Friday, December 19, 2008

For Cash-strong Businesses, the Acquisition Question
By Gary C. Harrell

In these turbulent economic times, there are two immutable certainties. The first certainty is that cash is king. Now, to be sure, it should be noted that cash has actually always been the king, even though debt and inflated asset valuations may have made their own good, albeit impractical, runs at overthrowing the kingdom. And the second certainty is the mergers-and-acquisitions practice, at least as we have known it, is now a badly wounded beast.

The latter certainty was evidenced in a recent Wall Street Journal article written by Matthew Karnitschnig. There, Karnitschnig began with an ominous declaration: “M&A is almost dead.” And though his words seem hyperbolic, he went further to point out that “…the severity of the current downturn and the disappearance of credit is changing how Wall Street puts deals together.”1

Of course, the Karnitschnig prediction could be dangerously premature and, if nothing more, only applicable for the duration of this downturn. Nevertheless, his words highlight an important point about the nature of our modern M&A arena. For years now, particularly since the latter portion of 2001, the buyout world had been en fuego. Unusually low interest rates meant to energize borrowing and spending after the terror attacks of that year also, not quite inadvertently, encouraged strategic and financial buyers to make their own moves. With debt priced so cheaply, everyone from the executives of healthy companies to the barons of private equity thought it was a good time to borrow other people’s money and acquire some well-positioned enterprises. In fact, according to the international law firm Wilmer Cutler Pickering Hale & Dorr, LLP, deal-flow reached its height in 2005, with 31,524 M&A deals, valued en masse at $1.9 trillion.2 But all of that has changed, and now as cash becomes necessary and debt becomes scarce, the volume of these deals—even the low-profile ones—has dropped off substantially.

This is not to say that the opportunity for deals is gone. To the contrary, there are even more good deals to be had. The problem, however, is rooted in our natural tendency for risk-aversion. Put simply, if we are burned by the fire once, we are increasingly less likely to put our hands back into it. And in many ways bankers and business executives have been quite scorched by this latest downturn in the economy. To illustrate this point, many of the remaining solvent lenders and investment bankers are openly unenthusiastic about financing any new deals at old levels. Rather, they want to add more covenants to even viable deals, and they want to know just how likely they will be repaid on time by the borrower who is also being asked to absorb more of the deal’s risks. And for their own part, borrowers—those seemingly healthy businesses and PE entities—are more interested, at least for the moment, in hoarding their cash reserves, out of fear that those positions might be needed, if the downturn does not subside. Hence, for those willing to take a chance, and equally willing to lay down more of their own skin, the game has just gotten very interesting.

Though some might look upon these difficult times with dread, others must remember that opportunity resides even in the darkest of conditions. For the acquisitive spirits among us, the downturn has created a buyer’s market, replete with fresh prospects at better prices, and the same opportunities still exist for cash-laden businesses who had been considering expansion projects of their own, at least before the downturn solidified. To be sure, wrestling with bankers for the credit to do these deals might be arduous, but if companies with requisite capital are willing to put those positions to use, they can produce long-term benefits.

“Instinctively, people want to sit on the sidelines—maybe wait things out for a while. That’s the wrong attitude,” explained Larah Rauscher of Strix Systems, Inc, a wireless-networks firm, located in Calabasas, CA. “If you have a strong cash position, there probably won’t be a better time to find opportunities so inexpensively.” That is the reason Strix Systems has pushed ahead with the opening of an R&D facility in Mumbai, India.

The expansion of an enterprise is never an easy process, some might rightfully contend, inasmuch as it does require rigorous research, planning and budgeting. What’s more, they would also say that a sour economy really is not a good time to build out infrastructure, especially if suppliers and customers are hit hard by these conditions. There is no doubt that those points are accurate; however, while credit may be difficult to come by, and while signs of immediate economic recovery might not be on the horizon, even the most cautious professionals in cash-strong enterprises have noticed that the downturn has produced a more hospitable environment for their expansion plan. Building out new facilities, for example, can come in under budget, as material costs and construction costs come down. Likewise, the pool of talented and skilled workers is larger, which means the costs of labor can be better contained. And in the buyout world, the price tags on target enterprises are not likely to induce sticker shock. Indeed, today’s environment offers a chance for those dollars to go much further, almost anywhere in the world, than just about any other time in the last decade.

Even still, for a cash-strong business, deciding to build out new operations during this opportunity or to acquire the existing operations of another enterprise can be as difficult a choice as any ever made. Of course, when faced with this choice, expansion is often a reasonable path for some decision-makers who see acquisitions as messy and problematic. Indeed, amalgamating the business processes and integrating the supply chains of disparate businesses can take some time. There is also the matter of redundancies; all jobs, for example, cannot and should not be sustained in the merged enterprise. And, if those were not enough concerns, some executives would point to the inherent cultural differences of two companies as being a potential powder keg for destroying the merger, down the road. Hence, they would consider it a safer bet to build their own operations.

The challenges notwithstanding, there are still some tangible benefits to making the acquisition of an existing operation. Axiom Strategy Advisors, LLC, would like to take this opportunity to point out just a few:

v Acquiring an existing enterprise will give a buyer operationally ready assets faster than buying all new assets and building out the necessary infrastructure to make them ready.

v Rather than attempting to invoke competition, an acquirer will obtain the customers, personnel, brand name, market share, geographic positioning, intellectual property, and product lines of a target company.

v By acquiring an existing enterprise, the cash-strong business will have access to additional production capacity, or service capabilities, and it will be able to spread more of its fixed costs over a larger customer base. What’s more, when the acquisition is vertical in nature—that is, when an acquirer is buying a supplier—the former has the ability to drive down costs and increase the profit margin on the ultimate goods or services that it sells.

v With the acquisition of an existing enterprise, buyers will gain access to new markets either geographically or through its new product lines. This access typically provides diversification to the company’s revenue stream.

v From a tax and accounting perspective, the acquisition of an existing enterprise can be more beneficial than an expansion. That’s because the transaction costs associated with a buyout, in many cases, can be amortized over an elongated period of years, in accordance with the IRS Tax Codes. (As an example, the Codes offer a “safe harbor” provision that, in some cases, grants acquirers a ratable amortization of fifteen years on intangible assets without consideration for the useful life of those assets.) Meanwhile, no such provisions readily exist for a company only wishing to expand. Instead, an expansion will only impact the assets of the company’s balance sheet, and the costs of the effort will only be expensed in that single year.

For businesses with the capital to do so, this does appear to be an excellent time to make some strategic moves. With many costs down, building stronger operational positions will allow these businesses to be ready when the economy does begin to recover. Acquisitions can be a formidable part of these operational positions. In fact, acquisitions can bring with them new customers, new talent, new processes and products, and new revenue. Hence, buying out an existing enterprise can be highly beneficial, and should remain a consideration of those decision-makers with the ability and will to forge ahead.

Will every acquisition work? Naturally, the answer to that question is not an entirely positive one. Acquisitions require thorough amounts of analytical due diligence, and the effort to integrate the operations of any two existing businesses has to be meticulously planned and perfectly choreographed, in order for there to be post-transaction success. In short, the process needs to tap leadership, resources, and genuine expertise, to make things happen, and that is where a consultancy like Axiom Strategy Advisors excels. However, that is fodder for a different quarterly.

Gary C. Harrell is the managing principal of Axiom Strategy Advisors, LLC. For additional information, please write

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1. “The New Deal: M&A Game Shifts”, Wall Street Journal. Matthew Karnitshnig. December 11, 2008
2. 2006 M&A Report. Wilmer Cutler Pickering Hale & Dorr, LLP. 2007.

Copyright 2008 All rights reserved; Axiom Strategy Advisors, LLC

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