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Weekly UpdatesCorporate boards must not lose sight of one of their primary responsibilities--to focus management on strategy development and long-term business performance. This is especially true in today's market when the prevailing focus of management may be to impose constraints in response to recessionary conditions. A key component of an effective corporate development strategy is strategic acquisitions.
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Like the economy, merger and acquisition markets move in cyclical patterns. Beyond the obvious cycles of reduced deal activity and valuations, some cyclical trends are now favoring strategic acquirers. Boards of directors would be wise to encourage their management teams to prepare for and exploit these opportunities.
The M&A cycle
Private equity groups' prominence in the acquisition market has faded and this trend will continue for several years. Syndicated credit markets tapped to fund these acquisitions have dried up and will remain so for the next few years. The stock market decline has forced institutional purveyors of private equity capital to reassess their assets allocations and portfolio liquidity, resulting in diminished capital allocations. Fund performances will catch up with public market trends and the results will not be attractive, resulting in the contraction of private equity firms.
The M&A market cycle will also swing to smaller deals. With both stock and M&A market valuations down, deals involving larger corporations are more likely driven by restructuring sellers versus acquirers pursuing corporate development. In addition to restructuring, activity in the middle market will also be driven by the life cycle needs of aging entrepreneurs and private equity limited partnerships, both of whom will face increasing pressure to create a more liquid equity investment.
In recent years, speed to close and value dominated the decision-making criteria for evaluating potential suitors. These were the hallmarks of private equity. Today, strength of financing and strategic fit are key criteria sellers and their advisors use to assess suitors and assign a probability to close. With strong balance sheets and firm banking relationships, focused corporate acquirers should exploit this advantage.
Conventional wisdom suggests that valuations are down and sellers will not be motivated until there is an alignment of market values with their intrinsic value. This is typically true at the onset of a cyclical downturn but as noted above, the pressure of weakened financial performance or non-economic life cycle considerations begin to mount. Credit market conditions will compel weakened firms to seek suitors at attractive acquisition prices. As the duration of the cycle becomes more apparent, life cycle sellers will be influenced to consider more creative ways of structuring deals to bridge the gap between market and intrinsic valuations.
It sounds trite to say it is a buyer's market, but history supports this assertion. The vintage years of private equity investment performance are those just after the recessionary periods of the mid 1990s and early 2000s. Honest private equity professionals will confide that this timing, and the market impact on cyclical valuations and deal structure, had a significant impact on their investment successes. In the context of current market outlook, directors would be wise to push management to prepare for and consider acquisitions now.
Acquisition strategy
Acquisition activity should be driven by corporate strategy. Some of the most successful strategic acquirers have achieved superior performance through a series of small, incremental acquisitions. Acquisition targets must benefit a business unit's performance and competitive position. Targets should expand a business' intellectual properties, increase product offering or customer reach, reduce costs, or improve asset utilization.
Acquisition strategy should involve different points of view with balanced organizational decision making, rather than a top-down activity. Successful acquirers have a common trait of empowering unit managers to seek out and sponsor acquisitions. Line managers are responsible for determining the strategic direction of their business unit. These managers should be encouraged to seek out opportunities and advocate for deals that could augment organic growth. Corporate officers are most effective when they provide encouragement, counsel, and tactical support of line managers' initiatives.
The goal of every acquisition should be to generate a positive contribution to the creation of shareholder value. A key role of senior management is to evaluate the potential of strategic acquisitions to increase the value of the company. While legal and market forces require management and their advisors to focus on value at the time of close, careful consideration should be given by managers to stress testing against multiple scenarios. Value is created in the future and stress testing will identify the key variables that will have the biggest impact on the creation or dissipation of value.
Post-deal integration is key to creating value. Having identified the key variables that will drive value creation, a plan to attain these goals must be established. Responsibilities must be assigned and accountability identified. Additionally, board members must insist that they be periodically apprised on a post-closing basis of line and corporate management's progress toward the attainment of these goals.
Growth via acquisition should be a premeditated endeavor. Internal and external resources must be devoted and aligned in anticipation and support of this effort. The last year has been witness to unprecedented contraction in deal activity. Investment banking, accounting and tax due diligence, legal, insurance, and human resource service providers have seen one of their more sustaining client constituents, private equity groups, run off the field. Boards and management should avail themselves to these resources and tap into the deal industry's network of relationships and deal flow.
Finally, many industries are now competing on a global basis. Directors should encourage management to look abroad; supply chains now stretch around the globe as the English language and Western business practices have been adopted by the international business community. The support networks of advisory firms have evolved beyond historic multinational clients and are now enabling cross-board middle market deal activity
Case study
A recent Houlihan Smith & Co. transaction highlights the opportunities awaiting corporations that have implemented these practices. Houlihan Smith & Co. represented the owners of Analytical Methods, Inc., a lower middle market company providing specialized aerospace software and consulting services. The acquirer was a division of multinational Israel Aerospace Industries, Ltd. The authority IAI's divisional managers possessed to seek out and investigate acquisition candidates was key to making this deal possible. The deal was too small to ever attract the attention of corporate management; however, corporate practices encouraged unit managers to find and advocate deals that would grow their units. Pre-established corporate development guidelines enabled efficient review, analysis, and approval by overseas corporate management.
A second consideration involving this transaction was the regulatory approval requirements of the Committee on Foreign Investment in the United States (CFIUS). CFIUS is an inter-agency committee that reviews proposed acquisitions of domestic firms by foreign entities. Particular emphasis is placed on defense and strategic industries. As IAI emerged as the lead bidder, the seller's deal team was expanded to include Washington-based legal counsel experienced in filing these voluntary notices. This effort was augmented by the buyer's pre-existing advisory team retained to provide support for this approval process.
A key responsibility of directors and the boards they comprise is to keep the corporation's focus on long-term strategy and corporate development efforts. Strategic acquisitions are a key component to achieving these goals. Over the next year or two, market conditions will favor strategic acquirers. Maintaining a prepared management team and updated practices will enhance a corporation's ability to successfully identify and respond to opportunities the market will present.
Joseph C. Lunkes, (PA is a senior managing director at Houlihan Smith & Company, a specialized investment banking firm that provides financial advisory and financing services to public and private businesses, founded in 1996, Houlihan is recognized as a leading provider of financial opinions, financing, merger and acquisition advisory, and other corporate advisory services. Lunkes graduated with honors from Loyola University and earned his MBA from Northwestern University's J.L Kellogg Graduate School of Management. He may be contacted at jlunkes@houlihansmith.com or (312) 499-5938.
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