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M&A: Pursuit you, sir

Merger mania is back with a vengeance. After languishing in
the wilderness for several years, corporates have rediscovered their appetite
for acquisition activity and 2006 looks set to be one of the busiest years for a
long time. Companies have spent the past few years repairing their balance
sheets and are now running their slide rules over potential acquisition targets
as the most logical way to fuel growth.

Funding is not going to be an obstacle to the M&A jamboree. On a global
scale, last year saw a record $5 trillion (£2.8 trillion) in corporate
fund-raising, an 18% increase over 2004, according to market research firm
Dealogic. Loans were the funding vehicle of choice as corporate debt volume
accounted for 34% of the combined total, though that was the lowest percentage
share in the past five years. Leveraged and high-yield corporate fund raising
amounted to 23% of total funding, a 22% increase. Given current interest rates
and the amount of acquisition capital from banks, private equity firms and hedge
funds, it looks like the trend is likely to continue along the same lines in

“The M&A market looks stronger than it has looked for the past five years
at this time of year and this is being fuelled by two things,” says Oliver
Ellingham, head of corporate finance Europe at French investment bank BNP
Paribas. “On the one hand, there is low growth in Europe and, because investors
are looking for higher returns on their investment, companies are turning to M
&A to secure growth. Corporates have been tidying up their balance sheets
and undertaking cost-cutting programmes for the past three or four years.
Therefore, if they are going to find growth, they’ve got to look to external
sources. Also, the ability for corporates to undertake strategic deals is
certainly there because there are sizeable synergies for the right
industrially-driven deals.”

Taking on debt

According to Ellingham, the two sources of finance for that M&A drive are
the bank market and the equity market. The lenders say there is a large supply
of bank debt available for the right deals at what look to be attractive rates
for the borrower, while the equity market says that equity can be issued, either
by way of a rights issue, or by the sellers taking paper for the right
industrial deal. Therefore, financing for the right transactions is unlikely to
be a constraint in 2006.

“The driving decision for most corporates is to take on as much debt as
possible,” he says. “Only when the limit of what the debt markets will provide
for transactions is reached, do corporates tend to look at issuing equity.
Clearly it is easier to create value with bank debt, given the current level of
interest rates. On the whole, the utilities sector will be active on a European
basis, and some of that will flow into the UK. We’ll see more in telecoms and
media and at the smaller end of the financial services space, there will be
transactions in the support services sector.”

Where corporates need to tread cautiously is in their ratings profile. The
increase of M&A and private equity deals threatens to undermine credit
quality among companies during the next 12 months. Credit rating downgrades are
expected to increase among industrial companies from the low levels of the past
two years, and they are likely to significantly outstrip rating upgrades.
Standard & Poor’s issued 142 downgrades against 116 upgrades in the year to
last November.

“The biggest risk for creditors is the continuing abundance of liquidity from
private equity firms and hedge funds, which we expect to persist into 2006,
given recent heavy fund-raising by buyout investors,” says S&P credit
analyst Blaise Ganguin. “Debt leverage in buyouts has reached record levels,
surpassing the peaks of the 1990s and suggesting bubble-like conditions in this
market. Additionally, covenant structures, which should provide creditors with
increased security, have weakened.”

This cautious note is echoed by Fitch Ratings, the UK-based rating agency.
Trevor Pitman, the company’s group managing director, says that financial
leveraging up by corporates is putting downward pressure on ratings. The agency
put Spain’s giant telecom group Telef-nica on negative watch when it announced
its acquisition of the UK’s O2. “Ratings will come down a bit because of M&
A activity,” says Pitman. “Telef-nica is a good example. It is talking 4 about
placing e4bn to e5bn worth of bonds to term out its bank financing and
re-finance the bank debt it has taken on to acquire O2.”

Corporate activity has picked up in the telecom sector, with a number of high
profile deals in the UK and abroad. Pitman says he expects to see more of this
in the coming months.

“In the past three or four years we’ve seen a lot of balance sheet
strengthening occurring among corporates worldwide and the UK has not been an
exception,” he says. “As these balance sheets and cash flows strengthen,
companies start to think about their next moves and M&A activity is a very
natural course for them to consider. The bank loan market has been incredibly
liquid in 2004 and 2005 and levels are still very high. A lot of this financing
is initially done in the bank market and this is creating a lot of competition.
There has also been talk of these deals being done in the capital markets and
re-financed in the bank market, and that looks to be very much the pattern.”

Hybrid approach

Whether companies feel they need access to the equity market is more
debatable. With stronger balance sheets they may feel that pure re-leveraging is
the correct thing to do rather than supplement it with equity finance.

Another factor to bear in mind is hybrid capital. The summer of 2005 saw a
small flurry of companies effectively issuing subordinated debt instruments.
This is a possible route for companies to consider when exploring ways to
re-finance their acquisition debt, particularly as it tends to help keep out of
the rating agencies’ bad books. The advantage of hybrid capital is that it gives
equity credit with the rating agencies and can help preserve the financial
ratios of a company. It can also be a relatively cheap way of raising capital
for the company.

The amount of credit corporates get with hybrid capital will depend on each
rating agency’s methodology and criteria for that instrument. No UK company has
issued hybrid capital recently outside the banking community, but market sources
say that several companies are now considering this route as a way of avoiding
having to go to the equity market.

Another factor to consider when raising acquisition funding is the pension
deficit issue. This is a well-publicised issue for UK companies and M&A
activity and returns of capital to shareholders is something Britain’s new
pensions regulator has to sign off. In recent weeks, about 150 companies
approached the regulator to make sure it would approve their transactions and
that the pension creditor of the company is not being disadvantaged by any plans
for M&A or returns of capital to shareholders.

The UK financial services community is set to attract predators this year,
according to M&A advisors. There is growing interest by the private equity
community in this sector, which remains highly fragmented in areas like asset
management and insurance broking. “Private equity firms are getting more
comfortable with what they’re prepared to do in financial services, as seen by
recent large transactions such as Saga and Travelex,” says Charlie Alexander,
director of transaction advisory services at Ernst & Young. “Historically,
private equity wouldn’t go near life insurance run-off businesses, for
regulatory risk and complexity reasons, but last year a number of these firms
looked at that sector. There is still a big wall of money to be spent by the
private equity and hedge fund players and, as a result, the community will look
at more complex deals if an appropriate return can be made.”

In addition, the large investment banks are starting to look actively at
sub-prime mortgage businesses, which, at first glance, may seem surprising.
However, it is their securitisation desks that are driving the flow and
financing of these types of businesses. The attraction for them is the fee
generating work that they can earn from the end securitisation products. Due to
their higher risk, the sub-prime mortgage loans result in a lower bond rating,
often as low as BB.

At the same time, the hedge funds, with their large appetite for alpha
returns, are purchasing this paper as a more attractive substitute for the less
risky/lower return AAA tranches held by banks and insurance companies. “The
investment banks may have started acquiring distribution platforms in sub-prime
mortgages, but we can see them potentially spreading into other areas like
vehicle financing or other sorts of traditional asset-based businesses, taking
advantage of cheaper securitisation funding,” says Alexander.

Banking on investment

The banks are still in the corporate lending game and will continue to rely
on SME business for funding. The good news for borrowers, of course, is that the
fierce level of competition is making this increasingly a buyer’s market.

Companies need a sensible mix of gearing, with the recognition that the
equity markets are fairly active. If a corporate has a good enough story to
tell, the equity markets will be there to help with regard to placing shares.
Any profitable, established business with high-quality cash flows will look at
the gearing route from an earnings-per-share perspective. But investors want to
see a balance. “If they feel that debt is in control of the business, this will
have a ramification on equity funding,” says Luke Ahern, director at broker
Corporate Synergy.

“The Highbury House story was a classic illustration of where debt was in
control of the company and brought it down.” Debt-laden magazine publisher
Highbury House went under when its CEO and former Sun editor Kelvin MacKenzie
admitted he was “defeated” by debts of £29.5m. “As an FD you are playing with a
very high risk-reward game if you are trying to tell the banks that they’re
wrong,” says Ahern.

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