The Gherkin (30 St Mary Axe, London) from below

Merger activity set to rise in 2011

Merger and acquisition activity in engineering is set to rise thanks to a corporate cash mountain and geopolitical turmoil.

For the past three years, engineering companies have not just had a hard time getting credit or selling products: selling off the businesses themselves has been near impossible.

At a conference on merger and acquisition (M&A) activity organised by Catalyst Corporate Finance, Philipp von Hochberg, managing partner at CH Reynolds Corporate Finance, used Germany as an example of how deals came to a juddering halt: 'In September 2008 the M&A market completely collapsed. There was no chance to bring any deal through. In 2009 there was no real recovery.'

One factor was the decision by the German banks not to force struggling companies into firesale: 'There were only a few distress situations. But only because the banks didn't touch anything.'

In the US, the decline in M&A activity started three years ago. 'The downcycle started in 2007,' says John Ippolito, a managing director at Headwaters Merchant Bank.

Now, advisors working on M&A are seeing an increase in the number of companies seeking deals, and they are not necessarily waiting for targets to declare themselves up for sale.

'I would describe our position as bullish. I would not describe this as a great time but it is an improving situation. We see 2011 as a time when people will put more capital to work as the debt markets open up,' says Ippolito.

The sources of cash for M&A now are somewhat different to those making the running before the recession started. In the years leading up to the credit crunch, private-equity firms were able to launch extravagant bids for large targets. In electronics, for example, private equity-led consortia bought Freescale Semiconductor and NXP Semiconductors from their commercial owners, saddling them with massive debts to finance lofty purchase prices.

Ippolito expects a number of private equity-backed companies to look for new owners or at least cash injections from more cash-rich corporations. 'Private equity has tended to over-leverage their portfolio companies. Now there is a significant opportunity to restructure balance sheets particularly in the private equity-sponsored marketplace.'

Large companies or 'strategics' who escaped the attention of private equity have done better and are now looking for ways to exploit their position.

'Corporate balance sheets are awash with cash,' says Ippolito. 'They have this cash that needs to find a home. Whereas private-equity buyers were outbidding strategics before the downturn because of the debt that was available, now strategics are in the position to win deals.'

Horacio Facca, a managing director at Headwaters Merchant Bank, says: 'There is an unbelievable amount of capital available. And we will see some natural selection from a debt-market standpoint. We are bullish about what we are seeing in the market.' So, even if you thought the company was not up for sale, the phone calls asking for you to set a price may still come in.

Steve Sellhausen, vice president of corporate development at Dover, says: 'We are trying to be much more proactive and going after targets rather than waiting for companies to be put up for sale. We love getting phone calls. But more and more we are going to find businesses that fit strategically.

'We have plenty of cash. What's the challenge? Finding opportunities to put that capital to use.'

Facca expects a large number of private businesses in the US to come up for sale soon. 'We hear a lot about baby boomers retiring,' says Facca. 'When we look into the businesses, we see that many of them coming up for sale are first-generation businesses. Their CEOs are looking to retire. So there are a lot of businesses coming up for sale.'

Even in Germany, where multi-generation family-owned Mittelstand companies are common and account for almost three-quarters of the engineering firms in the country, M&A activity is likely to increase. Unlike their US counterparts, the managers of these companies will not be selling up entirely.


'In the typical German family-owned company, tradition is key,' says von Hochberg. 'You could have a second, third or fourth generation in charge. They are not willing to sell. But the new development is that the new successors have studied at international business schools and possibly worked in investment banking. They are more open to alternative financing solutions and are willing to do deals with equity houses for growth, financing and acquisition.

'They will only allow a minority stake for the finance houses but they see a strategic need to be prepared for the future. Maybe that will see them join forces with a strategic partner from abroad. There is a strong chance that German family-owned companies will have to combine with US companies to combat protectionism.'

Fears over protectionism join other geopolitical reasons for the drive to merge.

'There will be a fight over technology in the future,' von Hochberg claims. 'There is a question of who will be the global leaders and where they will be located. Asia, China and India demand western technology. But the western economies should not think they have a competitive edge for a long period.'

In the short term, currency imbalances will influence government policy, which is likely to favour cross-border M&A by large corporations and the formation of joint ventures among smaller players. Although leading nations agreed not to engage in competitive devaluation in early November, exchange-rate problems have already caused concern in the West.

'The Chinese currency is dramatically undervalued,' says John Hudson OBE, chairman of Bromford Industries.

The Chinese government has come under pressure to set a more realistic exchange rate for the yuan but is likely to change slowly to avoid local disruption and the social unrest that will bring. The reaction from other countries will be to make Chinese and other foreign imports more expensive by other means: tariffs and restrictions.

'Because countries are not in equilibrium with respect to currencies and productivity, it will result in protectionism from all sides,' says von Hochberg.

'What will drive this process is US protectionism,' says Hudson. 'The US believes in free markets unless it's hurt. They are approaching panic levels as far as the global recovery is concerned.'

Protectionism will not just affect Asian corporations but businesses in Europe, such as the strong machinery and industrial suppliers of Germany.

'German companies will be forced to make acquisitions in the US or they will not have a chance against the US dollar to import their products. US will force imports to be more expensive to build up production in the US. That will occur until the budget deficit comes back in line.'

Von Hochberg believes international partnerships will become more common to try to work around creeping protectionism.

Today, companies in the West are focused on competitors in developed nations, says von Hochberg. But they are now turning to acquisitions in the developing world, particularly in Brazil, Russia, India and China - the so-called BRIC nations - realising that growth will be slow following the recession.

Facca says: 'US companies realise the need to reduce their domestic exposure.'

Von Hochberg agrees: 'The BRIC nations were not hit as hard by the economic crisis, so we will see a more rapidly increasing consumer business which will need greater local production infrastructure. Local consumption in the developing nations will increase faster than in the West.'

The growth of consumer spending will be paralleled by improvements in technology, von Hochberg adds: 'The BRIC nations are becoming a driver in the engineering sector. The western engineering firms still have a leadership position. But they are faced with the situation that they will lose their competitive edge during the next decade. And they have to deal with the gap in engineers.

'To strengthen their portfolios, US and EU companies are looking for acquisitions in Asia. Because of the huge number of graduate engineers they are producing, Asia is an attractive location for the future.

'Companies will also access Asian suppliers through joint ventures as well as through mergers and acquisitions,' says von Hochberg.

Not all companies will be available for purchase in the BRIC nations as their own buying power improves, von Hochberg adds: 'State-owned holdings will increase to keep control of engineering companies within Russia.

'BRIC countries will still need western technology to build up their infrastructure in the coming decade, so they will invest abroad as well. The BRIC countries are in a strong financial position. The companies have strong balance sheets and there are state funds that can act as acquisition sponsors.

'In contrast, the western world has to deal with its massive public deficit,' von Hochberg warns.

So, while governments strive to separate their economies, engineering firms will be doing their best to connect across borders.

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