M&A Environment in 2012

As investment bankers with more than 400 completed transactions, 321 Capital Partners is tasked with navigating the ever-changing waters of the mergers and acquisitions (M&A) world. Our expertise is based on an understanding of banking, buyers, sellers, general macroeconomic trends, and market knowledge, not to mention trends in bankruptcy law. The following is a real-world perspective, from the trenches, on the M&A outlook for 2012. As we lay this out, we are going to call on colleagues for insights in their respective fields, i.e., bankers, owners, buyers, and yes...lawyers.

Market

Uncertainty—though not at the same levels as the last few years—still rules the day. According to The Grant Thornton International Business Report, a Q3 2011 survey indicated the United States is suffering from a Business Optimism outlook of 8 percent. Essentially, this means that more business owners in the United States were pessimistic than optimistic in their outlook for the next 12 months. We anticipate that this lack of confidence in the U.S. will lead to increased M&A activity as U.S.-based firms reach into non-U.S. markets for market share and growth not available in a sluggish domestic market.

Emerging giants Brazil, Russia, India, and China (the BRIC countries) had Business Optimism Outlooks of 25 percent in Q3 2011. Businesses in these emerging markets will look to further invest in their native markets through capital improvements and potential acquisitions or mergers with technology leaders in more developed markets. The fact that the International Monetary Fund (IMF) projects mature markets to grow at 1.9 percent while emerging markets will grow at a 6.1 percent pace furthers our opinion that 2012 will bring a number of acquisitions or mergers aimed at capitalizing on the opportunities in emerging markets and the technology and intellectual property available in the developed markets.

Anticipate increased M&A activity as European companies, hit by the economic woes of Greece, Italy, Portugal, and Ireland, divest their non-cash-producing business lines. Cash rich companies will pursue strategic investments in businesses poised to capitalize on the emerging markets or opportunities to acquire American-based assets at discounted values.

Buyers

Businesses looking for growth will continue their push to increase sales outside the borders of the United States, as domestic growth remains anemic at best. GDP growth in the U.S. is projected at 2.7 percent for 2012, signaling that companies will most likely not attain substantial organic growth if their sales base resides solely in the United States. The recent announcement from the Federal Reserve on plans to keep the Fed window at or about zero percent until 2014 illustrates that the march back to prosperity will continue to be a slow walk. While improvements in key indicators show continued progress in the manufacturing sector, ongoing high unemployment and suppressed wages will translate into another year of lax domestic consumption. This is evidenced by the fact that we are producing as much as we did in pre-recession 2007 with six million fewer workers.

A strong Canadian dollar means our neighbors to the north will continue to look to the U.S. for opportunistic plays, while American companies look to the north for increased sales penetration. International firms will look to further expand into the U.S. market with opportunities to purchase middle-market companies that are weary from the last three and a half years of an ailing economy. Distressed business opportunities abound, and expect powerhouses such as Inteplast and AEP to continue to make moves. Acquisitions will continue from Brazil, India, China, and Russia as companies from these areas look to acquire technology and intellectual property necessary to fuel their bustling economies, as well as gain a foothold in America.

Private equity funds will continue to make strategic acquisitions, expanding the platforms they have been building over the last several years in a down economy. Matt Zakaras, COO and general counsel at Chicago-based Echelon Capital, a boutique private equity firm with a focus on distressed manufacturing stated, "We, like everyone else, are continuing to pursue undervalued businesses with proprietary products and strong brands. Our focus is on manufacturing businesses and we anticipate opportunities in the distressed space, especially if there are large swings in commodities prices. We are also finding distress with businesses that sell into the European market where the unresolved debt crisis has created paralysis. With respect to U.S. manufacturing opportunities, we are seeing a trend away from outsourcing to Asia as the increased labor costs in some circumstances have decreased Asia's competitive advantage."

A good example of a strategic acquisition can be found in the sale of Charlotte, N.C.-based Pinnacle Films, Inc., a $50 million per year producer of stretch wrap films. 321 Capital Partners led the bankruptcy auction in which five industry leaders attended a spirited auction that saw 28 rounds of bidding before a successful acquirer was crowned. Why did industry giants chase a bankrupt manufacturer of a commodity such as stretch wrap so vehemently? The answer is simple: scale and market share.

In every market, but especially the packaging and package-printing markets, the need for scale is essential to survival. With hordes of cash not being deployed for the benefit of organic growth or capacity expansion, industry players recognize the need to increase revenues through acquisition, and decrease operating cost through increased scale.

We expect 2012 to continue with this theme as the "big guys" get bigger and the smaller players continue to be folded-in or run over. Ailing middle-market companies not willing to seek refuge in a strategic partnership will continue to experience margin pressure as larger competitors increase scale and bolster market share through acquisition.

Sellers

Sellers will be motivated by several key factors when contemplating a sale or strategic alliance in 2012—outside pressures from competitors or creditors, lack of accessible capital, the search for scale in a margin-sensitive industry, or an exit strategy from the business.

Competition is going to increase until the attrition of competitive businesses creates a balance between demand and capacity. Much the same way the over-saturated housing market has kept new housing starts low (or more appropriately, in-line with real demand) excess capacity in the market will keep margins razor thin in all segments, with the exception of products with truly unique or patent-protected qualities.

We do not anticipate this "thinning of the herd" will be completed or close to completion in 2012. Thus competition will slowly continue to push the weaker players towards sale or strategic alliance. To owners and managers occupying this segment of motivated sellers, we offer the following advice: be the first ones to the beach. We expect diminishing valuations for the late adopters, while early adopters may reap the rewards, becoming platforms for industrial focused private equity firms or the crown jewel in a strategic expansion.

The national census bureau states that 49 million Americans will be 65 or older in 2012. Look for the baby boomers to continue to plan their exit strategies that were put on hold. Those that were ready to leave in 2008, but forced back into the fire by the financial collapse may look to exit in 2012, as the market is perceived to be on somewhat of an upswing.

Unfortunately many of these owners are going to find values below their lofty expectations. Even owners that are offered the values they desire will find deal structures requiring involvement beyond their expectations. Often time multi-year consulting or employment will be required of the selling party. Coupled with potential ties to the real estate in the form of landlord or seller held note, expect to see sellers engaged for years to come, not simply cashing out and hitting the beach for their golden years.

Lending environment

Those companies expecting lending to loosen significantly in 2012 will be in for another rough year. The well-known advertising campaign for Dunkin Donuts, "America runs on Dunkin," should be more aptly repurposed to "America runs on credit". Credit has and continues to be the lifeblood of the U.S. economy. However, falling commercial real estate values will persist in 2012, driving a continued weakness in banking balance sheets. According to The Society of Industrial and Office Realtors (SIOR), industrial vacancy rates are projected to remain in the 11.7 to 12.3 percent range for 2012. This balance-sheet weakness will prevent many institutions from lending at the volume necessary to truly spur the economy.

While some liquidity is re-entering the market, it will most likely be redirected at those that are less needing and better collateralized. The tightness in the lending market will cut both ways, as buyers will also have less access to acquisition funds. Those that have stockpiles of cash will continue to deploy capital, with continued care. This will create the necessity for more creative, structured deals, as acquirers either are not able or willing to finance large up-front costs. Instead, acquirers will require future operations to finance the transaction, with the previous owners tied to operational performance well after the close of the transaction.

Owners that have comfortably existed in default for 2011 may be surprised to find a renewed vigor from their banks' workout departments in 2012. Institutions that have been diligent in moving bad loans through note sales or aggressive workout departments may be in a better position to force the issue, calling defaulted notes, thus spurring some increased sell-side activity. While stronger banks may not be welcomed by managers of struggling companies, stronger banks tend to promote a healthier economy in the long run by lending when appropriate, and thinning the herd through swift exercise of their rights and remedies.

Legal

We anticipate that 2012 will see more bankruptcy filings as strengthened banks and creditors begin to force the issue. Chapter 11 bankruptcy filings were down 15.9 percent in 2011 when compared to 2010 and down 24.1 percent when compared to 2009. This may seem counterintuitive given the recent economic malaise. Keep in mind bankruptcy is at its definition, protection sought from creditors. If the creditors themselves are unstable, they are less able to make aggressive moves thus driving sale-side activity. Business in the United States has not improved enough to account for the drastic reduction in business bankruptcy filings over the last two years. Expect the stronger banking institutions to aggressively pursue the remedies that they have forgone over the last two years, thus driving more bankruptcy sale/purchase opportunities in 2012.

As pricing pressures continue, the need for protected technology and sustainable margins will continue to be imperative for survival. S. Jason Teele, Bankruptcy counsel for Lowenstein Sandler furthered this point with his prediction for 2012. "Patents promise to be a significant issue on the M&A front over the next 18 months, particularly in the context of asset sales in chapter 11. Given the behavior of so-called "patent trolls"—companies that acquire large portfolios of patents to obtain settlements from other companies that allegedly are infringing those patents—many companies have been forced to defensively "troll" and acquire patent portfolios in order to protect their business/manufacturing processes. As a result of the spending associated with defensive patent acquisition many companies find themselves strapped for cash and in need of financial restructuring. In the case of Nortel, the company's enormous patent portfolio generated substantial interest by several bidders, including giants such as Google and Apple, who were anxious to acquire the patents also for primarily defensive reasons. Similar interest could be generated if Kodak's patent portfolio is placed for sale in that company's pending bankruptcy case. Although Nortel and Kodak exemplify patent trolling on a grand scale, the practice is prevalent in companies of all sizes across a wide variety of industries."

In summary

All of the insights and projections that we present are simply that—an educated guess on what 2012 will bring. The good news is that an informed business person is best equipped to make the decisions that will help the company succeed in an ever-changing landscape.

To prosper or survive 2012 you could be faced with being a buyer or a seller. Without fail, the most common mistake owners make is trying to control the sale of their company without professional help. Buyers want a buffer between themselves and the seller to negotiate sensitive points. Owners need qualified professionals who have weathered the storm in the past. If you see a sale or acquisition in your future, seek out an experienced professional to help guide you home.

About 321 Capital—Three Twenty-One Capital Partners, LLC is an international investment banking and advisory firm with over 30 years of M&A and advisory experience. pP