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Strategics strike back

The return of strategic buyers in the US is giving a long-awaited boost to exit opportunities for private equity firms. Conditions for exiting appear particularly compelling for smaller portfolio companies.William Kan, CFA and Georgiana Fung, strategists with Merrill Lynch Small Cap Research, dissect the changes that newly acquisitive corporations have brought to the US private equity landscape

Strategic buyers are returning to the playing field after being on the sidelines for the last few years. Recent announcements of mergers and acquisitions are the clearest signal of corporations' willingness to look outward and to have the conviction for striking deals once again. Strategic acquirers have added incentive in that stock investors have affirmed this uptick in M&A activity by rewarding the stock prices of participants.

The most notable changes that the return of the strategic buyers will bring to private equity will be increasing exit opportunities and added competition for assets.

Conditions for the return of strategic buyers have been improving for some time and should continue to improve barring some unforeseeable disruption. They include the rebound in the equity market, low interest rates, the collapse in credit spreads, the surge in bond issuance and the broadening in the types of companies that have been able to raise funds. In addition, strategic players now appear to be in the position of doing something other than devoting their efforts to addressing systemic concerns regarding accounting, financial transparency, the health of their balance sheets, risk of default, corporate governance, terrorism, war and economic uncertainty. Transactions that they did do may have been divestitures related to a write-off as opposed to acquisitions. The list goes on, but the clouds that lingered over them were dark indeed.

We draw linkages between the public and private equity markets by leveraging our work on smaller cap equities, which share more traits with private equity investments than do large cap stocks. Furthermore, we believe conditions in the public market can help gauge private equity exits and investment opportunities.

BUY UP, STOCK UP
In the dark days of 2002, we wrote a report on private equity entitled “A Time to Invest, if Not to Harvest.” Today's more promising environment and the return of strategic buyers have altered the landscape for private equity. Harvesting or exit opportunities, in particular, are starting to ripen. Until recently, exits were difficult. They were dominated by portfolio swapping – transactions to exit done within the private equity community – while trade sales to strategic buyers were modest and the IPO market remained moribund.

Stock investors have been giving strategic buyers a strong vote of confidence. Both smaller and larger buyers with M&A announcements in the fourth quarter of 2003 on average outperformed their respective size benchmarks subsequent to the announcements. Furthermore, smaller strategic buyers have been generating larger excess returns than their larger counterparts after investors have had a few days to digest the news.

Smaller cap buyers outperformed the Russell 2000 by more than 0.4 percent in the five days after an acquisition announcement in the fourth quarter (see chart, opposite page). In contrast, large cap companies outperformed the S&P 500 by 0.2 percent during the five-day period. If this relationship holds, the environment may be more conducive for exits via a trade sale to smaller, middlemarket strategic buyers.

THE VALUE OF SMALL ASSETS
Even before it became clear that strategic buyers were back, valuation multiples were already rebounding. The addition of strategic buyers should support exit opportunities and may further enhance the clearing multiple of companies being exited.

Multiple expansion may be particularly significant for smaller assets that were acquired by the private equity community during the years of neglect in the late 1990s. Beginning in 1999, investors started to pay more attention to smaller cap stocks. These have been outperforming their larger cap counterparts for almost five years now. Their valuation multiples have expanded, and they have narrowed their valuation gap with large caps.

As smaller stocks have outperformed, it has been the smallest companies, those in the MLSCR US Micro Cap Composite (companies currently with equity market capitalisation between $70 million and $370 million), that have garnered the most improvement. Their book value multiple has expanded from a low of 0.3x in 2000 to 0.7x book value currently. Chart 2 illustrates that they sell at a relative multiple of 0.22x, which translates into a 78 percent discount to the price-to-book value of Large Caps. This compares to a 92 percent discount in 2000. The multiple expansion points to healthy returns for private equity funds that hold these types of assets while potential strategic buyers may find the valuation discount attractive.

Better capital market conditions have also broadened exit opportunities. According to figures from Merrill Lynch High Yield Strategy, the amount of high yield paper issued in 2003 that was related to M&A totaled $25 billion, almost the total of the amount in 2001 and 2002 combined.

In recent months, the calendar for IPOs and secondary offerings has picked up. Strategic buyers ranging from General Electric to Pioneer Drilling have tapped the market for funding for their recent acquisitions. Despite these improvements, not all cylinders of the funding machine appear to be running at full force yet. The Federal Reserve's figures suggest that bank lending is another potential source of funds that would support the acquisition plans of strategic buyers.

COMPETITION STIFFENS
The opportunities for private equity that come with the return of strategic buyers come with costs. Compared with 2002, the return of strategic buyers will bring competition to general partners that was not there for a few years. It was not long ago that private equity seemed to have an exclusive on deal flow. This offered firms the luxury of time to conduct due diligence for a potential target company in a period when valuation multiples of companies were contracting. Going forward, we suspect the added competition from strategic buyers will squeeze the time available for due diligence. Bidding will heat up, and the availability of financing will likely add fuel to the fire thereby contributing to higher multiples.

Although the current environment supports the return of strategic buyers, it is premature to say that they are well entrenched or that they are already crowding out private equity from investment opportunities. The steep valuation discounts between smaller companies and large cap companies that persist suggest that valuations are still compelling. Rather than competing for investments in these companies, strategic and financial buyers may also partner together in striking deals. This is not an uncommon practice for private equity in transactions involving energy and media assets.

Given added competition, more private equity players may look overseas. Our review of the global equity market indicates that investors may have more success identifying potential M&A candidates in the Asia-Pacific region than in Europe or the US. Using smaller cap public companies selling at or below 4x EV/EBITDA as a gauge, we estimate that the percentage of Asia-Pacific companies below that threshold has risen to 15 percent, which is substantially above its long-term average. Opportunities appear less abundant throughout Europe, which is near its long-term average of 14 percent. At 3 percent, these opportunities appear even less abundant in the US. However, more foreign-based buyers may explore assets in the US to take advantage of the depreciation of the US dollar.

William Kan, CFA, is Director and Strategist and Georigana Fung, Strategist with Merrill Lynch Small Cap Research. A version of this report was previously released by Merrill Lynch in its March 2004 Private Equity Insights report. Kan may be reached at bill_kan@ml.com.