Hostile Lending May Slow Consolidations<@VM>Hostile Lending May Slow Consolidations (cont.)

Jerry Grossman

By Jerry Grossman

A consolidation among major aerospace and defense companies that began in the 1990s was substantially complete by 1997. Among the active participants in those consolidation-oriented acquisitions were Lockheed Martin Corp., Raytheon Co., Boeing Co. and Northrop Grumman Corp.

During 1997, the consolidation of midmarket government information technology and technical services companies began to accelerate. Industry factors driving this consolidation included continuing sluggishness in defense and government spending; the perception that greater size would become an advantage, given the emergence of more flexible contracting vehicles and bundled procurements; and the rapid deployment of technology tools with attendant IT support requirements.

Capital market factors also were important in fueling and sustaining consolidation of government IT and technical services companies. From mid-1997 through mid-1999, both equity and debt markets provided strong support for consolidation.

During this period, equity market indices moved higher. The Dow Jones Industrial average climbed 36 percent to 10,855, the Nasdaq Composite rose nearly 64 percent to 2,563 and the aerospace and defense index increased about 13 percent to 1,344.

By contrast, the price and performance multiples of public government technology companies were stable to down slightly, from 5 percent to minus 10 percent.

During this same period, debt markets were providing strong liquidity and low borrowing costs in both the senior debt and subdebt sectors. At the senior debt level, the prime rate for borrowing dropped from 8.5 percent to 7.75 percent, while the three-month LIBOR (the London Interbank Offer Rate, which is what the largest international banks charge each other for loans) declined from about 5.8 percent to 5.2 percent, with aggressive lending practices dominating.

At the subordinated debt and mezzanine financing level, yields were steady to slightly increasing. Corporate issues (five-year term) rated B- increased from 8.75 percent to 9.9 percent, as the spread over treasuries expanded from 3 percent to 4.25 percent. The public high-yield market was not only inexpensive, but also liquid. In that environment, acquiring companies could use either their stock or cash as "acquisition currency."

The cost of capital, in either case, was very low. Acquisition prices of defense
and government technology companies reflected these dynamics as they reached record price and performance levels. But that was then. The picture at present is looking much different.

Capital markets trends generally are moving unfavorably. Debt capital markets clearly are less liquid and decidedly more expensive. This is true at both the senior debt and the subordinated debt and mezzanine levels.

For example, in the period between June 1999 and the present, three-month LIBOR has moved upward by 160 basis points, or 1.6 percent, to 6.8 percent, while the prime rate has risen 175 basis points to 9.5 percent.

In addition, senior lenders are tightening credit standards and loan covenants in response to intensified regulatory scrutiny and concerns about loan portfolio quality amid a slowing economy. The supply of longer-term subordinated debt capital has diminished, while the cost has risen. The public high-yield market is dormant.

Subordinated and mezzanine financing is being privately placed with insurance companies and specialized funds providing the bulk of the funding. Coupon rates and yields have risen substantially since June 1999. For example, corporate issues of five-year terms rated B- carry increased yields: 9.90 percent in June 1999 vs. 12.5 percent currently. Subordinated and mezzanine financing yields, including warrant participation, are in the 15 percent to 20 percent range.

During this same 12-month period, the aerospace and defense index has fallen by 25 percent, the Dow Jones has declined about 4 percent, and the price and performance ratios for public government technology companies have declined slightly. Taken as a whole, these trends will, if continued, affect defense technology consolidation in two ways.

First, higher costs of capital coupled with lesser availability will force buyers to recalculate pricing. All other things being equal, higher capital costs reduce post-transaction earnings per share. Lower price and performance ratios ? i.e. price to earnings multiples ? suggest that each dollar of earnings has less value.

Clearly, when the buyer's stock has lost market value, acquisitions become more expensive to the buyer and potentially less valuable to shareholders.

Second, funding sources will provide less capital, usually under more stringent terms. That either forces prices lower or changes the transaction consideration from cash to stock (and other non-cash forms), or both. During the past year, government and defense technology acquisitions have reflected a higher proportion of stock transactions, about 55 percent vs. 45 percent the previous year.

At this juncture, seller pricing expectations remain robust. Unless the Federal Reserve Board eases the upward pressure on interest rates, sellers may have to rethink their pricing expectations.

In this environment, transactions with identifiable strategic value will continue to occur at attractive valuations. These deals typically involve selling companies with distinguishable strengths, brand identity and market positioning.

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va.

Equity Market Indices

Dow Jones Industrial7,9158,71310,85510,449
Nasdaq Composite1,5651,7812,5633,861


3-month T-Bills5.45%5.20%4.70%5.85%
3-month LIBOR*8.50%5.70%5.20%6.80%
Prime Rate8.50%8.50%7.75%9.50%
5-year Treasury5.75%5.50%5.75%6.25%
5-year B-Corporates8.75%8.70%9.90%12.50%

* London Interbank Offer Rate
**5-year B-Corporate over 5-year Treasury
Source: Houlihan Lokey Howard & Zukin

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