Dealer's choice

Market volatility and economic uncertainty are not allies in the world of dealmaking. The extreme turbulence in the equity and debt markets over the past 18 months -- severe dislocation followed by steep recovery -- has had the expected effect of reducing M&A activity significantly. As the markets continue to stabilize and doubts about the overall economy seem to be lifting, what can we expect in M&A activity in the short term?

M&A volumes will be up. M&A activity should increase compared with the first half of 2009 -- both in the number of consummated deals and deal sizes. Over the past year, many acquirers have been extremely cautious in evaluating target- company opportunities. Even though valuations are down from their peak period a few years ago, deals have been moving slowly. Buyers of all kinds have been reluctant to pull the trigger on acquisitions, driven by a palpable fear of "catching the falling knife" on valuation.

Meanwhile, the sellers' views on valuation in some cases have not been adjusted to reflect the new economic reality, and buyers have been unwilling to stretch to meet these high expectations. Buyers have also been spending significant time on diligence and integration issues, attempting to avoid missteps that could result in value destruction in the transaction.

As the world economy shows signs of breaking out of recession, buyers will be more confident proceeding with acquisition plans, relieving the pent-up demand created by the abundance of caution seen recently. Moreover, buyers may be motivated to act before target-company valuations start to climb measurably. Target companies that face impending liquidity crunches due to limited availability of credit to refinance debt with upcoming maturities will be eager to explore M&A transactions.

Strategic buyers will dominate. Strategic buyers will play an outsized role relative to financial sponsors in this surge of activity, as the availability of acquisition financing on favorable terms remains scarce and strategic buyers can bridge valuation gaps through exploiting merger synergies (revenue enhancement and cost reduction). Moreover, with equity prices climbing, strategic acquirers have sources of currency through equity not available to financial buyers.

Strategic acquirers with healthy balance sheets will seek the opportunity to acquire distressed competitors or strategic targets with complementary businesses at reasonable valuations to build market share and top-line growth. The recent economic turmoil has served as a catalyst for change, and strong companies are adapting to the new economic environment -- increased strategic M&A activity will be a natural by-product of these adjustments.

Financial buyers will be opportunistic and flexible. Financial sponsors are a resilient group. While strategic buyers will have an edge in the near term, financial buyers have shown flexibility in getting deals done, including minority purchases, earnouts and seller financing. This trend toward opportunistic flexibility will continue until the leveraged buyout debt markets return to a semblance of normalcy. Moreover, many financial sponsors have access to significant amounts of cash they must put to work, so these firms will be motivated buyers, especially in the middle market where financial sponsors can compete effectively without access to acquisition financing.

Deal terms will continue to rotate in buyers' favor. We have seen evidence of shifting deal terms, such as indemnification baskets and caps, survival periods for representations and other risk allocation provisions, in buyers' favor recently, but not as much as one might expect in an M&A environment like the one we are experiencing. Shifts in these terms take time as the market absorbs the new dealmaking reality.

In several deals I have been involved with in 2009, the buyer was willing to accept seller-friendly deal terms in relation to risk allocation in exchange for what the buyer perceived to be a quality business operation and opportunity at a fair valuation relative to recent history.

As sellers are forced to deal with liquidity constraints at target companies, particularly as long-term debts mature and refinancing alternatives remain limited, they will be more willing in the near-term to provide buyer-friendly risk-allocation packages. The market shift will be gradual but noticeable as we continue to move away from the extremely seller-friendly deal terms of the recent past in search of a new equilibrium.

Howard T. Spilko is a partner with Kramer Levin Naftalis

& Frankel LLP.