The IPO Market Is Dead and Acquirers Are Getting Harder to Find, Leaving Some Private Company Founders and Investors With No Way Out
Some take longer than others, but bubbles eventually burst. And when over-inflated asset values correct sharply, innocent bystanders also can be hurt.
The crash in the technology-laced Nasdaq is no different. Among the victims this time are private companies in Orange County and the rest of the U.S. that are looking for an exit strategy or for funds for expansion.
“The public market has dried up, and that has had a ripple effect on the private companies,” said Stephen Fillet, executive director in the investment banking department of CIBC World Markets.
“Last year was rocky for many small technology (and other private companies) looking to raise funds,” said David Barnes, director in the M & A; group of Los Angeles-based Houlihan Lokey Howard & Zukin.
Most private companies or funds that are looking for an exit strategy either have to approach the public market with an initial public offering or be acquired by larger companies. But with a 39% fall in the Nasdaq last year and a further decline in stock prices this year, private companies that want to raise funds have hit a speed bump.
The IPO market dried up early last year as the slide in the stock markets began, and the M & A; route has since closed for many money-losing private companies. Venture funding is also more or less out, as venture funds are struggling with their portfolios of under-performing technology companies and are less active in funding start-ups and new projects. Thus, companies that are still losing money but need second or third round of funding have really nowhere to go.
“Certainly the IPO market was dead last year,” said Michael Morris, CEO of GMA Partners Inc. He said that the decline in public markets also affected M & A; activity and more difficult for founders to realize the value of their companies through acquisition.
Barnes said that this year the M & A; route for most companies could continue to be a difficult exit strategy,especially for firms that don’t have positive cash flows.
Investment bankers are talking nostalgically about 1999, when the value of M & As; hit a record in the U.S. In 2000, the M & A; activity on a nationwide basis declined for the first time in nine years. The total value of M & A; deals declined by 7% to $1.325 trillion, according to data complied by Los Angeles-based Mergerstat. In 1999, the value of M & A; deals rose 19% to $1.425 trillion.
M & A; increasingly had become a popular exit strategy and a way to consolidate businesses in corporate America. In 1982, there were 2,346 M & A; deals valued at $54 billion. In 18 years, the number of deals went up four times and the value of transactions was up 24 times.
When the stock markets started sliding in April last year, investment banks and securities firms at first were unperturbed. They said that if private companies could not tap public markets, they would look at mergers and acquisitions. But the M & A; route hasn’t panned out very well, either.
There are several reasons for the decline in M & A.; One of the main causes is the fall in stock prices. Share prices of many technology companies have fallen by 50% or more from the highs they reached early last year. This has reduced the attractiveness of corporate equity as a currency with which to pay for acquisitions.
“The currency of acquiring companies has been debased with the decline in the stock markets,” said Bill Gay, an M & A; attorney with the Irvine office of Snell & Wilmer.
Terrance McGovern, managing director of the investment banking group at Newport Beach-based Roth Capital Partners Inc., agrees.
“The acquisition abilities of companies that used their high stock prices has been hampered,” he said.
Also, the market declines have made acquirers less willing to pay lofty valuations for buyout targets. Thus, a fall in stock prices is having a cascade effect on the valuations of private companies.
“Valuations are coming down a lot,” said Fillet, who covers the Internet infrastructure at CIBC. Meanwhile, with the U.S. economy coming to a grinding halt and companies missing their earnings targets, merging or acquiring a money-losing company is the last thing the management group of a public company would want to do.
Barnes said that the decline in M & A; dollar volume and average deal size has come down mainly because of the decline in valuations.
According to Mergerstat, the average price of a company that was acquired in 2000 was 11.2 times its earnings before interest and tax, or EBITA, down from 12.4 times in 1999.
Especially sharp declines in valuations took place in dot-com companies as most of the business models failed to make money.
“They don’t have anything to sell,” Barnes said. “No product and no cash flows.”
He added that in 2001 it is going to be even harder for many Internet companies to raise money through an IPO or find an exit strategy through M & A.;
Fillet agreed that companies are becoming more selective in deciding whom to acquire.
“Only if it makes a strategic fit will companies consider acquisition or a merger,” he said. “We approach a mid-size company and see if it can become an 800-pound gorilla through an acquisition or merger with another company.”
“People are still acquiring to support a strength or complement a weakness,” said Ronald Speyer, founder and president of Costa Mesa-based Emerge Corp., an online M & A; service provider and consultant. “But it’s highly strategic.”
That said, the number of M & A; deals inched up last year on a nationwide basis. Last year, companies were involved in 9,556 M & A; transactions, up 3.1% from 1999 level. Orange County companies were involved in 353 M & A; transactions, up almost 15% from the 1999 total.
“Purchase-price expectations are down, but the number of deals is still at an all time high,” Barnes said. “That is a positive, good sign.”
And acquirers, especially acquirers that prepared for the market downturn, are finding other ways to make deals than the simple stock swap, said Speyer.
“It’s gone from a two-layer cake to a 10-layer cake,” he said, with features like consulting agreements with management and other non-cash considerations being thrown into the usual cash-and-stocks mix.
Some acquirers also are tapping lines of credit and cash reserves put in place before the downturn, he said.
Another acquisition strategy for a bear market is the earn-out. That is when a buyer acquires, say, 80% of a company immediately, with an agreement to buy the remaining 20% in a few years when presumably the valuation will be much higher and the founders can then realize their return.
“There’s still a tremendous amount of cash in the marketplace,” Speyer said. “What’s changing is how it’s employed,not as much in equity, more in the structural components of the deal.”
Moreover, leveraged buyout, or LBO, firms have raised more than $60 billion in 2000. LBO firms invest in private companies with the goal of taking them public or merging with other companies.
“On a very conservative basis, that would mean additional deal capacity of $150 billion in the market,” said Barnes.
LBO firms tend to leverage themselves three to four times to get higher returns on their investments.
Surely, with the IPO market almost dried up for private companies, LBO funds raising more than $60 billion and the need to consolidate in a global environment, M & A; activity is likely to remain healthy this year. But if the public markets continue to slide, then 2001 could see a further drop in deal volumes.
“I am sure that 2001 will be lower,” said Roth’s McGovern. “Deals can get done, but the pricing can come down somewhat,from six to seven times cash flow to five times.”
Also, for money-losing private companies, there seems to be no bailout coming,either turn around quickly or file for bankruptcy.
“In order for a company to receive new funding right now, it needs enough cash in the bank to at least break even,” said Fillet. “Without a turn in the market, the chances of money-losing companies going out of business are more than what they were a year back.”
McGovern put it succinctly: “The strong players will get stronger and the weak will get weaker.”
But despite the economic downturn, OC companies will remain attractive to potential buyers, said Speyer.
“Orange County has been and continues to be a four-star location for acquirers,” he said. “The talent pool, access to world markets and overall pro-entrepreneurial atmosphere are still here.” n
