Merger and acquisition (M&A) activity rose significantly in 2010 and that trend has continued without interruption so far in 2011. In particular, there has been a marked increase in hostile public M&A, cross-border M&A, and the return of private equity-backed transactions, as the marketplace begins to feel more stable and confident.
The fundamental drivers of current M&A activity are little changed from the drivers that characterised the marketplace before the financial crisis hit. However, changes in the market have brought about new challenges in areas such as valuation, financing, deliverability and risk management which, in the context of a rapidly evolving regulatory environment, continue to have an impact on target and acquiring companies. Buyers and sellers are having to recalibrate their sensibilities to deal with these challenges, with an increased focus on flexibility and innovation.
But the willing and finances to do this are there. For example, more than $1 trillion in cash balances currently sits on corporate America’s balance sheet with more than $350bn of that held by the 20 companies with the highest cash balances. Similarly, access to financing for investment-grade borrowers is available at extremely attractive interest rates. By most estimations, private equity sponsors have more than $500bn in ‘dry powder’ – the term used to describe capital that has been set aside for private equity funds.
With this level of cash ready to be deployed, the rise in M&A activity can be expected to continue through 2011. But uncertainty in the macroeconomic environment means that buyers remain cautious in some sectors and geographies.
Buyers with strong balance sheets and access to the capital markets have shown an appetite for strategic acquisitions and willingness to pursue their targets. Kraft’s acquisition of Cadbury in early 2010, for example, demonstrates an opportunistic bidder identifying and methodically pursuing a target viewed as an ideal strategic fit. French pharmaceutical giant Sanofi-Aventis’ quest to buy biotech company Genzyme, which was finally agreed earlier this year, represents another such example.
The importance of valuation
Nonetheless, valuation remains a significant challenge in M&A deals. Partly as a response to this, there has been an increase in share-based transactions in the past year, as issues over value can be less material in such instances. When it comes to asset-based transactions, however, buyers and sellers have deployed several techniques to bridge the valuation gap. In Germany, as in other markets, for example, parties have looked for innovative ways to bridge the differentials with asset swaps, vendor loans and contingent value rights.
Where possible, buyers in private acquisitions are also seeking to be more selective, ‘cherry-picking’ assets and leaving behind difficult-to-value or ‘onerous’ assets, thereby eliminating valuation challenges on those assets altogether.
An ‘asset carve-out lite’ approach provides one such example. In this case, the buyer acquires, for example, specific intellectual property (IP), R&D, distribution and customers, leaving behind other assets, such as the production site. The seller engages in interim manufacturing until the buyer’s own production site is fully operational. Of course, such an approach is not always acceptable to a seller, who may not wish to remain burdened by such obligations.
Overall, in US public M&A deals, share-based transactions are the exception, although they are expected to increase. In the US, the use of equity as consideration in public deals of companies in the same industry helps to eliminate disputes over value. In private transactions, share consideration and vendor financing are used to bridge the valuation gap when outside financiers are not prepared to finance a price that the seller will find attractive.
Earn-outs (where the purchase price is dependent on the future performance of the target business) are also used as a mechanism to bridge the valuation gap when the seller predicts an increase in profitability, but the buyer is conscious of economic uncertainty. However, many buyers and sellers alike remain wary of the challenges of earn-outs achieving the desired economic outcome in practice.
Milestone payments, or contingent payment rights that increase payment if certain milestones are met, or upon the occurrence of certain events, are also used in the US and other markets.
The risk of penalty
Regulatory risk is high on the agenda for most buyers and sellers. M&A deals are increasingly facing regulatory challenges across jurisdictions from the new merger control regimes that have been created in recent years (most notably in the European Union and the US). More merger control regimes are on the way, including India’s amended Competition Act 2002, relevant sections of which are due to come into effect on 1 June 2011.
The impact of these regimes should not be underestimated. It was government regulators that rejected American International Group’s (AIG) proposed $2.2bn sale of its Taiwan insurance arm, Nan Shan Life, to a Hong Kong consortium, questioning the consortium’s ability to raise funds and run the insurer. National Australia Bank’s proposed $13.3bn acquisition of AXA Asia Pacific was blocked by regulators on anti-monopoly grounds, and BHP’s proposed takeover of Potash Corporation failed to secure approval in Canada at the end of 2010.
Sellers have become so wary of execution risk that, in many cases, we have seen strategic buyers volunteer antitrust analysis and offer to provide undertakings to make necessary divestitures in order to address sellers’ concerns upfront. Sellers, in turn, may discard bidders that they believe will bring material antitrust (or anti-competition) risk to the transaction.
Regulatory changes in other areas are also having an impact on M&A markets. In the US, new legislation, in the form of the so-called ‘Volcker Rule’ of the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010, prohibits bank holding companies and their affiliates from owning interest in or sponsoring hedge or private equity funds by 2012.
This regulatory development, along with other regulatory changes in the financial institutions sector, are likely to drive M&A activity over the next few years.
In a joint Clifford Chance/Finance Asia survey published in October 2010, 77% of respondents cited protectionism as the most significant concern for buyers in the US/Asian M&A market. This marks a sizeable leap from 56% of respondents who indicated the same in the prior year. The economic situation and increased protectionist rhetoric in, for example, the US, probably contributes to this perception.
However, it’s not just a question of perception. In the latest round of regulatory action under the Exon-Florio Act (enacted by US Congress in 1988 to review foreign investment within the US), a politicised process has become more politicised, with amendments giving Congress a formal oversight role in the approval process. According to these amendments, the president may block the investment where ‘there is credible evidence that [...] the foreign interest exercising control might take action that threatens to impair national security’.
However, government intervention in Germany appears to have waned, highlighting the difference between the European approach and the US/Asian approach. Even in cases in which government intervention would be arguably palatable (for example, where a national champion, such as construction company Hochtief, finds itself in a hostile situation, as it does at present), the German government continues to adopt a laissez-faire approach.
The road ahead
Despite such regional differences, buyers and sellers across the world have responded, in general, in a similar way to pressures brought about by changes in their market and regulatory environments. Sellers have sought deal certainty and will continue to do so, and buyers who introduce mechanisms safeguarding transactions to increase the likelihood of deal certainty are more likely to steal a march on other bidders.
Parties should proactively manage issues, which are likely to be raised by politicians and other stakeholders early in the process, even ahead of any public announcement. If this is done, they often achieve their objectives.
Matthew Layton is a partner and global head of corporate at Clifford Chance LLP
This article was first published in Legal Strategy Review, issue 7
PUBLISHER'S NOTE: In the magazine version of this article, the author was credited as ‘Michael’ Layton. We apologise to Matthew Layton for this, and have corrected his byline in this online version
THE URGE TO MERGE
Sietze Hepkema of Allen & Overy highlights key trends in global M&A activity
The picture that emerges at present is a broadly positive one, with 2010 heralding a gradual return to form in the international M&A markets. Even though activity in the fourth quarter was broadly in line with, but not much ahead of, that of the preceding three months, fears of a double-dip recession have gradually subsided and sentiment appears to be on the up. This is despite the sovereign debt problems that continue to loom over the eurozone, which have served to undermine confidence, but may, in time, present their own opportunities for M&A.
We have witnessed some headline-grabbing deals in key sectors that have served to buoy investor confidence, but the macro-economic situation remains uncertain and there are a number of issues preventing the genuine resurgence of big deals. With some notable exceptions, the year 2010 did not deliver the feared wave of new protectionist legislation that many had predicted would stand in the way of cross-border deals. The global rush to secure energy and power assets did drive some nations to use existing investment laws to prevent takeovers, however, and we saw some countries stretching the definition of ‘strategically important’ assets to ward off unwanted acquisitions of precious national targets.
Globally, it continues to be the emerging economies of Brazil, Russia, India and China (the BRICs) driving cross-border M&A, both inbound and outbound.
Exciting times
As a whole, the Asia Pacific region is increasingly active: it accounted for almost 50% of all hostile acquisitions in 2010. Strong growth in gross domestic product (GDP) and strong currencies across much of Asia Pacific, coupled with a more benign economic environment than the US and Europe fuelled a boom in outbound activity.
The hostile public offer by Korea’s KNOC for the UK’s Dana Petroleum marked a significant shift in tactics and a sign of confidence by Asian companies when buying assets in developed markets.
Overall, the energy and natural resources sector remains the most attractive to bidders in all major markets, though activity levels are resurgent in technology, media and telecoms and in the life sciences arena. We expect to see more deals in the financial services industry later this year as the sector digests the fine print of new regulations over the course of the next 12 months and major players move forward with re-organisations and asset disposals.
The fourth quarter of 2010 saw the greatest volume of deals since the second quarter of 2008, as the transactional markets enjoyed a slow and steady revival. Bank lending remains hard to come by, however, and the mismatch in seller and buyer price expectations that has stood in the way of deals for the past few quarters continues to act as a very real stumbling block.
We can look forward to the recovery gathering momentum in the year ahead, but it will be some time before M&A returns to anything like the levels we had got used to pre-credit crunch.
Sietze Hepkema is co-head of the global corporate practice at Allen & Overy LLP
BEST PRACTICE: DON’T GET CAUGHT OUT
Trust your instincts on antitrust, says Jon B Dubrow of McDermott Will & Emery
In M&A transactions, the parties are often focused on negotiating the transfer of assets or equity, and may treat antitrust (or anti-competition) issues as mere procedure. Parties may neglect potential antitrust concerns until after the agreement is negotiated. But, by that point, negotiating and strategic planning opportunities may have been lost, and substantive antitrust defence of a deal may be compromised by imprudent document creation or other missteps along the way. Companies neglect antitrust issues at their peril.
It is essential to scope out whether the proposed transaction raises potential antitrust concerns at the earliest stages of the transaction planning process.
Some preliminary questions to ask include: Do the parties compete with one another? Will the transaction result in the consolidation of the market to only a few competitors? Does one party supply the other, and, if so, is the buyer acquiring a key input that might foreclose its rivals from access to the supply chain?
Monitor how you refer to the deal within correspondence too. Documents prepared by the parties and their advisers evaluating the deal are the most important information in the regulators’ initial review, and can make or break the antitrust review of a deal. When creating transaction-related documents, parties should be careful to avoid antitrust ‘buzz words’, such as: market leader or dominant position. This obviously applies to all press releases, talking points, frequently asked questions and filings, but also to all internal presentations, documents and communications – including ‘private’ email correspondence.
Jon B Dubrow is a partner in McDermott Will & Emery LLP. He is based in Washington DC
These articles also first appeared in Legal Strategy Review, issue 7
