Why the credit crunch should help M&A activity

The credit market turmoil is altering the global playing field in buyouts and acquisitions, a field rife with complaints in recent years about too much money chasing too few good deals.

The credit shortage puts pressure on pricing and transactional quality, while also giving public companies a better shot at acquisitions that the more aggressive private equity firms might previously have snatched away.

Acquisition by private equity firms has become increasingly common in recent years in both the US and Europe, with deals growing rapidly in both number and size, notes Michael S Weisbach, from the University of Illinois at Urbana-Champaign. Weisbach is the co-author of the paper, "Leverage and Pricing in Buyouts: An Empirical Analysis".

As recently as 2002, Weisbach notes, total deal value hovered around $30 billion (Dh110bn) a year. In 2006, buyout transactions totalled around $233bn in the US and $151bn in Europe. Private equity deals now account for some 20 per cent of worldwide M&A, up from 3.1 per cent in 2000.

Moreover, with a current overhang of some $250bn in buyout funds that are committed but uninvested, the buyout trend is unlikely to stop – although it does appear to be taking a rest.

Not surprisingly, the spectacular growth in private equity transactions has been matched by equally strong growth among firms that specialise in them. These firms have raised large amounts of equity capital from their limited partners and even larger sums of debt capital from the syndicated loan market, using the capital to buy public corporations and business units as well as family-owned firms and companies previously owned by other private equity concerns.

Today, the financial structures that private equity firms choose for their portfolio companies turn out to be radically different from those that public corporations use when making acquisitions. In fact, they are almost the inverse of one another. Extensive use of leverage has long been a distinguishing characteristic of the firms, whose equity typically comprises just 20 per cent to 30 per cent of total capital, a ratio that has steadily declined. For public corporations, by contrast, equity is more likely to comprise 70 per cent to 89 per cent of the total. The availability of credit in recent years and the ability to structure deals with greater leverage resulted in ever-higher purchase prices. Buyout firms learned to price transactions, first, by borrowing as much capital as possible and then, by factoring in the extent of the debt obligation and tacking on an additional multiple of, say, three times the target company's earnings.

How did the availability of debt capital become equated with higher purchase prices? Because, notes Weisbach, to borrow less and bid less would have meant losing a prime buyout target to a competing fund. Ask a gathering of corporate treasurers to explain how their companies determine the pricing and leverage appropriate for a given acquisition, and their answers will be shaped by predictable considerations like projected returns, corporate tax rates, borrowing capacity and so forth.

But put that question to a room full of private equity fund managers, and the response will be short and simple: "If the banks will lend it, we'll take it!"

Indeed, a private equity firm that appeared reluctant to borrow and spend aggressively might have difficulty pooling investors for its next fund launch.

Until recently, the cycle of hyper-competitive borrowing and bidding meant that even the largest and shrewdest private equity firms found it difficult to negotiate a buyout in private. Instead, businesses of varying shapes and sizes were auctioned off at ever-escalating prices that required ever larger amounts of leverage. As prices and debt levels continued to rise, these transactions became less profitable for the funds' general and limited partners, although profitable for owners of the properties being acquired.

For now, that cycle has ended. With credit both scarce and expensive, Weisbach thinks the focus must inevitably shift – from deals that command the highest leverage and that can be flipped the fastest to those where investors see real opportunity for adding value.

From the value investor's perspective, the best deals are more likely to be those that are done during a cyclical trough like the present one. Not surprisingly some of the most successful private equity firms built their reputations on the deals they did in the last down-cycle. 

- From Knowledge at Wharton, courtesy the New York Times Syndicate's Global Business Perspectives