A Time to Mourn or a Time to Mine?
April 22 2008 by Jake Cohen Joerg Nuernberg And Anne Yang
This is a gem!” exclaimed the MD of a renowned European technology firm as he examined the sample of a perfectly formed piece of plastic lens shown to him by the chief technology officer of a Singaporean plastic injection company. “Why would your parent company want to sell the company away now that it has finally built up all these technological capabilities?” The CTO could only shrug and explain that the parent company was facing cash flow problems and had little choice but to sell its subsidiary to raise cash to pay its current bank loans.
Like the sample of the cut plastic, many “gems” can be unearthed across the world, especially in Asia and Europe, due to the current credit crisis. They are companies that have great growth potential when cut and polished and are fundamentally solid, but have been affected by the credit crunch. This presents opportunities for strategic acquirers to dig and buy the gems at a discount, especially now that the miners who had been most active in digging them out over the past four years-the private equity firms-are finding it increasingly difficult to finance their acquisitions with cheap bank loans. For example, in Europe, the valuations of private company sales to private equity has fallen by 14 percent in the third quarter of 2007 to a multiple of 15.3 times a company’s earnings. Meanwhile, the valuations of private company sales to corporates fell by just 2 percent to 13.4 times earnings. The private equity buyout premium-which pushed up the price/earnings ratio on the MSCI-600 of “median” stocks to a record high of 20 in May 2007-has vanished. The P/E ratios on the DOW 30 big stocks are much lower-because they are too big even for the large private equity firms like KKR and Carlyle.
Mining for Rubies in Europe
A decade of corporate restructuring, economic integration and international expansion in Europe has created a region with many hidden gems. The European gems are like rubies-the second hardest gemstone after diamonds-in that they have built up strong foundations over the years and are generally well-run. Europe‘s economic fundamentals are also sound. Its rate of unemployment fell to the lowest level in 25 years, which should boost domestic spending, while strong growth in emerging market economies should compensate for some of the impact on exporters of a U.S. slowdown. However, European economic growth in 2008 will be curtailed due to three primary factors: the strong euro, which will be especially painful for exporters; higher oil and borrowing costs; and the impact of inflation on consumer spending.
Powered by exports, Germany‘s gross domestic production (GDP) rose by 2.6 percent in 2007, which was one of its highest rates of growth since the start of the decade. However, the German companies are highly dependent on the U.S. economy and customers and are hit as a result of the slowdown in U.S. customer orders. U.S. consumers, instead of buying high-quality, more costly German products like Sienhauser earphones and Puma shoes will switch to less expensive substitutes like Samsung earphones and Wal-Mart brand shoes. Magazine Euro Am Sonntag predicted that more than one-third of all companies in Germany will feel the effects of the credit crunch. It also says bankruptcy filings are expected to increase as economic woes cascade down to the corporate sector. Germany‘s Chamber of Industry has been flooded with distress calls from family Mittlestand firms unable to roll over credit lines.
The restructuring of distressed companies as an alternative to a breakup has a long history in the U.S., where the Chapter 11 procedure offers protection while balance sheets are rebuilt and operations overhauled. In recent years, this approach has spread to Europe, where legislative changes now permit companies in distress to be rescued rather than extinguished. However, few German companies have taken advantage of the changes, which has also led to opportunities for foreign buyers to swoop in to buy them. Companies, predominantly in the cyclical areas of industrials and materials, are most vulnerable to the current credit crunch and slowdown in the U.S. economy. These companies are capital intensive, heavily export-oriented and have less flexible productions.
One such example is ThyssenKrupp AG. As part of its continuous portfolio rationalization process, it decided to sell off a subsidiary: ThyssenKrupp PrÃ¤zisionsschmiede. The German-based manufacturer of high-tech auto com ponents generated revenues of ï‚€ï€ 290 million in fiscal year 2006-2007. In January 2008, Sona Okegawa Precision Forgings Limited, the India-based manufacturer of forgings, announced plans to acquire the Germany-based manufacturer of high-tech plants and components for an undisclosed sum. By acquiring ThyssenKrupp, Sona Okegawa achieved immediate capacity expansion and international exposure, leveraging on ThyssenKrupp’s network into China, Russia and South America, thus adding a ruby to its crown.
Mining for Emeralds in Asia
The U.S. sub-prime crisis was the most important financial event of 2007 to impact mergers and acquisitions activities in Europe and the U.S. In Asia, the impact has hardly been noticed. Although the volatilities in share prices in Asia have followed their counterparts in Europe and the U.S., the value and volume of deals being done is expected to remain strong through 2008. In India, the business community brims with unbridled optimism fueled by that country’s domestic economy growing nearly 10 percent in 2007 and its emergence as a serious player in global M&A. While tightening belts in their home markets, Western firms-particularly in the U.S. due to the weak U.S. dollar-continue to increase their operations and activities in Asia to compensate for the dismal U.S. market.
Asian firms, on the other hand, are keen to seek investment and technology partners to upgrade and expand abroad. In China, and to a certain extent in India, many companies are started and managed by young entrepreneurs. Not interested in selling their companies yet, they nonetheless pursue high-trajectory growth paths. In many instances, this means they are interested in accepting capital and technology transfers to aid expansions, which gives foreign companies the opportunity to buy stakes in pre- IPO gems. As a result, valuable partnerships between East and West can and will continue to form despite the ongoing credit crisis.
Similar to Europe, there are many hidden gems scattered throughout Asia. Like emeralds, they are valuable but brittle. Although not as strong fundamentally as their European counterparts, with the right systems and processes they can become extremely valuable. M&A activity in Asia in 2008 is expected to be focused in North Asia-China, Korea, Taiwan and Japan-but the whole of Asia is a fertile mining ground for strategic bidders. Many companies remain undervalued, while others seek to shed underperforming and non-core assets. Some examples of emeralds dug out from Asia include Edwards Tianli Pharmaceutical Systems, which was acquired for Euro 9 million by IMA SpA, a listed Italy-based producer of automatic packaging machines for the pharmaceutical and tea industries. The acquisition will enable IMA SpA to penetrate the China market and strengthen its position.
Getting Fit to Mine
Of course, not all companies are fit to mine. A thorough fitness check can gauge whether going out into the world to mine will be beneficial to the overall health of the organization. The current financial crisis has reminded many companies of the concept of restructuring in both good and bad times.
Restructuring of companies can take the forms of financial and operational restructuring. Financial restructuring entails refinancing at each level of the company’s capital structure, which includes securing debt/loan financing, forming strategic partnerships, pursuing M&As and, in cases of financial distress, reorganization. Companies not fit for mining would do well to focus on securing their loans.
Easy access to liquidity in recent years encouraged greater flexibility in restructuring, and innovative debt instruments subsequently brought new lenders and investors to the table. Unfortunately, the good times are over and instruments like equity bridges, covenant-lite loans and payment-in-kind notes are things of the past. With credit markets in turmoil, many companies are finding it more challenging to raise the money they need to fuel their business.
Fortunately, bank executives emphasize that quality borrowers-companies with good management and a sound business-will still be able to snag good deals. If your business is sound now and was sound before the credit crisis, and the fundamentals have not changed, then there is no reason for the bank to take a different approach (unless something has happened at the bank). Thus, if your company has yet to establish a relationship with a bank, now is the opportune time to do so, as lenders will continue to have an appetite for the right businesses.
Operational restructuring involves increasing the economic viability of the company’s underlying business model. Examples of operational restructuring include the sale of divisions or divestitures of products lines, or cost cutting measures like the closing down of non-performing facilities. For companies in financial distress, both financial and operational restructuring would need to be conducted quickly and efficiently to return the company to healthy fitness levels.
For companies with capital or the ability to raise capital, a window of opportunity to mine gems from around the world has opened. Warren Buffett, Wilbur Ross and Ron Perelman are plunging into the mine shafts to scoop up companies hit by the financial turmoil after years of being shoved to the side by high valuations and fierce competition from private equity. These savvy “value” investors believe the financial and capital market crisis now offers a great opportunity to dig out the gems.
In fact, Warren Buffett has already invested approximately $6 billion in a wave of deals since the crisis began. After years of sitting on the sidelines, companies with strong financials will find that there is no better time than now to start mining.
Jake Cohen is affiliate professor of accounting & control and business law at INSEAD. Joerg Nuernberg and Anne Young are partner and senior consultant, respectively, at the international consulting firm Droege & Comp.