Private Equity Firms Reinvent Themselves in Challenging Credit Environment
NEW YORK, June 23, 2008
Inbound M&A activity recovering and getting stronger
—In the current credit market where access to syndicated loans to finance large transactions is limited, private equity firms look for alternative ways to deploy capital, focusing on distressed investing, private investments in public entities (PIPEs), partnering with corporate buyers and minority investments. Inbound investments into the United States will continue for the remainder of the year and accelerate into 2009, according to the Transaction Services group of PricewaterhouseCoopers.
Bob Filek, a partner with PricewaterhouseCoopers' Transaction Services, observes M&A in consolidating industries such as automotive, consumer products, energy, financial services, manufacturing, technology and retail are fueling activity in 2008. In the current economy, companies are re-evaluating their business or portfolio to dispose assets that aren't strategic or core. In particular, consumer product companies are shedding assets and disposing of non-performing brands. The retail industry is already in the process of selling distressed assets. “If you look across all industry sectors, whether corporate or private equity, everybody is assessing their core competencies and doing transactions that make them lean, nimble and more competitive,” said Filek. Dispositions offer strategic industry players and international buyers opportunities to consolidate, gain scale and access new markets.
At $96.7 billion, U.S. leveraged lending for the first quarter of 2008 represented a 69% decline from the same period last year and a 91% drop from the fourth quarter of 2007 (Thomson Reuters
). This downward trend underlines the difficulty for private equity firms to secure financing for large transactions. “Because large deals, which had been private equity’s sweet spot, are not getting done due to the contracted lending environment, many private equity firms have returned to their roots and are buying distressed and other assets," said Greg Peterson, a partner with PricewaterhouseCoopers’ Transaction Services group. The number of US businesses filing for bankruptcy totaled 8,713 for the first three months of 2008, the highest quarterly filing since the fourth quarter of 2005 and the highest first quarter since 2004 (American Bankruptcy Institute
). Should this trend continue, we are likely see more distressed M&A activity.
According to Thomson Reuters, announced U.S. deal value and volume through May 2008 totaled $428.6 billion and 3,750 deals respectively, down from $699.8 billion and 4,754 deals for the same period in 2007. Private equity accounted for 26% of the U.S. deal value and 17% of volume for the first five months of 2008, compared with 37% and 19%, respectively, for the same period in 2007. Peterson said he foresees transaction structures will change in the short term as private equity firms need to put in more equity to get desired deal financing terms. However, private equity firms are not pressured by their limited partners to spend capital raised as they did during the last distressed cycle in 2001 and 2002. “Private equity is patient money. These firms do not have to make any rash moves. Expect to see more creative structures from private equity including partnering with strategic buyers for sector specific opportunities,” stated Peterson.
Despite the appreciation of foreign currencies, foreign interest in the U.S. hasn't been at the level one would expect. For the first five months of 2008, there were 598 announced inbound transactions, down from 761 for the same period in 2007 (Thomson Reuters
). "The U.S. is for sale. Our currency is deflated and that is attractive for international buyers. That said, inbound investments into the U.S. will be tempered due to the uncertainty of the U.S. economy. We will continue to see activity but it won't accelerate until the U.S. economic picture gains some clarity," stated Filek.
Other themes that characterize the M&A landscape in the second half of 2008 include:
- Outbound transactions—U.S. companies are tapping into high-growth emerging markets of China, India, Indonesia, Eastern Europe, South Africa and the Middle East. The preferred form of transaction in these markets is joint ventures.
- Middle market—Middle market continues to be active with the difficulties in obtaining financing for large transactions. Private equity firms continue to fund middle market transactions where they do not require syndicated debt.
- Regulation changes—The looming threat of a capital gains tax increase may cause an uptick of M&A activity in the fourth quarter of 2008, as these businesses seek to monetize prior to the end of the year, either partially or wholly. Additionally, the new business combination accounting standard FAS 141(R)—Business Combinations—is likely to motivate companies to close transactions by December 31, 2008. This will allow certain costs to be added to the purchase price rather than be expensed. Another regulation likely to cause a rise in M&A activity includes changes to how companies account for non-controlling interests or minority investments, FAS 160—non-controlling interests in consolidated financial statements, starting for some companies in 2009. We are likely to see companies expedite their timeline to obtain control of their current minority investments before the rule takes effect. After the implementation, these transactions will trigger gains and losses as well as balance sheet revaluations for the investment.
- Industries that continue to present consolidating opportunities:
- Financial services—The financial services industry is taking a beating with credit problems continuing to worsen affecting sectors beyond sub-prime. Sectors within financial services are still dealing with the ripples of the sub-prime collapse affording opportunities for industry players with strong balance sheets to acquire assets at a discount. Opportunities to infuse capital in cash-strapped companies continue to emerge.
- Automotive—Automotive deal activity is expected to continue as companies seek ways to cope with high material costs, shifting consumer demand towards fuel efficient vehicles and a depressed U.S. market, which PricewaterhouseCoopers' AUTOFACTS anticipates will fall to 14.8 million light vehicles in 2008, the lowest annual sales volume in 13 years.
- Energy—With the price of oil increasing and the pressure to seek alternative means to address the growing energy need mounting, energy companies look to acquire and build up their portfolios. A wave of consolidation is underway in the equipment and services sector and it should run into 2009. High commodity prices and resulting demand for equipment and services related to oil and gas exploration and production have produced healthy balance sheets and strong earnings, affording companies with strong financials to consolidate.
Master limited partnerships (MLPs), still struggling with competition and deal pricing, are modestly moving ahead. Industry watchers are looking for signs that a consolidation of MLPs is starting. Should this happens, substantial deal volume is expected.
In the upstream space, commodity price volatility has resulted in gaps between seller and buyer expectations. That said, there is more bullishness on natural gas than oil, and continued interests from both strategic and private equity investors are to be expected.
- Consumer products—Consumer products companies continue to shed non-core assets and non-performing brands. Sources of growth continue to be a priority. Ethnic products and emerging markets continue to be the driving forces of growth.
- Technology—Internet is the bright spot in the technology industry. Although the sector is maturing, it is still growing, particularly for on-line advertising driven businesses. Consolidation in other sectors continues, especially among small and medium size public companies. Inbound acquisitions from Asia and Europe will also drive broader sector activity.
"This environment is ripe for opportunities. Acquisitions done in challenging times such as these consistently rank at the top of transactions with the best returns," said Filek. However, given the credit and economic uncertainty, rigorous due diligence and detailed scenario and downside modeling are a must, Filek added.
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