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The deal drought: IPOs and M&As are down but not out

Although transactions may be few and far between at the moment, there are still deals to be done in a down market, experts at a recent Knowledge Wharton conference believe. The ‘drought' is severe but not terminal.

The rate of financial deals has plummeted since the collapse of the late-90s economic boom. IPOs, mergers and venture funding have all seemingly evaporated, and with them thousands of financial industry jobs.

This is how the economy is working off the hangover of the 90s, Wharton professors say, but experts hint that you can still find deals going on, if you look in the right places. “The deal activity in the Internet era was extraordinarily high, and today it's low,” notes Wharton finance professor Marshall Blume. “Normal levels are in between.”

IPO? No

The IPO market, which funded hundreds of questionable Internet firms in the late 90s, is one of the most brutal indicators of the deal drought. You might think the market was overheated in 1999, when 480 IPOs raised $91.7bn, according to IPO-trackers Renaissance Capital. But even back in pre-bubble 1995 there were 335 deals raising $31.4 bn. Compare that to 2001, with only 83 deals raising $44bn (because of some big ones, such as Kraft and Accenture) and the first nine months of 2002, with a mere 50 deals raising $18.6bn.

Linda Killian, an analyst with Renaissance, says there's a drought in the IPO market that she hasn't seen since the mid-1970s. “The IPO market has always been driven to a large extent by tech and biotech,” she says. “Telecom has totally evaporated, and biotech is licking its wounds right now and figuring out its next step.”

Of course, the economy has a lot to do with the weakness in the IPO market, but there are other factors at work as well: an increased focus on good corporate governance, a collapse of entire economic sectors and skittish investors who don't feel like getting burned again.

Sector diversity is slowly coming back into the IPO market, Killian adds, and that's a good thing. “As we got into the late 90s, telecom became a larger and larger part percentage-wise of IPO issuance. Bad money crowded out good money. Tech and telecom were over 60% of the IPO calendar.”

The new-model IPO calendar has more room for insurance, health care and banking IPOs, according to Killian. Spinoffs and recapitalizations are also playing a significant role, as companies try to ride out the bottom of this economic cycle.

The IPO-mania of the late 90s wasn't healthy for investors anyway, Wharton finance professor Jeremy Siegel says. According to Siegel, IPOs are a mug's game; insiders who get first crack at the stock get profits, and everybody else often gets burned. “Unless you get allocated the IPO at the offering price, IPOs are some of the worst investments to make,” he says.

M&A? No Way

The merger scene is also comparatively quiet right now. With 5,400 deals totaling $346bn though Sept. 30, this year's level of mergers is down to that of 1996, according to an analysis in the October 14 issue of BusinessWeek.

The merger drought may actually be a good thing, the magazine says, noting that of the nearly $4 trn in mergers from 1998 to 2000, 61 per cent actually destroyed shareholder wealth.

Many of the biggest losers were, predictably, Internet and technology companies like Healtheon/WebMD in its February 2000 acquisition of Medical Manager, which underperformed the health care sector by a mind-boggling 152 per cent as the Internet bubble popped. But the all-retail mergers of Dillard's and Mercantile Stores, and of Office Depot and Viking Office Products, also ate up shareholder value, according to BusinessWeek.

The main problems were that buyers paid too much, intoxicated by the ethos of growth, the magazine reports. Buyers who paid with stock did the worst. So perhaps it's a good thing that depressed stock prices are scaring off sellers, as Blume says. “Frequently, the payment in M&As is done in stock; if stocks are temporarily low, as some managers perceive, you're using your stock cheaply and [sellers] aren't getting a bargain,” he notes.

According to Bob Frost, vice president of middle-market M&A at US Bancorp Piper Jaffray, buyers have gone back to fundamentals. Companies are looking for high-quality acquisitions that dovetail well with existing businesses. “In 1997 and 1998 buyers were looking at properties outside their core businesses. That's not the case any more; people are very focused.” Look at health care, consumer products and food for strong merger activity in this down market, he says.

Venture capital activity is also depressed, experts note. The private-equity firms that help seed new companies have plenty of capital available, but they're just not seeing a tremendous amount of good companies to invest in, says Sean Mallon, an associate at Mid-Atlantic Venture Funds. “The feeling is that there's somewhere between $60 and $110bn of uninvested venture capital out there that will at some point be looking for a home. Historically, that's a huge amount of undeployed money.”

Even though their wallets are bulging, venture capitalists aren't rushing to bestow largesse. Instead, they're concentrating on over-due diligence - researching potential investment targets to within an inch of their lives. “We look for product that is deployed if possible, revenues if possible, good brand-name customers if possible, and knock-em-dead management teams,” Mallon says.

Piper Jaffray' s Frost agrees, saying that although there's a “tremendous overhang” of capital in VC firms right now, VCs are holding their checkbooks close to their chests. “For high-quality companies you can generate substantial interest from the private equity community. For lower-quality or questionable companies it' s a difficult market.”

Distressed Deals

There may be a deal drought, but investors shouldn't be too worried, Blume says. Other than a “knee-jerk reaction” leading to a flight from equity mutual funds, “it's hard to argue that the market is undervalued right now”.

Deal volume will stay relatively low for a while, but there are still deals to be done in a down market, Siegel points out. He says to expect mergers from failing firms looking for saviours, such as the airlines (if the federal government permits them.) “I think there's going to be a lot of deals for distressed companies and distressed assets.”

And Siegel doesn't think the deal drought is so bad. Investors are cautious and somewhat discouraged, but he's seen worse. “Investor attitudes are way down, but I've seen them more pessimistic than they are now. At the bottom of the 74 bear market there was much more pessimism, and at the bottom of the 82 market there was more pessimism,” he says. “Not every irrational exuberance is followed by an irrational despondency.”

Copyright © 2003 Knowledge Wharton

Knowledge@Wharton is a bi-weekly online resource that offers the business insights, information and research from a variety of sources. These include analysis of current business trends, interviews with industry leaders and Wharton faculty, plus articles based on the most recent business research, book review and conference and seminar reports.