How the current market is affecting mergers and acquisitions Featured

9:59am EDT March 1, 2011
How the current market is affecting mergers and acquisitions

After a few slow years, the mergers and acquisitions arena is beginning to pick up steam, and that means more opportunities for both buyers and sellers, according to David Watson and Michael J. Meaney, co-chairs of the Mergers and Acquisitions Practice at McDonald Hopkins LLC.

“Activity in the M&A markets indicates that 2010 was a much stronger year than 2008 and 2009, which were very negatively impacted by the recession,” says Meaney. “Activity in 2010, both in terms of number of deals and volume, was way up, really accelerating toward the end of the year. And all indications show that it will continue in 2011.”

Watson adds that although some sales were forced by financial distress, “some industries, such as health care, were active despite the broader economy.”

Smart Business spoke with Watson and Meaney about trends in the M&A market and how both buyers and sellers can take advantage of current conditions.

What is the current state of the M&A market?

There will probably be fewer transactions this year caused by distress, and more segments where good companies will be available at relatively full prices. Potential buyers fall into two broad categories: strategic buyers and financial buyers.

Strategic buyers, or corporations seeking to acquire a business in their own or a complementary business, are becoming more confident, based on the strength of the economy, that they can make an acquisition that will have a favorable result. Many of those buyers have strong balance sheets and the larger ones are seeing ready access to capital to the degree that they need to raise it externally.

Financial buyers, such as private equity funds, are also becoming more active because many are flush with cash and are under pressure to invest. Now that the economy is turning around, they are more confident in their ability to make profitable acquisitions. Many private equity groups will not purchase a troubled company at any price, preferring to purchase healthy and sound businesses. In a market where people were holding good businesses off the market, that severely restricted the availability of businesses that met the criteria of many professional buyers.

Are prices beginning to trend higher?

Yes, but there are still good deals. As prices begin to go back up, businesses that are ready to be sold will be offered to market either by owners who want to retire or by private equity groups that need to exit an investment in their portfolio.

It is important to note that, although prices expressed as multiples of cash flow are rising, business cash flow is often still lower than it was, so purchase prices in the sense of absolute dollars probably have not fully recovered.

How are transactions today different than they were three to five years ago?

Although banks are still finding their way back into the market, both buyers and sellers should expect banks to do intensive due diligence. Buyers and sellers should spend a good deal of time understanding what the bank needs and make sure key criteria of the deal are brought to lenders early in the process in order to avoid surprises later. We have seen several transactions falter late in the process when banks have discovered obstacles not previously brought to light.

Another increasingly critical area is state tax liability. It used to be that most of the attention was on potential federal tax liability, but with states under extreme budget pressure, they have become much more active in going after companies to make sure they are paying every dime that is supposed to be paid. Our state tax experts have become extremely busy advising our clients in this new era of aggressive state tax enforcement.

In this new environment, buyers are paying more attention to whether the target company may have hidden state tax liability issues. It is important to ferret those out before buying and to make sure the transaction documents give you sufficient recourse if liabilities do surface later.

What other issues need to be considered?

Issues around employment are getting a lot of attention, including the classification of employees and whether they are exempt from wage and hour laws. Another issue is workers who, in the eyes of the employer, are independent contractors, but in the eyes of the government are employees for whom payroll taxes should be withheld. With the government looking for additional revenues, these areas are seeing a lot of enforcement, calling for increased vigilance before purchasing a business.

Finally, there has been a great deal of seller financing, both in the form of contingent payment arrangements, such as earn-outs and in the form of the fixed deferred payments such as seller notes. But contingent post-closing payments are one of the most likely places for a dispute to arise, both as to how the payment should be calculated and as to whether the buyer has operated the business in a way to maximize the amount of the payment.

Can business owners handle deals on their own?

Having good financial and legal advice from experienced professionals can have a major impact on outcomes. We have seen swings in the price of a business of as much as 100 percent above, or 50 percent below, the originally proposed price, either by structuring a process that includes higher offers or by discovery of issues in the due diligence that change the willingness of the buyer to pay the indicated asking price. There really is an opportunity to affect your outcome by thinking up front about what your issues are and how you might solve them.

Find an adviser who wants to do the transaction that you want to do and asks questions about your objectives, rather than someone who, right out of the box, is telling you exactly how the transaction should be structured.

David Watson is a co-chair of the Mergers and Acquisitions Practice at McDonald Hopkins LLC. Reach him at (216) 348-5814 or dwatson@mcdonaldhopkins.com.

Michael J. Meaney is a co-chair of the Mergers and Acquisitions Practice at McDonald Hopkins LLC. Reach him at (216) 348-5411 or mmeaney@mcdonaldhopkins.com.