The thrift that companies exercised during the recession by building up their balance sheets is coming back to haunt them in the form of pressure to buy, and it’s lifting the mergers-and-acquisitions market to levels that could approach historic highs.
Global M&A activity bounced back in 2010, rising 22.7 percent to $2.09 trillion over 2009 as U.S. M&A rose a less robust 2.8 percent to $714.3 billion, according to The Mergermarket Group. Still, both volume figures were well below the levels of 2008, when global activity hit $2.5 trillion despite a near freeze in fourth-quarter activity following the year’s financial crisis, and the progressively higher levels of M&A from 2005 to 2007.
But M&A is ready to bounce back, and not necessarily on the backs of megadeals like LVMH Moët Hennessy Louis Vuitton’s $6 billion embrace of Bulgari or pitch for Hermès or even the recently closed $3 billion purchase of J. Crew Group Inc. by TPG and Leonard Green & Partners.
“If you look at large strategic players, they did exactly what they should have done through the great recession,” commented Kenneth Berliner, president of Peter J. Solomon Co., the New York-based investment bank. “They were conservative with their capital expenditures and with store openings and other expenses. As business started to get a bit better, starting in late 2009, cash had built up significantly on their balance sheets.”
For the strategics, the options were few. They could put it back into their own businesses to a certain extent and they could buy back their own shares, as many did.
“Companies are being very discerning about how they spend, and they’re not doing massive share repurchases,” said Berliner. “The next place they look is acquisitions.”
For financial players, like private equity firms, there’s cash aplenty — money not spent during the lean times, the ability to raise new money and “debt and equity markets in about the best situation they’ve seen in years. It’s a healthy M&A market for buyers and sellers because there’s liquidity and they can borrow cheaply,” Berliner said.
Acquisitions might prove attractive to retailers, even if it’s practically by default. Berliner noted that stores generally go through similar cycles, expanding geographically, through different channels of distribution, into international markets and often going vertical in their sourcing. Once those possibilities have been exhausted, an acquisition becomes increasingly plausible.
He doesn’t expect much activity in the way of distressed companies: “The great era of ‘amend and extend’ [with credit agreements] took care of a lot of the issues. A lot of companies that were running out of runway got more runway and, as the economy got better, they were able to borrow again, whether from banks or other sources.”
Berliner does expect increased activity in the months ahead, and a modest improvement in the economy despite some accelerating economic headwinds, but he also anticipates a greater deal of scrutiny in the wake of the controversial acquisitions of J. Crew and Del Monte Foods Co., both of which aroused shareholder ire amid allegations of less-than-transparent negotiations. “Those situations will cause a number of boards to hire multiple advisers and exercise their fiduciary duties in a very serious manner,” he said. “They’re going to want to make sure they’re getting the very best advice in as impartial a manner as possible.”
Allan Ellinger, senior managing partner of investment banking firm MMG, also sees pickup in M&A activity among his clients, many of them apparel wholesalers, and he sees other factors coming into play as well.
“Companies worked hard to bring their overhead down during the recession and generally were successful in doing that, but there’s a tremendous amount of pressure right now,” he said. “With increased costs from Asia and on fabric and their inability to pass along increases to retailers, I’m seeing shrinkage in gross margins of anywhere from 3.5 percent to 5 percent. There’s a point in time when you just can’t reduce your overhead, when you accept that you can’t economize your way to profitability.”
The solution for many vendors, he noted, is “to seek shelter elsewhere” by looking for acquirers with greater economies of scale.”
MMG, a middle-market specialist that advised Jimlar Corp. on its acquisition by Li & Fung’s U.S. affiliate, believes that, with so much cash on the sidelines, there’s more competition for attractive purchases, which is helping to drive up purchase multiples. Ellinger, who says multiples are hovering in the range of five to six times earnings before interest, taxes, depreciation and amortization, also sees more use of the tactic of sellers being compensated on the basis of earn-ups rather than earn-outs. In an earn-up, the seller stays on and is compensated based on his or her ability to increase profitability, rather than just maintain it, as is the case with an earn-out. And he notes the typical sellers, who may be seeking enrichment of the franchise rather than solely of themselves, need to get started early and be prepared to stay in place while their properties are absorbed.
“More and more smart buyers aren’t buying from guys who want to go home,” he said. “They’re the soul of the business and they want them to hang around for four or five years.”
Joseph Pellegrini, managing director of consumer retail at the Robert W. Baird & Co. investment bank, believes that the M&A market, like the retail market, will be distinguished by a “flight to quality.”
“There’s no reason for a strategic buyer to buy a broken business,” he said. “They’re looking for situations in which 1 plus 1 equals more than 2. They’re looking for brands that have performed well through the economic downturn, that had the products and innovations and business models that allowed them to plow through revenues during the worst of the downturn.”
In many cases, the companies that fit those criteria are those emphasizing lifestyle merchandising, performance products and aspirational living — firms such as Under Armour Inc. and Lululemon Athletica Inc., which are publicly held, and The North Face, which was acquired by VF Corp. in 2000.
“A lot of people say they have a lifestyle, but you can always tell the good from the bad after a while,” Pellegrini said. “If they wind up selling on price, there are going to be issues. It’s the companies that walk the walk, talk the talk and live the life — those companies seem to be growing.”
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