Buyer be quick (Corporate Dealmaker)

Buyer be quick

[ Share ] [ E-mail ] [ Leave a Comment ]

When German engineering group Siemens AG announced its $993 million acquisition in May of the systems and services business of United States Filter Corp., it was welcome news for Veolia Environnement SA, the parent company and seller. Paris-based Veolia, an environmental company and formerly part of Vivendi Universal SA, has been trying to offset losses, and the Siemens purchase would help it refocus on its long-term service contracts.

But the private equity world didn't receive the news so warmly. It wasn't just that the Siemens bid edged out a raft of top leveraged-buyout firms, including Blackstone Group, Carlyle Group, Kohlberg Kravis Roberts & Co. and Warburg Pincus LLC. To many, Siemens' triumph also signaled the return of the strategic buyer in large corporate divestitures, after a two- to three-year hiatus.

Until recently, a weak economy and the collapse of the stock markets kept strategic buyers pretty much sidelined, even as interest rates stood at record lows. Meanwhile, private equity funds, awash with uninvested capital and bolstered by hyperactive debt finance markets, have filled the gap, competing aggressively with one another in the absence of strong strategic interest. In many cases, the firms have outbid strategic buyers.

Lately, however, the dynamic has begun to shift, investment bankers and industry executives say. As the economy has improved and stock markets have rebounded, strategic buyers have regained confidence and are diving into auctions.

"We're definitely seeing the return of the strategic buyer to the marketplace, and we expect that will continue," says William Hiltz, senior managing director at New York advisory firm Evercore. "Nevertheless, we think financial buyers will remain an important source of mergers and acquisitions activity, unless we see a significant change in conditions in the leveraged-finance markets."

Since May, the high-yield markets have shown signs of skittishness amid the prospect of rising interest rates. Several companies have recently pulled their junk bond sales off the market, citing lackluster interest. The tremors have yet to curb the LBO firms' appetites for acquisitions. The high-yield market remains strong, alongside competition from banks and other debt financing sources. But for financial buyers, the warning signs are there.

"We've been experiencing a cyclically very strong high-yield market, but over the past few weeks, the market has definitely turned," says Warren Woo, managing director and head of financial sponsors at UBS. "If this continues, it could impact financial buyers' competitiveness."

Corporate divestitures tend to occur in cycles, as companies follow periods of intense M&A activity by disposing of noncore or underperforming assets. But the Sept. 11 attacks and the prolonged economic uncertainty afterward forestalled corporate selloffs. The pace of divestitures has since picked up again, albeit slowly. Last year divestitures accounted for about 40% of total M&A activity in the U.S., up slightly from 2002, according to FactSet Mergerstat. This year to date, activity has held steady.

At the same time, the percentage of corporate carve-outs going to private equity firms has edged up. In 2002 and 2003, financial buyers won 19% and 23%, respectively, of all corporate divestitures, up from an average of 15% in prior years.

In this seller's market, many divesting companies are making the sales process seem nearly glacial to eager buyers. In part, this may be due to concern over Sarbanes-Oxley issues or more thorough preparatory work, says Shaun Kelly, a partner at KPMG LLP. When executives proceed with a sale, private equity executives, who have been quietly priming management teams behind the scenes, scramble to get exclusive rights to negotiate a deal.

How a corporate seller picks the right buyer for a carve-out depends in part on its objectives. Corporations sometimes don't want to sell to an entity that will likely compete with them down the road. Conversely, choosing a strategic investor with industry experience or one that could later enter into supply contracts to provide outsourced services can give the seller a high degree of comfort.

Historically, of course, strategic buyers have enjoyed an advantage over financial buyers because they can tap operating synergies, a euphemism for cost savings from adding something on to the existing business. "If you have a strategic and financial buyer looking at the same property, and assuming perfect information and the same assumptions about the economic prospect, the strategic buyer in theory would be willing to pay a little more for it than a financial buyer and win almost any auction," says Alan Klein, a partner at Simpson Thacher & Bartlett LLP in New York.

But financial buyers, notwithstanding higher return requirements on equity, have had access to leverage at such low interest rates that on a blended weighted average cost, they can be competitive with a strategic buyer. "You can get 4.5 to 5 times Ebitda leverage on your business, so you could pay a fairly healthy price," says Marty Mannion, managing partner at Boston's Summit Partners.

Moreover, Mannion adds, financial buyers have increasingly assumed operating risks as well. Typically, private equity firms would bid based on the existing operations of a business. These days, financial buyers often incorporate projected Ebitda improvements in a price when bidding for the company.

In certain sectors, too, the logical strategic buyers may not be in a financial position to bid aggressively. That was the case late last year, when Time Warner Inc. sold its Warner Music Group for $2.6 billion. The buyers were Seagram scion Edgar Bronfman Jr. and private equity firms Bain Capital LLC, Providence Equity Partners Inc. and Thomas H. Lee Partners LP. The purchase price - which equated to a multiple of about 8 times Ebitda - trumped an offer from EMI Group plc and another private equity-backed team.

"A couple of years ago, you'd have been surprised to see Warner Music land in the hands of financial sponsors," one buyout executive says. "That's true for some of these very large deals being done."

Similarly, Suez SA's fiercely contested auction last summer for its U.S. based specialty chemicals unit, Ondeo Nalco Co., stirred interest from General Electric Co., but antitrust concerns proved too large a hurdle, and LBO funds showed up in strength. New York's Apollo Management LP, joined by others, muscled its way into a $4.2 billion purchase, which translated to an 8.2 times Ebitda multiple.

Besides moving quickly, financial buyers can often execute a deal and finance it with a higher degree of certainty than strategic buyers may provide. In April, Electronic Data Systems Corp. sold its product life cycle management software unit, UGS PLM Solutions Inc., to a private equity investor group consisting of Bain Capital, Silver Lake Partners and Warburg Pincus, despite some strategic interest in the property. The strategic buyer didn't have "the same level of interest that financial buyers were able to get to," a source close to the transaction says.

Working with the seller's requirements also tipped the scale. Part of EDS' mission was to strengthen its balance sheet by reducing debt. The cash sale brought it closer to its stated goal of zero net debt by 2004, an EDS spokesman says.

In the end, the choice came down to the Silver Lake team and several other private equity groups, including one with KKR, Golden Gate Capital and Texas Pacific Group. KKR's group was said to have bid slightly more than the Silver Lake team's $2.05 billion cash offer. But the latter's track record in technology investments was a big plus.

Often, a private equity firm may have a portfolio company looking for a tuck-in acquisition, in which case it becomes a strategic buyer itself. But sometimes a partnership between a strategic buyer and financial buyers is even more effective. That proved to be the case in GE's $2 billion sale last summer of its Financial Guaranty Insurance Co. business, which provides financial guarantee policies for public finance issuances. GE wanted to focus on higher-margin market segments, and FGIC was a slow-growing business. GE picked a consortium led by PMI Group Inc., a Walnut Creek, Calif., mortgage insurer, and including Blackstone, Cypress Group and Bank of America Corp. Of course, it helped that other likely strategic buyers were not actively looking at the time.

Increasingly, however, financial buyers have had to stand down because it's just prudent to do so. Once they realize that a strategic buyer is seriously pursuing a deal, financial buyers aren't willing to go head to head, advisory executives say.

At an auction for retailer J.C. Penney Co.'s drugstore unit, Eckerd Corp., earlier this year, the strategic buyers held sway. The financial buyers, including Blackstone, T.H. Lee, KKR and Texas Pacific, all backed off. Canadian drugstore company Jean Coutu Group (PJC) Inc., which offered to buy the chain three years ago but was rebuffed because the price was inadequate, ended up splitting Eckerd's stores with CVS Corp., for a combined cash payment of $4.5 billion.

Siemens' USFilter deal was something else. Eager to expand into a new business area, the German conglomerate made a pre-emptive bid for the USF assets, valuing them way above what the potential private equity bidders had calculated. The financial buyers never made it to the final stages.

In effect, a source argues, it was "a commentary on corporates getting more confident in their own businesses, in the general economic environment and in their ability to move into tangential areas that you wouldn't have seen two years ago."

For financial buyers, then, the challenge becomes how to stay competitive without overpaying. Private equity funds are bound by return thresholds. If the cost of capital is higher, returns will be lower.

"Financial sponsors are mandated to put money to work at good prices, but if it becomes too expensive, they're supposed to withdraw," one investment banker says.

In the end, "it's always about buying and selling at prices that make sense." - Vyvyan Tenorio

Divesting to whom?
Strategic buyers always dominate the market for business units being shed by corporate owners, but conditions in recent years have boosted financial buyers. Meanwhile, both kinds of buyers are paying more.
U.S. corporate carveouts by dollar volume ...				... and by number of deals
Year	Financial buyers ($mill.)	Strategic buyers ($mill.)		Financial buyers	Strategic buyers
2000	$15,667.55	$187,027.22		323	2,089
2001	$12,377.34	$153,858.27		351	2,108
2002	$27,800.24	$111,455.65		419	1,854
2003	$30,852.05	$96,320.71		580	1,947
2004*	$22,722.59	$37,816.93		244	753

Average multiples paid by carveout buyers
Multiples of Ebitda	2000	2001	2002	2003	2004*
Financial buyers	7.52x	7.83x	8.08x	7.81x	8.07
Strategic buyers	9.93	9.37	8.67	10.13	11.12
Year to date through 5/18. Negative multiples or multiples larger than 25 have been excluded. Financial services deals have been excluded. Source: Mergerstat*