February 19, 2010 4:35 pm

Bargain hunters should beware value destruction

Chief executives like nothing more than finding a bargain, and many are hoping the economic crisis will provide opportunities, as companies worldwide sell assets to repair their balance sheets.

Having spent the past 18 months cutting costs and conserving cash, companies with strong balance sheets are hoping to exploit depressed valuations in hard-hit sectors.

“Companies are increasingly using M&A as a tool to fix balance sheet issues, as much as for strategy. It is very clear that a number of companies that need to reduce leverage are considering selling assets,” says Thierry D’Argent, managing director, M&A at Société Générale.

Bankers argue that using M&A as a way to grow in the current market is particularly appealing because lower prices bring previously unattainable targets within reach of a buyer. This is particularly true of the financial services sector, which is expected to account for the bulk of deals, as institutions divest assets to pay back governments that have bailed them out.

“Steady as she goes has been the ethos throughout the 2009 financial services deal market,” says Nick Page, partner at PwC. “However, a restructuring-led wave of deal activity will gather momentum across the European financial services landscape as we move further into 2010.”

Royal Bank of Scotland is paying a high price for the state aid it received, winding down or selling £250bn worth of non-core assets within four years and reducing its balance sheet by a further £50bn by offloading parts of its core business.

American International Group has also been pursuing disposals to pay back the US government, which saved it from collapse in September 2008 with a $182bn bail-out. The financial services group has announced more than two dozen deals to raise an expected £12bn.

However, AIG’s management also stopped the sale of divisions such as Japanese units AIG Edison Life Insurance and AIG Star Life, when it became clear they would not fetch the price they had hoped.

Unrealistic expectations over the valuation of assets has been the main reason why the volume of deals coming out of restructuring situations has been so low. However, with markets becoming more stable, bankers and consultants say the gap is narrowing.

“Companies may not be willing to sell at today’s valuations, but there is a premium to repairing balance sheets, having a strong credit rating or indeed restoring the ability to seize opportunities,” Mr D’Argent points out.

Bankers also expect private equity groups to become more active in helping companies restructure, as the availability of bank debt returns.

Istithmar, the investment arm of the troubled Dubai World conglomerate, recently put Inchcape Shipping Services, the port and shipping agent, up for sale to help Dubai World restructure its $22bn of debt.

“The diversified private equity players have been bulking up their debt, hedge and distressed funds to take advantage of opportunities in distressed debt, reflecting their ability to evolve and successfully navigate choppy waters,” says Greg Peterson, partner in PwC’s Transaction Services group.

To aid cash-strapped buyers, some sellers are providing pre-arranged debt packages, known as “staple finance”. Last year, Barclays offered staple financing during its sale of iShares, providing potential bidders with up to 80 per cent of the money needed to complete an acquisition of the division which specialises in exchange traded funds.

Similarly, Commerzbank is offering staple finance on the auction of Ratiopharm, the German generic drug maker that was put up for sale after the Merckle Family, its owner, ran into financial difficulties and was forced to hand over most of its industrial empire to its creditors.

However, although M&A during a downturn can tempt cash-rich buyers, industry experts advise caution because buying distressed companies does not guarantee higher returns for shareholders.

Recent research by the Cass Business School in London found that acquisitions of distressed targets may create value for bidders in the short term, but there was a struggle to improve long term returns.

Analysis of the bidders’ operational performance one year before a deal and three years after the combined group was created shows a sharp deterioration. Bidders in such deals underperformed those in non-distressed deals.

A target was defined as distressed if its interest cover ratio – a key measure of a company’s ability to pay its expenses, including debt – was less than 1 and featured in the bottom 25 per cent of the relevant industry in the year before the deal was announced.

Much of the value destruction was determined by timing. The best time for a deal was just after a crisis, when the market started to recover. Many shareholders, for example, were furious over Bank of America’s takeover of Merrill Lynch and Lloyds Banking Group’s merger with HBOS.

Both deals were struck in haste during the worsening US banking crisis in late 2008, with little due diligence. Opponents argued they did little more than expose healthy banks to billions of dollars in risky loans and investments.

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