in Indiana?

Middle market transactions are generally thought to be insulated from the risks attending large, multi-billion dollar transactions because they are not dependent on the availability of cheap credit or the willingness of large national and international banks to make sizeable loans. They are generally financed through smaller, local or regional banks which have not been affected by the subprime mortgage crisis. Or, they may have a larger equity component that does not require as much debt financing.

In addition, the decision to sell all of, or a significant stake in, a middle market company is often related to succession planning, estate planning or other more personal issues, rather than purely a creature of market forces. A family may choose to sell its business even in a market slowdown if the time is right for other reasons.

General economic conditions will continue to affect levels of M&A activity, even in the relatively insulated middle market. There's no question about it. If a recession occurs, lenders will continue to tighten their terms. Leverage multiples will be lower and covenants will be tighter. Those conditions will result in less money being available to private equity buyers and strategic buyers alike.

However, if economic conditions continue to decline, strategic buyers are likely to begin to play a larger role in the market. Sellers' price expectations will likely be reduced due to general economic conditions as well as the lack of competing private equity bidders to drive up the price. As a result, strategic buyers are likely to see opportunities to acquire complementary businesses at a bargain price.

In addition, smaller private equity firms continue to operate in the middle market, and some say that the economic conditions are ideal for them. Many middle market companies may be affected by worsening economic conditions, but the fundamentals of the business may remain strong. This scenario represents an ideal acquisition for a private equity fund with money looking for a home. Smaller private equity firms may also be more willing to put in the big equity stake that is demanded by today's bankers, who are no longer willing to take on the lion's share of the risk by funding a transaction primarily with debt.

It's true - overall M&A activity thus far in 2008 is down from the levels we saw in 2006 and early 2007. Keep in mind, though, that those were record years in terms of M&A activity. We should not expect those levels to be sustained. From a deal lawyer's perspective, we should instead be happy that we will return to those levels in later years. M&A has always been cyclical, as has the economy. We can be confident that M&A activity will rebound. We only have to wait and see how long it takes.

Janice Wilken is a partner in Ice Miller's Private Equity/Venture Services Practice Group.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.