The Impact of Value on M&A Activity

The “Market” is Not Always Right When it Comes to Value, Especially in M&A Transactions

The mergers and acquisitions market began a slow recovery this last year after a sharp downturn in 2009. Was the slowdown caused by banks reducing lending activity, cash hoarding by businesses, economic uncertainty, or the simple failure of buyers and seller to agree upon price? Michael Blake takes a look at how value is variously defined—“fair market value,” “fair value,” “investment value,” and “market value”—and offers an assessment of what may prove to be the primary market M&A activity drivers going forward.

Introduction

The merger and acquisitions (M&A) market is slowly recovering after a sharp downturn in 2009.  Historically, the decline in M&A activity was blamed on banks sharply reducing their  lending activity.   Later, the blame shifted to cash hoarding and broad economic uncertainty, especially in terms of the tax and regulatory environments.  What is slowing deal activity today is what slows the sales of any good or service—the simple failure of buyers and sellers to agree upon price.

Defining Value 

The definition of value depends upon the context in which it is used. These definitions are called “standards” of value in the appraisal world:

• Fair Market Value assumes a hypothetical sale and is used almost exclusively for tax compliance purposes. This tends to result in the lowest estimate of value as fair market value recognizes discounts associated with the difficulty of selling stock in privately held companies. 
• Fair  Value  also  involves  or assumes a sale  and hinges  on what is  considered “fair,” but it differs in application from fair market value in that it is most often used in accounting,  divorce,  shareholder  disputes,  and fairness  opinions. The definition of fair value varies by jurisdiction, but generally avoids consideration of the difficulty of selling a position in a privately held company. 
• Investment Value refers to the value of an asset to a specific individual.   One example is the family-owned business that employs many family members. The value of the business to these individuals may be significantly higher than it is to a financially-motivated buyer.
• Market Value is the highest value a person might pay for a business or business interest and, as such, considers synergies.  Applying a standard of market value sometimes explains why a buyer can justify what some observers might consider “overpaying” for a particular company.  Market value is not often applied in the business valuation community because most appraisers do not participate in the valuation of real world transactions as they occur.  HA&W’s business valuation practice  is  unusual  in that most of our engagements are advising  buyers and sellers in the course of an actual, ongoing transaction.

The “market” is not always right when it comes to value, especially in M&A transactions. Many factors not captured in available market information may cause a company to be bought or sold.  These include limited sample size, special circumstances that may not be known, illiquidity, questionable comparability, and human error.  For example, an investor group led by Magic Johnson bought the L.A. Dodgers for $2.15 billion. The second highest bid was reportedly $1.4 billion. Did Johnson overpay or did everyone else underbid?   Could Johnson’s group sell the Dodgers right now for what they paid?   The price wasn’t necessarily the Dodgers’ fair value, but what each party ultimately decided to accept.[1]  The market is one data point, but not the only one.

M&A Activity and Trends

Overall, activity in small  (under  $100 million in deal  value)  M&A  is  on the decline.  From a recent high of 1,730 closed transactions in 2008, only 1,001 deals closed in 2011 (according to Pratt’s Stats). Leveraged buyouts (LBOs) are also down globally, although the downward trend in North America has followed the U.S. economy, with its lowest point in 2010, while the trend in Europe follows the overseas economy, peaking in 2010 and now declining as the European Union financial system faces its own liquidity and solvency crisis.

The financial sector has seen the largest jump in the number of strategic deals since 2008. In   that   year, financial transactions   trailed   consumer discretionary,   information technology, and industrials.   In 2012, financial deals have outpaced those other sectors nearly two to one.  While many transactions in the financial sector do involve willing buyers and sellers, many others involve the acquisition of a distressed company and the takeover is often strongly encouraged by the U.S. regulatory authorities.

Of course, a transaction only occurs when the buyer and seller can agree on the price. Transactions are taking longer—12% longer, in fact.  It is taking longer to resolve the bid-ask spread, from a low of 201 days to close to 226 days in 2011. Buyers are willing to pay up for blue-chip M&A opportunities but are heavily discounting incremental risk. Furthermore, cash at closing is also increasing as sellers are less willing to take notes. The fact that asset sales are increasing in frequency also is a sign that buyers have a bit more leverage in the market, as asset sales tend to be tax-favorable to the buyer.

M&A Valuation

Market  multiples  are up  for  financials  compared to other sectors, according  to S&P CaptialIQ, which may seem counterintuitive.  The market seems to indicate that there is a high growth potential for financials as compared to industrials, for example (although industrials seem to be rebounding).  Internationally, financials are also strong in Europe for the same reasons they are in the U.S., followed closely by utilities, due in large part to interest in renewable energy as European regulators require a greater portion of their electricity to be generated from renewables.  Interest in BRIC (Brazil, Russia, India, and China) deals appears to be on the upswing.

Financing Markets

Private equity (PE) has taken a beating since 2007 as a result of the downturn.    Deal values in that year averaged $764 million and are down to around $302 million in 2011 (with a low of $122 million in 2009), according to the Private Equity Growth Capital Council.  Many thought PE firms would come to the rescue, but PE money has dried up as funds save their capital  to  ensure companies  in their  portfolios  are sufficiently capitalized.     Capital-per-commitment   is   also   trending   downward.    Again,   these investors are focusing on quality, content to sit on their cash if they don’t see what they want.  They would rather not do a deal at all than to do a “bad” deal. The presidential campaign is also bringing negative attention to the PE industry.

While banks are lending again, they are more careful in doing so and the move to a more intangible market means that it is more difficult to determine creditworthiness.  In spite of these headwinds, commercial loans are trending upward from their low in 2009. Banks are also reporting that there is not great demand for loans, either for expansion or M&A.  If a buyer can’t agree to a price with a seller, the buyer doesn’t need the loan.

The PE industry, once expected to fill the void left by  retrenching  banks, has not deployed  their capital  in a large  way.   They have responded to lower availability of leverage by reducing deal activity.  The pressure on PE to provide compelling returns is strong, and a key driver of those returns is entry valuation, or the valuation at which an asset enters the PE portfolio.  Returns on PE investment are down from a high of nearly 60% in the mid-1990s to a loss of nearly five percent in 2008, and much of the poor performance is attributable to high-entry (purchase) valuations.   Further complicating matters is the fact that PE firms are holding their assets longer than they had planned. The average age of an asset in PE portfolios is nearly five years, almost a year and a half longer than in 2007.

M&A Drivers

Over time, we see more pressure to sell than to buy.  As the U.S. population ages, we will see more and more companies up for sale and fewer buyers, as buyers typically tend to be younger than sellers. Private equity investors will soon face the necessity of liquidating assets to wind up their portfolios on time.   Weakness in the Euro zone is likely to sideline many potential European buyers.  Corporate cash balances, at an all- time high in absolute terms and historically high relative to debt, figure to remain high and undeployed, serving  as insurance  against  protracted  economic  weakness or  a second downturn.

Conclusions

The current M&A market is complex.  Buyers and sellers both want to transact on their own terms.  In some sense, they need to do so. A seller of a business will have trouble reinvesting the proceeds at an attractive yield relative to risk.   Buyers have assets of their own to sell and continue to hold out for their price.  We have rarely seen an M&A market quite like this one, if ever. Buyers and sellers navigating these uncharted waters need a skilled and experienced advisor or team of advisors to appropriately ascertain value and take advantage of the M&A  opportunities that are out there.

Michael Blake, CFA, ASA, is Director of Valuation Services at Habif, Arogeti & Wynne, LLP. He has 15 years of valuation experience including transaction support, intellectual property appraisals, fair value accounting, litigation, and valuations for securities-related engagements. Michael’s valuation experience includes information technology, medical devices, healthcare drug development, restaurants, computer hardware, electronic entertainment, telecommunications, broadcasting, alternative energy, publishing, business services, e-commerce and Internet-driven services, aerospace, paper and timber, beverage, media, manufacturing, and private equity. Contact Michael Blake at (770) 353-8373 or michael.blake@hawcpa.com.

IRS CIRCULAR 230 DISCLOSURE:

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us, however, if you have any questions regarding this matter.