Financing M&A

Merger-and-acquisition (M&A) activity in any industry segment usually reflects the overall health of its economic conditions. In good times, companies have cash and confidence to pursue expansion activities and new growth markets—many times, via the M&A route. In not-so-good times, the activity slows, as companies look inward toward strengthening their existing businesses through cost reductions and efficiency improvements. During a presentation at the Flexible Packaging Association (FPA) annual meeting held in March 2008, Doug Lawson, managing director and packaging group sector head for BMO Capital Markets (www.bmocm.com), noted a change in economic conditions that would be reflected in M&A activity. At the time, he predicted that M&A activity in the packaging industry would slow in 2008 (albeit, from record levels in 2007) due to a slowdown in the overall economy and a tightening of credit markets.

What a difference a year makes! Although the signs of a recession and credit crunch were apparent early last year, few people, if any, were able to imagine the magnitude of either the recession or the credit crisis. The recession is deep, global, and of a magnitude not seen in decades. The credit market has virtually collapsed in all areas of the world and even after large infusions of governmental support by countries all over the world, credit availability is still limited.

BMO Capital Markets recently released its third annual report on packaging M&A activity, titled “Mergers and Acquisitions in the Packaging Industry: 2008 Annual Deal Review.” In this report, Lawson states, “After a record year in 2007, the M&A environment was affected by challenging market conditions in 2008. The credit crisis and a difficult economic environment combined with unprecedented spikes in resin, oil, and paperboard prices and resulted in a significant slowdown in packaging M&A activity.”

Some highlights in the report include:

• The number of global M&A transactions fell 35 percent from 2007 to a total of 252, the lowest level in 10 years.

• While North America was the second most active region worldwide, it also experienced the largest drop from 2007—close to 40 percent fewer transactions.

• The number of transactions was evenly split across packaging industry sectors: rigid (29 percent), paperboard (24 percent), and flexible (23 percent).

• Strategic acquirers led M&A transactions with 66 percent versus 34 percent for private equity firms.

What is interesting about the magnitude of these statistics is that they reflect the entire results for 2008. It began transitioning from the record levels of 2007 and went down hill (or off the cliff) from there.

The way 2008 ended is better reflected in a series of M&A reports recently released by PricewaterhouseCoopers LLP (PwC, www.pwc.com). Covering a broader industrial manufacturing sector (which PwC loosely defines as “providing the equipment found on factory floors around the world”), it reported a total of 11 transactions announced in 4Q08 versus 71 worldwide in 4Q07.

In an article titled “2008: Year in Review” in its “January 2009 Packaging Perspectives” report, Mesirow Financial (www.mesirowfinancial.com) also reported on the drop off in both second half 2008 activity and private equity funding. “Transactions [total global M&A] were also impacted by a severe tightening of the credit markets,” states the author, William J. Hornell, managing director for Mesirow Financial. “The commercial banks, investment banks, hedge funds, and high-yield markets that had fueled a spectacular run-up in leveraged buyout M&A activity collectively stopped providing capital for leveraged deals in 2008 … leveraged buyout deal volume fell an astounding 74 percent [in 2008].”

The report goes on to note the impact in the packaging sector. “While there were certainly a few notable deals—International Paper/Weyerhaeuser, Rock-Tenn/Southern Container, Sappi/M-real’s Coated Graphic Paper Business—overall volume contracted by 41 percent. In particular, there was a noticeable absence of large private-equity-led transactions in the second half of 2008.”

Going forward, Hornell says that there are still “two bright spots that remain for packaging M&A. The first is that private equity groups continued to raise large amounts of capital in 2008 … [second is that this] money will find a home, and packaging should continue to be an appealing industry to private equity investors.”

Financing the deal

Financing any business investment in today’s climate will be a much more involved process than it was in the recent past when capital was readily available. Rick Weil, director, investment banking for Mesirow Financial, outlines a number of ways acquisitions can be financed. “A large force in printing and packaging acquisitions over the last several years has been the growth in private equity firms. Private equity firms are pools of institutional capital (pension funds, insurance companies, endowments, among other sources) that invest in predominantly privately-held companies,” he says.

“Given the credit crunch of late, other forms of financing acquisitions include seller notes and earn-outs,” continues Weil. “As the name indicates, seller notes are promissory notes payable, with interest, to the seller of the company at negotiated terms. Earn-outs allow for additional consideration to be paid to a seller if earnings performance metrics are met after a transaction closes.”

According to Weil, the capital structure of an acquisition usually consists of:

• Senior debt—This is the least expensive and most secure source of financing in the capital structure. The amount of senior debt that would be available to finance a transaction is subject to meeting certain credit criteria such as interest coverage, fixed charge. and debt to EBITDA (earnings before interest, taxes, depreciation, and amortization). Senior lenders also examine the value of the acquisition’s assets.

• Mezzanine debt—This is subordinate to senior debt and is more expensive, often carrying an interest-only coupon in the mid-teens or higher. Mezzanine debt may also include equity warrants, and typically does not amortize during the term of the debt.

• Equity—This is the most expensive capital. Private equity groups typically seek 20-25+ percent internal rates of return on their capital. In today’s market, private equity firms are often required to contribute 45 percent or more of a purchase price in equity, as compared to 20-30 percent in recent years.

No matter how M&A financing is structured, in today’s climate, the rules that lenders are applying have tightened up. According to Weil, lenders are factoring more uncertainty and risk into their pricing. This has led to lenders focusing more attention on a company’s current performance and the outlook for the next year. “Historically lenders have given a lot of weight to a company’s trailing 12-month performance, but that metric, while still examined, is less critical than a company’s current performance and outlook,” observes Weil. “Lenders today are also closely examining the financial health and outlook of a company’s main customers and their respective industries.”

Kevin Hartney, senior VP of People’s Capital & Leasing Corp. (www.peoples.com), acknowledges that financing is more difficult to obtain and probably more expensive when it is offered. Although he reports that his company is doing “business as usual” in the industries it serves, this is not the case across the board. “Many banks and finance companies have curtailed or even stopped lending, while others that are still lending have raised their rates and lending standards. This makes borrowing more of a challenge, but good companies that have deserving projects to finance can still find money on a reasonable basis. It’s just harder to find,” he says.

Good candidates

In today’s environment, a company that is looking for financing must present a good case. Hartney says People’s Capital is a cash flow and collateral (value) lender that deals primarily with asset purchases. “When evaluating credit worthiness, we look at a company’s ability to generate cash flow sufficient to pay its existing debts, as well as the new debt being considered. We evaluate how they have paid their debts historically and check bank and trade references. On larger transactions, we might check receivables and payables aging. We also evaluate customer concentrations.”

In the tight lending environment that exists today, Weil says an attractive candidate for financing would have the following attributes:

• A history of growth in profitability;

• Diversified revenue streams among both customers and industries;

• A strong and experienced management team;

• Strong financial controls and reporting processes;

• A flexible cost structure and additional cost-cutting initiatives to implement if business conditions warrant them; and

• Compelling growth opportunities that don’t necessarily require inordinate amounts of capital expenditures.

Changing times

The environment for financing M&A activity has taken a significant turn. Two years ago, obtaining capital was like picking low-hanging fruit. Today, however, the fruit has withered on the vine. What is available is harder to secure and will cost more.

While the extent of the collapse of the credit markets has boggled the minds of economists everywhere, there is much being done by governments around the world to shore up the financial systems and to re-invigorate the credit markets. It is apparent, however, that it will take many months for these actions to have a meaningful positive impact.

In the meantime, well-managed companies with a compelling business model will still be able to secure financing, but it will take more work and likely cost more. pP