On July 15, $32.2 billion pharmaceutical giant Pfizer Inc. announced that it would buy $13.8 billion drug maker Pharmacia Corp. for the impressive sum of $60 billion in, glory be, an all-stock deal. Hearts began to palpitate; palms began to sweat. Ah, now that’s more like it, Wall Street thought.

But as many suspected at the time, it was just a brief throwback to the rich past. The numbers tell the story: Deal volume of $321 billion for the first nine months of the year is just 55% of what was generated in the first three quarters of 2001 and a mere shadow of the pace set in 2000. In fact, given a potential annualized total of $426 billion for 2002, this is the slowest year for M&A on a nominal basis since 1994. What’s more, if one excludes the Pfizer-Pharmacia deal, companies have racked up 70% of the value of this year’s acquisitions using cash, well above the long-term average of 60%, according to J.P. Morgan Chase. That’s a complete turnaround from few years ago when bloated stock prices and lax accounting guidelines encouraged companies to do deals with stock alone: In 1998, stock deals peaked at 69% of all M&A transactions by value.

Market Slide Impedes Pricing

But little in the stars–or more importantly, the numbers–is particularly conducive to deal making. After the small pop from the Pfizer-Pharmacia deal, the stock market resumed its downward trend. The economy looks precarious, and Washington continues its saber-rattling toward Iraq. In other words, as the year approaches its close, little seems to be favoring a return to the stock-swapping M&A glory days of just a few years ago. “CEOs are having such a hard time getting a handle on their own businesses that it’s impossible for them to feel confident about evaluating another business, even a competitor’s,” says David Parker, partner for technology mergers and acquisitions at Thomas Weisel Partners in San Francisco.

It is not as if no deals are getting done. However, many of the ones that do see the light of day are not Wall Street’s cup of tea–and from top management’s perspective, not the type that significantly transform a company or its share price. Instead, the watchwords are “conservative” and “strategic,” which has resulted in modest gains for careful buyers. “The deals that are getting done in the present business environment are generally smaller, all-cash and highly strategic, and shareholders tend to view these deals positively,” says Rick Esherich, managing director for M&A valuation at J.P. Morgan Chase. “The kind of deal volume and the valuations that we saw in the late 1990s and 2000 simply are not coming back, particularly in [technology, media and telecommunications]. As a result we’re seeing much smaller volume, but safer deals in general.”

LBO Firms’ War Chest

The outlook is not much rosier for the first half of 2003, given that the nation is still in the grips of the same pervasive uncertainty that stifled business this year. For bankers and executives, that probably means another few quarters at least of 2002 redux–strategic purchases and liquidity-driven sales of assets. The one ray of sunshine: Wall Street and finance executives expect more of these types of deals and better prices as the year progresses.

What’s behind the potential uptick? According to the pros, one plus will be the return of leveraged buyout firms with an estimated war chest of between $80 billion and $100 billion. Their targets will be the scores of companies near or in bankruptcy, particularly in the telecommunications and airline industries, and those so highly leveraged that they are forced to sell off key assets to decrease their debt load. LBO firms are already making their presence felt in two recent large deals: the $2.26 billion bid for Diageo PLC’s Burger King unit by a private equity consortium of Texas Pacific Group, Bain Capital and Goldman Sachs Capital Partners and the $7 billion sale by Qwest Communications International Inc. of its directories business to a buyout group headed by The Carlyle Group and Welsh, Carson, Anderson & Stowe.

LBO firms wanted to put their money to work this year, but only accounted for $30 billion–about 8%–of the total deals completed by mid-October. One reason is rather simple: Earlier in the year, financial sponsors did not believe–correctly, it would seem–that prices had bottomed out and thus were tough in negotiations. The prices are tempting now, and given that most expect the erosion to slow if not end entirely this year, the door will be open for the buyout firms to close more deals. “The interest from financial sponsors is really all over the lot. Relative to six months or 12 months ago, there are more attractive opportunities in every sector right now,” says Michael Ryan, a partner with Cleary, Gottlieb, Steen & Hamilton LLP who works frequently with private equity firms.

But LBO firms have two hurdles to clear if they are to complete more deals in the next 12 months: credit selectivity in the finance markets and the desire of many management teams not to sell at the bottom of the market. “The buyout business is dependent on the bank loan market and the high yield bond market, and both those sources of funding have been more difficult to secure lately,” says Ryan. A case in point: As of mid-October, the Texas Pacific Group-led consortium buying Burger King had been reportedly having difficulty closing the transaction because bank lenders, including Citibank and J.P. Morgan Chase, were facing difficulty syndicating the loans to other lenders, given concerns about Burger King’s performance and the sharp increase in troubled loans generally over the last year.”

Obvious Targets

If financing conditions improve somewhat, the return of strong bids from LBO groups should give a boost to the overall deal market, encouraging more firms to sell and lifting the shares of potential targets above recent bottom-dollar prices. “There are many companies that will be more confident in putting themselves up for sale in 2003 because of the return of financial buyers. Their presence puts a price floor under the sellers,” says Gregg Polle, co-head of global M&A at Salomon Smith Barney, a unit of Citigroup. “Many companies will ultimately be bought by strategic buyers next year, but they may not come forward without financial sponsors in the picture.”

Initially, the LBOs have been focused on the obvious targets, such as the stable cash-flow directory businesses of telecom concerns, the struggling airlines and cyclical industrial firms. But interest is spreading to riskier plays in such downtrodden sectors as telecom equipment manufacturers, software, network providers and semiconductors. “What sells right now are believable businesses with real assets that still have value. Companies that prove they have that in the tech sector are attracting the attention of financial sponsors,” says Ryan.

LBO firms will not, however, have the playing field to themselves. Cash-flush strategic buyers are expected to play the same role they did in this year’s market–only more so. Heading into 2003, deal advisors expect the focus on hard currency and strategic fit to continue, rather than a return to transformational deals that try to mesh different businesses. “There are a good number of very well capitalized companies out there, with large capacity on their balance sheets, inclined to use cash for strategic acquisitions going into next year,” says Salomon Smith Barney’s Polle. “With the equity markets still skittish, buyers and sellers alike may be more comfortable using cash for deals.”

Merger market watchers say next year’s anticipated M&A activity includes scores more “tuck-in” deals, where a market leader buys a business line or much smaller company in its field. Perhaps the poster child for this type of cash-driven deal is the Sears, Roebuck & Co. purchase of catalog retailer Land’s End Corp. for $1.9 billion. Sears raised the bulk of the financing in a quick trip to the high-grade fixed income market and closed the deal June 17, just over a month from its announcement, thanks to its all cash nature. While Sears agreed to pay a 22% premium for Land’s End, seen as pricey by some of the company’s analysts, it did so for a competitor with a net profit margin more than twice Sears’ own in 2001.

The move was heralded as a boon to Sears’ efforts to revamp its clothing lines and lure new shoppers into its stores. And investors responded by bumping up Sears’ share price at the end of the second quarter, though its shares have since slid sharply with the rest of the market. Even so this market response is atypical: In 1998, 1999 and 2000, buyers’ stocks dropped after acquisition announcements. For all deals announced in the first nine months of this year, the buyer’s stock has risen, at the median, 3.1%–the most positive market reaction to M&A activity in more than a decade.

That kind of response is apt to encourage other CEOs to think that there is some good to be derived out of these more modest, targeted expansions. “Companies have been very inwardly focused this year, with all the scandals, liquidity issues and the decline in the stock market,” says Polle. “In 2003, I expect more companies will be beyond those issues and will focus again on external growth, because growth is what drives earnings multiples.”

While cash-rich companies won kudos for their prudence, executives of those companies now want to also show investors they know how to put that cash to work. Take, for example, Novell Inc.’s purchase of SilverStream Software Inc. of Billerica, Mass., earlier this year. The $215 million cash deal, less the $100 million SilverStream held on its balance sheet, made sense for Novell as a strategic technology purchase, says Bill Smith, vice president of M&A at Provo, Utah-based Novell, a networking and business software company. “We have a lot of shares outstanding, and a larger than average amount of cash on the balance sheet, at nearly $700 million [at the time], so it made tremendous sense for us to offer cash for SilverStream,” he says. “But we see this as a technology acquisition that was well priced, not a deal that had to be immediately accretive to earnings.”

Boards Could Be Hard to Convince

Whether this purchase will prove to be a win for Novell, once corporate technology spending revives, remains to be seen. Novell isn’t letting the uncertainty stop it from putting its cash reserves to work. “Companies that were perceived as too conservative with their cash in the past are now in the catbird seat in this market,” says Smith. “As a result, we are open for business on the acquisitions side right now.”

But just as bank finance is holding back LBOs, boards of directors–already targets of disgruntled shareholders–may prove to be the conservative element that stifles growth in deal volume. “Boards of directors are raising the threshold criteria for deals lately because the floodlights are on them,” says Thomas Weisel’s Parker. “Both buyers and sellers are acting more risk averse right now because the market is not rewarding risk takers at this point, and is only being less punitive with those who are risk averse.”

Even so, between growth-hungry buyers, liquidity-crunched sellers and the return of the buyout shops to the market, a surge of deal making in 2003 is strong possibility. After all, it can’t get much worse. Can it?