18 February 2008 00:00 [Source: ICB]
The global credit crisis and the threat of a US recession have choked financing for large, leveraged deals. But there are other options available
Joseph Chang/New York
WITH THE credit crisis bringing the US economy to the brink of recession, a stubbornly stagnant high-yield debt market and broad concerns about a global economic slowdown, this perfect storm could sink the merger and aquisition (M&A) ship.
"Since it is likely that we will face either a prolonged debt crisis and/or possibly a recession, we believe there will be a slowdown in the chemical M&A market in 2008, in spite of the continued presence of the underlying factors that are driving M&A activity," says Peter Young, president of New York-based investment bank Young & Partners. "Financial buyers will have a subdued presence."
For all of 2007, the global chemical industry completed a record $55bn in acquisitions, breaking the previous record of $42bn in 2006, according to Young & Partners. The industry completed 81 deals over $25m in size in 2007 - slightly higher than the 78 transactions in 2006 and not far from the 2004 record of 86. There remains a backlog of about $28bn in deals that did not close in 2007.
"We expect that the macro environment in the US debt and currency markets, including the resultant impact on global debt markets, is likely to continue to impact M&A activity in the chemical industry," says Saverio Fato, global chemical industry leader at consultancy PricewaterhouseCoopers. "Although we do not expect activity to maintain its 2007 pace, we do expect that middle-market deals will remain active and that the bidding leverage will be strong with strategic investors, particularly foreign strategic bidders for US assets."
Private equity firms, which captured 22% of the total number of deals and 17% of the dollar volume in 2007, will play a reduced role in 2008 as they struggle to raise financing, according to Young.
"Multibillion-dollar buyouts are going to struggle to get off the ground, given the difficult debt financing market," says Tim Wilding, managing director and head of chemicals at New York-based investment bank Oppenheimer. "However, I'm cautiously optimistic that we will see continued activity in 2008."
"Deals over $3bn-5bn, and perhaps even as low as $1bn in some circumstances, for private equity are on the sidelines for the foreseeable future," says Telly Zachariades, senior managing director at New York-based merchant bank Valence Group. "Many investment banks are not willing to make big financing commitments until the backlog of debt to be syndicated is cleared."
"The larger deal activity has really seized up. Leveraged transactions north of $1bn are just not happening because the financing is not available," says Leland Harrs, managing director of the chemical team at US-based investment bank KeyBanc Capital Markets. "That will not change until the backlog of bridge loans and commitments clears up, and that will take several quarters at a minimum."
HIGH YIELD ON HOLD
There has been a dearth of high-yield debt offerings in the chemical industry since the US credit crisis hit in July 2007.
Last August, Saudi Arabia's SABIC was able to issue $7.7bn in senior secured debt and $1.5bn in senior notes to finance its $11.6bn acquisition of GE Plastics, but that was a special situation where banks rushed to the table to do business and build ties with SABIC and the Saudi government.
But it's been quiet since then. While Len Blavatnik's Access Industries was able to complete its acquisition of US-based Lyondell Chemical for $13bn in December 2007 with $8bn in interim financing, the company needs to issue long-term debt in the coming months - no small task in today's environment.
The interim loan, dated December 20, 2007, carries an interest rate based on LIBOR (London inter-bank offered rate) plus an unspecified margin. But after the first six months, the margin jumps by 0.5 percentage points, and will continue to rise by that amount every three months thereafter. The clock is ticking.
And US-based Solutia is suing its bankers Citigroup, Goldman Sachs and Deutsche Bank for failing to arrange $2bn in exit financing, a critical step for the company to emerge from bankruptcy.
"We are not seeing any improvement in the debt market," notes Chris Cerimele, co-head of global chemicals for investment bank Lincoln International. "The Solutia situation is a high profile example of continued trouble for the larger financings. We are not seeing that kind of problem with mid-market deals but conditions have not gotten any better over the past several months and many seem to think the situation will last through the remainder of 2008."
More creative financing structures may be what's needed. "Instead of going to the big money-center banks, buyers may have to disintermediate and go direct to alternative sources such as hedge funds, pension funds and insurance companies who are willing to club together and provide credit in large size," says Zachariades.
"Big US and European banks are not the only ones who lend money," Young points out. "Hedge funds may fill the gap. And there is lots of financing available from China and the Middle East."
And higher-interest rate mezzanine financing from non-bank institutions is also widely available (see end of article). But for now, the days of easy financing are long gone. And so private equity firms must create value in other ways.
"Private equity firms historically did well buying businesses using leverage and paying down debt from the cash flow. But the easy money days are over," notes Zachariades. "But now that some of that leverage is gone, they need to focus more on improving operations or creating value through bolt-ons. Firms with multiple existing portfolio companies and/or established in-house operational expertise will do better in this market."
MIDDLE MARKET ACTION
With multibillion-dollar deals harder to execute, activity is buzzing in the middle market, typically defined by deals under $500m.
"There will be a lot of activity in the mid-market area and smaller transactions that are not driven by the high yield debt market or bridge loans," says KeyBanc's Harrs. "We're going to see many bolt-on acquisitions and we don't see activity slowing down in this area."
"We are continuing to see strong activity in the mid-market," says Lincoln international's Cerimele. "Most of the interest we are seeing is from large corporations going for small and mid-sized acquisitions. This is especially true of companies based in Japan and Europe who are seeking acquisitions outside their borders."
"We haven't seen a downtick in activity or discussions in middle market," says Omar Diaz, senior vice president and co-head of chemicals at US-based investment bank Houlihan Lokey. "However, we see overall deal volume down about 20% versus 2007, comparable to 2005 levels."
Even private equity firms will participate in mid-market deals, notes Harrs. "There are a lot of financial sponsors that focus on mid-size deals, and they still have lots of money to put to work."
However, buyers will have to put in more equity to get deals done, even in the middle market.
Global private equity firm AEA Investors completed its acquisition of US-based industrial fluids firm Houghton International in December, despite turmoil in the credit markets.
"The level of equity financial sponsors were putting into deals in early 2007 had dropped to 20% or below," notes Oppenheimer's Wilding. "Now it is 30% or much more."
"In some cases, financial sponsors are willing to finance the entire acquisition with cash, thus eliminating financing contingencies," Harrs says.
Bankers see hot areas of deal activity in specialty chemicals such as adhesives, sealants and coatings, oilfield services chemicals, fine chemicals and personal care ingredients.
Private equity firm 3i recently agreed to acquire US-based pharma company Alpharma's active pharmaceutical ingredients (API) business for $395m.
"In fine chemicals, M&A activity remains strong and if anything, the pace is increasing," says Lincoln International's Cerimele. "There is a good number of assets on the market - much of it consisting of plants or operations that are being divested by large pharmaceutical firms. There's also a general strengthening in the outlook among contract manufacturers of APIs [active pharmaceutical ingredients) and intermediates, and this is leading to increasing acquisition interest."
There appears to be a greater understanding of the diversity of the chemical industry, and investors are picking their spots.
"The chemical industry is not being looked at as a big monolith, but as having many individual sectors - and the money is pouring into these profitable sectors with 20% EBITDA margins," sasy Houlihan Lokey's Diaz.
And many small to mid-sized family-owned businesses will be coming to market as the baby boomers start hitting retirement age.
"Many of these entrepreneurs are saying that the next generation is not going to take over, and that they will need to sell," says Jean Cayanni, senior managing director and head of the chemicals practice and capital raising at Cosa Mesa, California-based investment bank RSM EquiCo.
Turmoil in the credit markets, concerns about an economic slowdown, and a volatile stock market could put a damper on M&A valuations in 2008.
Specialty chemical M&A valuations averaged a robust 10.3 times EBITDA (earnings before interest, tax, depreciation and amortization) in 2007 versus 10.5 times in 2006, according to Young & Partners.
"Valuations have been strong in specialty chemicals as buyer interest remains high," he says. "We believe valuations will continue to move sideways in the near term. It is neither a seller's nor a buyer's market," says Young.
"I don't think strategic buyers have changed their views on valuation at all," says Oppenheimer's Wilding. "But clearly financial sponsors will not be able to pay as much as they were a year ago."
Some bankers expect a decline in transaction multiples, as buyers put more equity in deals and take on less debt.
"Sub-$1bn deals are getting done, but you need a higher equity component in the capital structure. This means equity returns go down, and valuations must come down," says Valence Group's Zachariades. "We won't be seeing too many double-digit EBITDA multiples in the foreseeable future. This may cause in a lull in deal-making as sellers' value expectations will take time to fall into line with the new valuation reality."
"M&A multiples of around 9x EBITDA will have to trend lower," says Houlihan Lokey's Diaz. "Leverage ratios [indicating how much buyers can borrow] have gone down, and increasing economic uncertainty will lead to lower transaction values."
STRATEGIC BUYERS STRONG
As private equity firms are up against the ropes, many strategic buyers are in strong financial shape and can afford to take their swings.
"Strategic buyers have been waiting for the bubble to burst in the LBO [leveraged buyout] community," says Oppenheimer's Wilding. "Inevitably, for the large transactions, strategics are going to have an advantage, and I think they will take advantage. Even a mild recession will not take them out of the game, as they are better capitalized than they have been before."
US-based Dow Chemical is awaiting a $9.5bn cash payment later this year as it completes its commodities joint venture with Kuwait's Petrochemical Industries Co. And Dow chairman and CEO Andrew Liveris has made known his intention of plowing the money into specialty chemical acquisitions. A multibillion acquisition is not ruled out, if the price is right.
"Companies such as Dow Chemical and PPG Industries can still do big deals with no major problems," says KeyBanc's Harrs. "Balance sheets in the chemical industry are generally better than they were a few years ago. And interest in acquisitions to spur growth is as high as it's been in years."
"Strategic buyers are going to have the upper hand," says RSM EquiCo's Cayanni. "They have all sorts of dry powder and can bid on assets knowing that private equity could have difficulty getting funding."
Strategic deals over $10bn in size in 2007 and 2008 included SABIC's acquisition of GE Plastics and Netherlands-based Akzo Nobel's £8bn ($16bn) buyout of UK stalwart ICI.
"You see these $10bn-plus deals by strategic buyers at over 10x EBITDA," points out Allan Benton, vice chairman and head of the chemicals group at New York-based investment bank Scott-Macon. "Strategic buyers will continue to be active, even for multibillion-dollar deals."
Besides being on the hunt, chemical companies will also be sellers of assets as restructuring and the search for shareholder value continues.
"Several companies have publicly announced that they are performing 'strategic reviews,' which is often a precursor for portfolio changes," notes PricewaterhouseCoopers' Fato. "Additionally, as the debt markets normalize, we expect to see divestitures move forward that may have been held back in the second half of 2007."
US-based specialty chemical firm Chemtura is on the selling block, having hired Merrill Lynch in December to explore strategic alternatives.
"The book is coming out soon, and will have several chapters," says one banker source, referring to the document that is available to potential buyers on companies up for sale. The company could be sold in pieces.
Chemtura has already started to divest businesses. It recently agreed to sell its $56m fluorochemicals unit to DuPont and its $175m oleochemicals business to New Jersey, US-based chemical company PMC Group.
Netherlands-based DSM is seeking to divest €1.4bn in chemical assets by 2010 to focus on life sciences and materials. Businesses for sale include melamine, urea, fertilizers, energy, elastomers, specialty products and maleic anhydride operations.
Financial sponsors are as likely to be sellers of assets as they are buyers.
"Private equity firms already own many companies and have limited fund lives where they need to sell," says Scott-Macon's Benton. "So they'll be looking at the sell-side as well as the buy-side."
Oppenhemier's Wilding says private equity firms that have assets with obvious strategic buyers may seek to sell, "but we also might see sponsors with portfolio companies taking advantage of a softer deal environment to pursue add-on acquisitions as opposed to looking at 2008 as an exit year."
Buyers from the Middle East, Asia and other emerging economies will continue to scour the landscape in for chemical assets North America and Europe in 2008.
"We will see much more global activity and a diversification of the buyer universe to include Asia, the Middle East, Eastern Europe, Russia and Latin America," says Valence Group's Zachariades. "Where there is growth and money, you'll see companies in those countries taking advantage of their newfound wealth and buying businesses in the West that have the technology and markets they need."
"We expect to see this trend continue with active foreign bidders including Indian and Chinese companies," says PricewaterhouseCoopers' Fato.
DON'T GO TO THE TOP - MEZZANINE FINANCING STILL AVAILABLE FOR M&A
With the global credit crisis making senior debt financing harder to come by, companies seeking to finance M&A transactions can still turn to mezzanine financing.
"Mezzanine financing is widely available from nonbank financial institutions," says RSM EquiCo's Cayanni.
Mezzanine debt typically carries a higher interest rate than senior debt, and the lender often also gets an "equity kicker" - an equity stake in company it is lending to.
Mezzanine lenders had been squeezed out of the white hot M&A market in recent years as senior debt was widely available from aggressive lenders, lessening the need to go to second-tier mezzanine financing.
But with the onset of the credit crisis, banks are less willing to provide senior debt, especially for large deals.
"Banks are afraid of syndication risk," says Cayanni. "If they're financing a multibillion-dollar deal, they don't want to be stuck with the debt."
Now there is finally room for mezzanine lenders to operate. "Many mezzanine lenders have raised funds in the past two years, but have not been able to put them to use because banks have been very aggressive with senior debt," he says.
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