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M&A Forecast 2005

PricewaterhouseCoopers forecast growth acquisition strategy returns in 2005 - this time with discipline. Moderate rises in deal volume are expected in the financial services, healthcare, technology, and manufacturing sectors, while inbound cross-border deals are to see the most activity.

M&A will enjoy a moderate pick-up in 2005, with more deals of all sizes, according to PricewaterhouseCoopers' Transaction Services group.

While corporate acquirers continue to approach mergers and acquisitions with caution, pressures to demonstrate growth coupled with abundant financing and cash reserves should raise the levels of corporate M&A next year. At the same time, cash-laden private equity buyers are already seizing many deal opportunities and will continue to compete with strategic buyers for middle market deals over the next twelve months.

"We're clearly at a turning point in the M&A market," said Bob Filek, a Transaction Services partner. "Companies will be more active across the board. They have a lot of cash, and there's a lot of debt financing available. In a little less than a year, financing sources have moved from financing acquisitions at 2.25 times EBITDA to a level of 5-plus times EBITDA."

Filek noted that as M&A financing sources chase yields and try to beat their benchmarks, they've been willing to go into lower-quality issues and take on longer maturities. Executives will also be shifting their focus from Sarbanes-Oxley compliance matters to growth and acquisitions. But it will be a while before management regains the kind of attitude existing in an overheated M&A market. That said, M&A is definitely up. Through November, U.S. buyers accounted for $790 billion of acquisitions, 31 percent above last year's $604 billion, according to Thomson Financial.

"The deal drivers in 2005 are simple: cost and growth," observed Greg Peterson, a Transaction Services partner focused on the private equity sector. "What buyers are asking is, 'How can we improve the cost structure and once we do that, what's the upside growth potential?' Deals that don't offer growth potential won't get done, despite cost savings - and that's true on the corporate side as well as the private equity side."

The breadth of deals already being done is a sign that future M&A gains will be spread across several sectors rather than in one or two. Filek and Peterson believe the following sectors will be active in 2005:

• Financial services - Look for continued consolidation in retail banking as companies seek growth. Insurance M&A will also increase as the industry looks to restructure in light of the recent regulatory shake-ups.
• Healthcare - The two drivers are consolidation and government mandates. Both corporations and private equity firms are focusing on healthcare as pressure to drive down costs accelerates consolidation as a way to build scale through volume gains and geographic coverage. The Medicare Prescription Drug Act will pump $400 to $500 million into the healthcare system over the coming years, and Medicare managed care plans, rural providers, drug companies, and PBMs (pharmacy benefit managers) stand to gain. Conversely, if pressures mount to curtail planned increases in Medicare reimbursements, hospitals could lose as they are the primary beneficiaries of payment increases.
• Technology - As companies shed former high growth businesses that have since become commodities, they will begin investing in new growth areas. Among the most interesting are the new technologies in entertainment and media. However, tech acquirers and their boards have learned discipline and have shifted their focus from growth at any cost to "good growth" - acquisitions that boost earnings and can be successfully integrated.
• Consumer products - Consolidation will continue as retailers step up their price and quality demands and manufacturers discard brands with little growth or profit potential. While some of these brands may simply be at the end of their lifecycle, others may be suffering because the owner lacks expertise and clout in a vital distribution channel. Such brands may present opportunities for market-savvy consolidators or private equity firms.
• Automotive - This remains one of the most troubled sectors in manufacturing as oversupply plagues car manufacturers and their biggest suppliers. Watch for companies to sell businesses with high fixed costs and create alliances in low cost areas including China.

Filek and Peterson believe the following issues will influence deal making in 2005:

• A return to buying growth. In a slowing business cycle, corporations use acquisitions to drive value. The cycle is clear: a drop in demand, belt tightening, lower growth targets, recovery, and strong growth followed by slower growth. We are now in the slower growth phase and will again see the return of acquisitions and mergers whose primary purpose is to boost otherwise flat growth. The acquisition process, however, will be more disciplined than in the last cycle.
• Overseas corporations will seek bargains here. A weak dollar will make it even harder for U.S. firms to do cross-border deals with their higher risk, social costs, typically longer timelines, and integration complexities. However, the weak dollar will drive some corporate bargain hunters in Europe and Asia to the U.S. Companies with large U.S. customer bases will feel pressure to derive more of their costs from the U.S. both to balance their currency exposure and enhance their market presence. Such cross-border activity could propel M&A in many industries including financial services and industrial products.
• The best IPO market since 2000. The availability of debt financing at extremely attractive rates coupled with uncertainty about how an adverse Sarbanes-Oxley Section 404 opinion might affect valuation have kept many IPO candidates on the sidelines during the second half of 2004. Next year, look for IPO activity to pick up in the second and third quarters as interest rates rise and the market becomes more comfortable with the way companies are valued. While manufacturing and technology will lead the way, investors will look for companies with solid cash flows and sustainable business models.
• Private equity wants home runs with lower risks. Since the market bubble burst in 2000, there's been a flight to quality funds by limited partners. The most successful PE firms responded by becoming much more disciplined in what they look at and how much equity they are willing to put to work in a single transaction. They continue to raise record amounts on new funds adding to vast sums previously raised. This puts pressure on stronger funds to put their money to work quickly in "quality" deals, which are often larger transactions that may offer better value and stronger projected returns. It's also the impetus for the continued heavy use of consortium bidding, which facilitates larger deals while lowering overall risk.
• Private equity gets the model right in Europe. The success of several recent deals demonstrates that the practice of using locally-based deal teams, European debt financing, and consortium bidding to snap up attractive corporate assets is working. While the focus is still primarily on Western Europe, Poland and other Eastern European markets may begin to heat up.

According to Filek, there is a wild card in deal-making next year: the impact of rising commodity prices. "In the current global environment, there's a lot of uncertainty regarding the sources of supply and demand for key commodities. We've never faced a situation where China is the third-largest exporter as well as one of the world's biggest consumers of physical commodities. It could get really interesting if we suddenly start to have more rapid inflation or limited supplies of core commodities. That could spur the defensive use of acquisitions to secure raw materials.

"Vertically integrated companies have been disaggregating for a long time, concentrating on core competencies, creating very lean and flexible structures and focusing on key customers and technologies," Filek added. "If there are real shortages or allocations of critical commodities, lower-tier vendors - the 'we get no respect' component of the economy for the last 15 years-may find themselves in real demand."

"The ambiguity in the global marketplace will affect U.S. dealmaking in ways we can't predict today," said Peterson. "Three years ago, we considered terrorist attacks the wild card. Today, the cost of dealing with terrorism is factored into things like shipping and insurance. Dealmakers have essentially redefined MAC clauses in purchase agreements, and are basically resigned to saying, "War and terrorism are not materially adverse changes; let's close the deal now!"

The Transaction Services group of PricewaterhouseCoopers (http://www.pwc.com/ustransactionservices) offers a deal process that helps clients bid smarter, close faster, and realize profits sooner on mergers and acquisitions, sales, alliances and financing transactions. Dedicated deal teams operate from 16 U.S. cities and some 90 locations in North America, Latin America, Europe and Asia.

PricewaterhouseCoopers (http://www.pwc.com/) provides industry-focused assurance, tax and advisory services for public and private clients. More than 120,000 people in 139 countries connect their thinking, experience and solutions to build public trust and enhance value for clients and their stakeholders.