Published by Reuters
New laws and regulations aimed at stemming the tide of corporate fraud will have a lasting impact on mergers and acquisitions. And while the short-term impact is slowing the already glacial pace of merger activity, in the long run, the new rules will help deals get done, experts say.
In late July, President George W. Bush signed the Sarbanes-Oxley act into law. Called the most sweeping reform of U.S. securities laws since the 1930s, Sarbanes-Oxley is part of an all-fronts effort to restore faith in corporate leaders. The SEC has passed rules creating a new accounting oversight board and is beefing up its enforcement efforts.
And there is still more to come: the National Association of Securities Dealers (NASD) is considering new measures, SEC is currently considering new rules to oversee lawyers involved in securities work, and the Financial Accounting Standards Board (FASB) may also review some of its rules.
Distracted by new rules that require executives to sign off on their companies’ financial statements and facing stiffer jail terms for false statements, an extremely volatile stock market and suspicious investors, few companies have had the time – or the attention – to devote to buying or selling companies. Deal volume is now generally not expected to show any significant improvement until next year.
But there is a silver lining amid the storm of scandals and restatements. Ben Boissevain, Managing Partner at middle-market investment bank Agile Equity, believes the new rules will be beneficial. “It will help increase corporate confidence, which I think is critical,” he said. “M&A is a function of corporate confidence.” After all, if you’re uncertain of the numbers, how can you do a deal?
While all the attention has been focused on large deals involving public companies on both sides of the table, some 90 percent of all deals that are getting done involve private companies. The median deal size recently has been around $25 million, notes Dan Donoghue, managing director of middle-market M&A for USBancorp Piper-Jaffray [NYSE:USB]. In the current environment, only the best quality deals are getting done, he said.
Do private companies need more regulatory oversight? Donoghue doesn’t think so. After all, the SEC’s role is to make sure the investing public gets a fair shake from large, faceless corporations where they have little or no influence. In a privately held company, the largest shareholders also operate the company.
Longer Deal Cycles
The new rules clearly mean it’s going to take longer to get deals done. There is almost unanimous agreement among the advisers we’ve talked to in recent months that buyers – and in some cases sellers, too – are taking a closer look, spending more time on due diligence.
“Any CEO who is going to personally certify the financial statements, you can bet he’s going to increase the amount of resources that are dedicated to the preparation and the verification of those statements,” Donoghue believes. “I’m sure the accounting costs are increasing substantially.”
“There’s more seller due diligence when it’s a private seller – public company transaction,” Boissevain said. “Typically before, you looked at the SEC documents, you looked at the financials they reported, and that was pretty much the extent of the due diligence. Now, the sellers, even if they are private, are requesting more on the due diligence side, a little more coverage in the ‘reps and warranties,’ and this makes sense.”
Private sellers are especially wary of any deal that involves public company stock as part of the purchase price, Boissevain said. “More deals are being done with shares in proportion to cash — you’re not going to get 100 percent cash these days. The value of those shares is critical. And given the volatility in the tech sector, you don’t want to sell to a potential future Worldcom and then see the value of your shares decrease to zero.”
“They’ll still do the deals, it’s not going to stop them from happening,” Donoghue said. “But it’s definitely going to cause the process to be slower and be more expensive.”
As sometimes happens when new laws are rushed through the process, there are some unintended consequences. The experts we talked to see at least two such cases. Cross-border deals have accounted for slightly more than half of all transactions involving U.S. companies over the past year or so. So it’s no small matter when foreign buyers or sellers are worried about the new laws. In particular, multinational firms with stock market listings in more than one country are concerned about how the rules might affect them.
Will prosecutors go after executives of companies based outside the U.S. in their zeal to halt fraud? The head of Germany’s industrial federation, the British trade minister and at least one European Union trade official have all expressed their concerns to U.S. regulators. The German official has voiced concerns that attempts to impose the rules on dual-listed firms would have to be challenged in court, according to The Financial Times. Some 24 German companies have dual stock listings there and on the NYSE.
“We constantly encounter the negative perception that our clients have regarding the U.S. judicial system and the potential legal liabilities associated with doing business here,” said Robert Gibbons, president of Kaupthing New York, an Icelandic investment bank with corporate clients throughout Scandinavia. The bank takes pains to advise its clients about the risks of doing business here, often engaging advisors to quantify the legal risks. Once they are fully informed, “We have been able to minimize any disruption to the business,” he said.
The increased regulatory burden – and the costs that go with it – could be the final straw for many small public companies, Donoghue believes. He thinks one impact of the new regulations could spark a number of deals as some companies decide they’re better off in private hands or as units of much larger public entities.
Mid-size public firms – those with annual revenues below $250 million or so – that are not involved in the “hot” industries that investors are drawn to, see few benefits and lots of added costs associated with being public, Donoghue said. They find it difficult to attract analyst coverage, and thus get little attention from big institutional investors, so their stock prices suffer. Many of these firms “are pretty well run, but they just are too small to be a public company in a world where being public carries such high regulatory and corporate governance burdens.” A decade ago, the target size for a company to go public was $100 million, Donoghue said. Today, the figure is closer to $700 million.
With all of that comes the added costs of finding and keeping independent directors. Not only has the cost of liability insurance for directors skyrocketed, but board members are increasingly targeted in shareholder lawsuits. “I think we’re starting to see more trepidation on the part of directors about serving on these boards,” Donoghue said. “It isn’t all that financially lucrative to serve on the board of a small-cap public company. So attracting directors is probably going to mean increasing the financial incentives” they receive.
“The small public companies are going to realize that the costs of being public are too high, and I think we’re going to see a lot of consolidation of public companies,” he said.
On the private side, Boissevain sees venture capitalists thinking twice about the number of seats they hold on the boards of portfolio companies. With the added costs, and the perception that VC firms have deep pockets making them attractive targets for litigation, “There are cases where board members have resigned because of the increased liability exposure,” he said, and there could be a negative impact on mergers when that happens. “VCs on the board have portfolio companies typically in the same space, and deals get done by a VC calling on portfolio companies as well as other VCs. So if there are less VCs at the board level, that will certainly affect M&A.”
Ultimately, the experts say, the new rules will have a positive impact on M&A volume. Financial statements personally guaranteed by CEOs – some of whom are, in turn, requiring department heads to sign off on their numbers – should increase confidence in the validity of a buyer or seller’s numbers. “They have to make sure that their house is in order, that it’s clean, that their financials are signed off on, that there’s no undue exposure.”
There may be some pent-up demand for acquisitions as companies have focused on their internal issues over the past year or so, Boissevain said. Eventually, they’ll be looking for ways to speed up growth and get ahead of the competition.
The investment banker sees the volume of technology deals increasing in the months ahead. While large corporations have been focused on their accounting woes, the pace of technological innovation and R&D has continued at small firms. Boissevain predicts the cycle is about to come around again. Companies that have cut back on technology expenditures over the past couple of years will find they don’t have time to catch up by building those new technologies, so they’ll acquire the companies that already have them, he said.
And Donoghue sees more strategic takeovers as small companies decide it isn’t worth it to go it alone as a public company. “Public-to-private sounds interesting, but it usually requires such a high level of debt financing and offers shareholders such a low premium that most small and middle-market companies end up finding better transactions and end up selling to larger strategic acquirers,” he said.
For the foreseeable future, strategic divestitures of noncore businesses and acquisitions of companies that complement core strategies will be fertile ground for M&A practitioners.