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M&A markets are growing, but gains are odd
October, 28th 2010

The prognosis for the mergers and acquisitions market continues to be upbeat for the rest of 2010, but a panel of M&A specialists addressing Faegre & Bensons annual industry seminar Wednesday tempered their considerable optimism with an armful of caveats.

Global M&A activity has grown 20 percent to $2 trillion this year, and the roster of buyers and sellers should keep the market growing into 2011, said Hugh J. Hoffman, managing director with Craig-Hallum Capital Group.

Non-financial companies have more than $1 trillion in cash on hand, and when they reach into those bulging wallets, theyre choosing to spend it on acquisitions and share buybacks.

Private equity funds are aging and exiting mature investments, which is opening a new round of fundraising and deployment of those recycled funds. Hoffman noted 15 private equity transactions worth more than $1 billion this year.

And hostile transactions are on the rise - a leading indicator of more M&A activity on the horizon.

The deal market is back, and there are a lot of drivers to keep feeding it, Hoffman said.

That uptick isnt even across the board, though. Most deals are being completed in the large company segment, where capital markets are providing cheap and plentiful debt financing, in both high-yield and investment grade bonds.

But theres a different story in small- and middle-market sectors, where most of the advisers, investors and lawyers attending Wednesdays session work.

Mid- and small-market buyers and sellers generally rely on banks to finance acquisitions, and those lenders are still showing some post-crisis reluctance to originate new loans, according to Brian Holcomb, a managing director at Greene Holcomb & Fisher.

They still have portfolio issues to deal with, headaches with regulators, Holcomb said. And theres still no appetite for collateralized debt obligations, which created a secondary market for those M&A loans during the last decade.

Mid-market deals that do close are more likely to be in the upper end of that segment, for targets with at least $15 million in EBITDA (earnings before interest, tax, depreciation and amortization), Holcomb said.

Leverage ratios are also coming back slowly from the credit-crisis lows, but we still see capital structure with 50 percent or more equity, he said.

Strategic buyers - companies looking to increase market share through acquisitions - are very busy looking at deals, said Jon Salveson, a vice chairman and head of investment banking at Piper Jaffray & Co.

Were probably at an all-time high in the number of conversations were having on the strategic side, he said.

But still-rocky business fundamentals are posing obstacles. Global consumption is still low, making it hard for buyers or targets to achieve revenue growth, and many companies continue to miss their revenue projections.

Theyre facing extreme uncertainty, Salveson said, and for mid-market companies forced to finance deals with high-priced equity, that uncertainty puts a chill on their appetite.

The health-care segment, which has delivered much of Minnesotas wealth for decades, is one of the hardest hit by consumption declines and uncertainty, Salveson said. Those companies see uncertainty in every direction - the regulatory regime, who their customers will be, and who will pay the health-care bills.

Thats left them in quicksand on Wall Street, Salveson said, pointing out that the sector had traded at a 30 percent premium to Standard & Poors 500 in the past, but is trading at a 25 percent discount now.

One incentive that will keep M&A markets busy in the near term is tax law. With capital gains rates expected to climb to 20 percent, up from the current 15 percent, companies with an interest in selling are feeling an extra measure of motivation to close by year-end.

As an example, Holcomb pointed to a cash-rich buyer who has made a low-ball offer on a target company. Hes playing chicken, offering a lower price, and betting that the seller will take less than they want in order to get the deal done and get some benefit from lower capital gains.

Salveson predicted the M&A climate and activity should continue strengthening into next year - just as long as another economic crisis doesnt come along.

If we can avoid a shock well be OK, he said. A lack of volatility is an enormous driver of deals.

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