Cash Is Key for Successful Dealmaking

A couple of big deals announced in recent weeks, including ExxonMobil's $40 billion acquisition of XTO Energy, point to a rebound in merger and acquisition activity in 2010. As deal-making ramps up again, a study from KPMG suggests transactions done with cash fare better than all-stock deals or those paid for with a mixture of stocks and cash.

The KPMG study, conducted with the University of Chicago Booth School of Business, found the average all-cash deal returned 1% after one year and 2.9% after two years, while the average all-stock deal showed a negative 5.3% return after 12 months and a negative 9.8% return after two years. The outcome of transactions financed with a mixture of stock and cash fell in between those two extremes, according to the study, and posted a negative 3.8% return after one year and a negative 3.7% return after two years.

Daniel Tiemann, KPMG's U.S. lead partner for the transaction and restructuring services groups, notes that the study shows a correlation between the method of payment and the acquirer's price/earnings ratio, with acquirers with low P/E ratios having more success than those with high P/E ratios.

"What you have is companies that, within their industry, are trading at a reduced multiple. They believe their stock is undervalued in relation to their peers, so they're more likely to use cash because in their view, it's a cheaper currency than their stock," Tiemann says. "And typically most of these companies are trading at a discount to their peer group because they're missing a geography or a key service line, there's something that puts them at a disadvantage. So they're out looking to plug that hole. They're already at the bottom and they're already being a lot more strategic about the acquisition."

The KPMG study also shows that there's an optimal level of dealmaking. Companies that do between three and five deals a year fare best, while those that do more than five deals see lower returns, as do those that do fewer than three deals. "Once you go over five, the returns start to drop because you're stressing the organization too much," Tiemann says. "And less than three, it's a big event, the organization hasn't done it so much."

Tiemann is upbeat about the outlook for the M&A market this year. After the financial pain endured over the last 15 months, companies are focusing again on how to grow, he says. "We're seeing M&A activity definitely pick up as companies are reaching out and buying a weakened competitor, or seeing this as an opportune time to do transactions."

Certainly dealmaking took a beating in 2009, with the 2,963 transactions in North America, down 26% from the total in 2008 and off 43% from the peak in 2007, according to mergermarket, an M&A information service. The value of last year's transactions was down 7% from 2008 and almost 50% below the level in 2007, the mergermarket data show.

Abigail Roberts, global editor at mergermarket, says the pickup in activity as 2009 drew to a close is a good omen for 2010. "The last quarter of 2009 was I think by far the strongest quarter, and you saw a real rush of more traditional M&A," Roberts says, as opposed to the distressed asset sales that predominated earlier in 2009. "As the market stabilizes, things are getting better. Traditional deals are coming back."

Roberts also noted expectations that initial public offerings will pick up in the first half of this year, in part because private equity firms are eager to unload some portfolio companies, and buyers aren't yet appearing for those properties.

For a look at the role treasurers are likely to play as mergers pick up, see Cashing in Next Wedding Season.

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