In 2006, mergers and acquisitions (M&A) worldwide nearly totaled $1.6 trillion. With M&A activity in full swing for 2007, readers and investors often ask what is just beyond the horizon in today's heated buyout environment. Many types of company acquirers are now competing to purchase a limited number of U.S.-based, investment grade operating companies. The trend points to a hyper-competitive landscape in which traditional buyout firms, financiers, hedge funds, investment banks and senior executives are competing for deals. (To learn more about M&As, see The Basics Of Mergers And Acquisitions, The Merger - What To Do When Companies Converge and The Wacky World of M&As.)

Factors Affecting the Buyout Landscape
Several factors are helping to drive acquisitions, including the insatiable demand for energy, which causes higher demand for oil-related equipment and services, and the continued economic expansion of the southern region of the United States. Energy services in particular have caught the attention of investment groups as many companies operating in this space are seeing record profits. These businesses also tend to be insulated from cyclicality, as America's energy infrastructure is old and in need of constant maintenance. Healthy corporate profits and an ever-tightening competitive market have also diversified the attention of the major players to other parts of the economy. These factors continue to shape the M&A landscape and will likely be the catalyst for buyouts moving forward.

The Players
Many groups have joined the acquisition fever. First, we have private equity. This group raises money from high net worth individuals, companies, retirement systems, pension funds and university endowments. Private equity usually exits the business after a hold of five to seven years. A portion of these equity groups are strictly financiers that are dependent on management to successfully grow the business. Others have more experience in operations, and usually partner with seasoned managers who are experienced in the industry to help the newly combined entities unlock value. (To find out more about private equity, see Private Equity Opens Up For The Little Investor.)

Hedge funds have also been more active in the marketplace. While these groups have been traditionally flexible in the approaches they have used, they are developing an increasing appetite for acquisitions. Additionally, special purpose acquisition companies (SPACs) are a relatively new acquisition vehicle that principally started in 2005. SPACs are acquisition companies that are funded with public money. They are raised solely for the purpose of acquiring a company. What makes them especially hungry is that their charter often requires them to acquire a company within 12 to 24 months, otherwise investors lose a portion of their committed capital. (For more see, A Brief History of the Hedge Fund.)

Mezzanine firms, which traditionally have played a financing role, also have conducted acquisitions. Additionally, the large investment banks have been very proactive in acquiring companies on their own accounts. Not only do they present companies for acquisition, the investment banks themselves are sourcing for good companies to buy.

Finally, management groups - former CEOs and seasoned executives - have turned to financiers and equity partners to help orchestrate management-led buyouts (MBOs). Many are successful in obtaining financial backing because their role in helping to consolidate fragmented industries has proved to be a lucrative formula for increasing enterprise value.

What do the major players look for?
Acquirers look for platform, cash-flow companies with the following general criteria and profile:

  1. strong, sustained growth
  2. a business model not particularly tied to commodity prices
  3. an operation that provides niche products and/or services
  4. a simpler, easy-to-understand business
  5. room for higher revenue through internal, organic growth as well as through acquisitions
  6. capable management team
  7. ability to sustain margins
  8. diversity in customer base
  9. current shareholder(s) willing to leave a portion of the equity for a "second bite at the apple"

In today's market, stories circulate among M&A professionals regarding exorbitant multiples being shelled out in order to acquire a company, both on middle market and large cap transactions. Jack Welch, former CEO of General Electric Company, often regarded 30% premiums over fair market value as a dangerously high price to pay for an acquisition. With the directive to extract returns for incoming shareholders and to justify such premiums, acquirers are pressured to tack leverage onto the newly acquired company's balance sheet in order to increase return on equity (ROE). With higher leverage, unfortunately, comes increased risk. Volatility in the cash output of a company can result from an economic, industry, or cyclical downturn, and the company may not be able to service the recurring, increased interest expense.

Acquirers have turned to several important strategies to compensate for risks associated with paying higher multiples in an acquisition.

  • Many partner with intermediary and professional organizations to find good companies that produce a healthy stream of cash over the long term and have demanded sustainability and insulation features in case of a downturn. Deal sourcers have traditionally partnered with M&A firms, investment banks and business brokers. Given today's market, such partnerships are critical. For instance, many acquirers now emphasize relationships that they hope will yield multiple transactions, as opposed to one-off transactions on a case-by-case basis.
  • Higher bonuses for introducing potential sellers are also becoming more common. These take on the form of additional cash incentives, higher commissions as a percentage of transaction value, equity participation in the deal, and opportunities to provide financing (and therefore charge interest) to fund a transaction or board participation.

Putting the Deal Together
Business development and deal sourcing executives are also looking to accounting firms, lawyers, stock brokers, estate officers, consultants and financial advisors to source deal flow. Accounting firms and lawyers, either through their current or former client relationships and extensive networks, are often aware of private companies that may take a development meeting from an intermediary acting as agent on behalf of a potential acquirer. Professionals like these are a large pool of M&A intelligence and can often possess inside knowledge about a company - including operations, financial statements, legal issues, and family situations and/or eventualities. The information they provide is leveraged to increase the likelihood of an acquisition event for an investing group.

Thus, the M&A marketplace is seeing a much higher level of buy-side work done by intermediaries and professionals. When investment banks and M&A firms, for instance, represent a seller and take his company to the market at full auction, they inform a wide array of potential acquirers. The auction process makes a successful transaction a nearly improbable event for most investment groups. When they hire intermediaries, however, they can task these agents to act on their behalf and conduct search assignments that meet certain investment criteria. By being able to connect with several potential sellers, rapport can be built, information can be shared and both parties can more quietly explore the possibility of a business combination.

The rise in new acquisition firms along with the infusion of foreign capital spells trouble for many investment groups not using strategies that will enable them to effectively acquire good companies. It will also likely lead to even more aggressive approaches such as an outright purchase of a M&A firm in order to fully and exclusively leverage its procurement capabilities. The world of M&A activity is often complicated, but one can quickly gain a respectable understanding of this market by focusing on the players and the key features those players look for when seeking strategic alliances.

Related Articles
  1. Stock Analysis

    The Top 10 Small-Cap Stocks for 2016 (ATI, ARCB)

    Discover the top 10 small-cap stocks expected to grow in 2016, complete with summaries and growth outlooks for each company and its expected price target.
  2. Fundamental Analysis

    HF Performance Report: Did Hedge Funds Earn Their Fee in 2015?

    Find out whether hedge funds, which have come under tremendous pressure to improve their performance, managed to earn their fee in 2015.
  3. Investing Basics

    Bill Ackman's 2 Best Investments (GGP, CP)

    Learn about the two best investments Ackman ever made. Ackman has demonstrated a consistent track record of success in all types of market environments.
  4. Investing

    George Soros: 3 Best Investments Ever

    Learn about some of the most successful trades famed investor George Soros has made during his career, including a billion dollar profit against the pound.
  5. Saving and Spending

    Where Does Bill Ackman Keep His Money?

    Learn about where prominent hedge fund manager Bill Ackman keeps his money. See how his short position in Herbalife has not been successful so far.
  6. Stock Analysis

    Elliott Management: An Activist Investor Analysis (HES, CTXS)

    Learn about the activist investor strategies used by Elliott Management. Read about the fund's positions in Hess Corp., Citrix and CDK Global.
  7. Stock Analysis

    Analyzing Porter's Five Forces on JPMorgan Chase (JPM)

    Examine the major money-center bank holding firm, JPMorgan Chase & Company, from the perspective of Porter's five forces model for industry analysis.
  8. Economics

    Does Big Money Hurt or Help Clinton and Rubio?

    Marco Rubio and Hillary Clinton lead their parties in raising money from Wall Street. Is that a help or a hindrance?
  9. Fundamental Analysis

    The 3 Best Investments When Bull Markets Slow Down

    Find out why no bull market lasts forever, and why investors should shift their assets away from growth and toward dividends when stocks slow down.
  10. Products and Investments

    There's a Reason They're Called Junk Bonds

    The closing of Third Avenue Managemet's Focused Credit Fund is a warning to investors and advisors. Beware the junk.
  1. What is securitization?

    Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming ... Read Full Answer >>
  2. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  3. Are hedge funds regulated by FINRA?

    Alternative investment vehicles such as hedge funds offer investors a wider range of possibilities due to certain exceptions ... Read Full Answer >>
  4. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  5. Can hedge fund returns be replicated?

    You can replicate hedge fund returns to a degree but not perfectly. Most replication strategies underperform hedge funds ... Read Full Answer >>
  6. Can foreign investors invest in US hedge funds?

    U.S. hedge funds are open to accredited investors. When they distribute profits to investors, those proceeds are taxed at ... Read Full Answer >>
Trading Center