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Pick and Choose

The much-touted rebound in corporate M&A activity has yet to materialise, but it may not be long before finance directors get a call from the chairman or CEO telling them to find financing for the acquisition that has been sitting in their ‘pending’ tray for the past two years.

“The recovery in M&A that many people were anticipating for this year has not materialised,” says Oliver Ellingham, head of corporate finance at French investment bank BNP Paribas. “M&A activity is down in the first quarter of 2004 compared with the same period last year. There’s a lot of talk, but not many tangible transactions being announced.”

Some corporate finance bankers say the M&A market has started to acquire a busier feel about it than it had last year, but it’s still far from booming. Corporate development departments may be cautiously reviewing candidates for acquisition, while the level of activity compared with 2000-01 and much of the 1990s remains relatively subdued.

Corporate UK, however, is cash-rich and P&L statements are looking healthier now than they have since the markets started a downturn. Ellingham believes this factor will eventually rekindle confidence to the extent that takeovers go back on the agenda for growth. “As companies increase their profitability and generate surplus capital, it is probable that M&A will recover,” he says. “But I don’t think this will happen this year or in the first half of 2005, for that matter. Undoubtedly, there is greater pressure now to get the deal right, given the much higher level of accountability.”

The one exception to sluggish performance in the M&A market is the financial institutions sector, where corporate activity has been extremely active in the past few months, with significant growth shown in the amount of acquisition finance being sought. David Barker, global head of financial services at Ernst & Young, points out that there has also been an upsurge in mezzanine funds. “There is growing interest of certain financial services companies to get more structured leverage into a transaction,” he says. “The balance and complexity is often governed by the regulator and the rating agencies, so these companies need to have an eye on both factors. Even some of the smaller financial services companies will want capital market as well as bank relationship solutions and securitisation,” says Barker.

He attributes the revival in financial services M&A partly to the approaching enactment of Basel II. “There is also the whole issue of capital destruction inherent in the markets in the past two or three years,” he says. “The balance sheets of insurance companies and asset managers have suffered a vast amount of capital write-off and this has had to be repaired by the rights issues, in some cases, and in others by divestments and private equity sales. Securitisation techniques allow for a number of companies to act almost on a level playing field with a bank. You don’t need a large balance sheet to be a mortgage lender these days. It can be done through the capital markets,” says Barker.

The challenge facing corporates that decide to take the plunge is to work out how much debt they can take on board without causing unreasonable damage to their balance sheet, rating and reputation. Ratings, in particular, are becoming an increasingly important issue in a changing regulatory environment. Companies are resolute about sticking to their investment grade ratings and will, in some cases, accept a downgrading to BBB flat. But there is a firm reluctance to let the rating slip below that level to avoid jeopardising their existing public debt.

In fact, one topical matter is whether bonds should carry protection against downgrades by rating agencies to below investment grade on a change of control. “The Marks & Spencer 10-year bond issue last January was done at a spread of 93 basis points (bp) over gilts and was quoted in early June at +400bp,” says Michael Lacey-Solymar, head of the midmarket group at Swiss banking group UBS. “The company is exactly the same one as it was six months ago, but the perception of what would happen to bondholders if Philip Green took over and financed his bid in the way he implied was taken seriously by credit markets. Any holder who bought the bond at 100 or thereabouts would now be looking at a bond that is trading in the low 80s,” explains Lacey-Solymar.

“The bond market in January was rosier than today and issuers were able to get better terms. M&S made good use of that in January and I suspect there will be a lot of attention by purchasers of bonds to make sure there is protection against this,” he says.

Most corporate advisers are telling clients to keep a watchful eye on the post-acquisition scenario a few years down the road. Banks are flush with cash and eager to lend, but over-leveraging jeopardises a company’s financial flexibility to deal with an unexpected downturn in the market or, indeed, another acquisition opportunity that may come along.

Companies have formed the view, and rightly so, that there is a plentiful supply of bank debt. Most corporates know that if they need to find financing they can get it, although in many cases acquisitive corporates will wait until they find the opportunity and then talk about acquisition finance. In this case, companies should borrow as much as they can while keeping a sound balance sheet, says Ellingham. “Debt is relatively cheap and clients can now fix quite a long period of time and lock into financing for the medium term while getting the project bedded down. Mid-to-upper midcap companies would typically leave a little bit up their sleeves. But for the right transaction, it makes sense to borrow as much as one requires.”

While corporate activity lingers in the doldrums in terms of access to capital and acquisition finance, the markets do seem buoyant, says Lacey-Solymar. “That’s probably a function of the interest rate environment and the strength of banking,” he says. “There haven’t been major banking problems in Europe that would have affected the credit market and most lenders are eager to help FTSE-250 companies looking to fund acquisitions.”

Lacey-Solymar emphasises that in the FTSE-250, a lot depends on whether a company has a rating. With interest rates still comparatively low, debt is a cheaper route of financing than the equity market. “If a corporate has a market cap of more than £1bn, there’s a reasonable chance it would have accessed the bond markets,” he says. “If this is the case, there’s also a good chance the company would have got a rating and the natural inclination will be to safeguard it. The deterioration of credit ratios that often comes from aggressive acquisition financing can be a factor in working out how much debt a company is prepared to take on.” Lacey-Solymar notes a higher level of sophistication in UK boardrooms today regarding the impact of a rating downgrade on bondholders and on the stockmarket perception of a company. “That can feed into the equity market,” he says. “One of the bits of analysis that we start with is the impact on ratings. If it’s going to risk a downgrade, it can be a significant impediment for a board to see it through. So more often than not you’re talking about a mix of debt and equity that allows you to optimise the cocktail. Therefore, a corporate compromises nicely between avoiding a rating downgrade and avoiding dilution by issuing more equity than is needed.”

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