ICAP Conference 2009

25

Financial Meltdown - Crisis Of Governance?

What’s next for

corporate development?
Opportunity and risk in the financial crisis

This publication contains information in summary form and is

therefore intended for general guidance only. It is not intended
to be a substitute for detailed research or the exercise of
professional judgment. Neither EYGM Limited nor any other
member of the global Ernst & Young organization can accept
any responsibility for loss occasioned to any person acting or
refraining from action as a result of any material in this
publication. On any specific matter, reference should be made
to the appropriate advisor.
 F I N A N C I A L M E L T D O W N
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What’s next for
corporate development?
Opportunity and risk in the financial crisis
Consequences of
the financial crisis
The collapse of the US subprime mortgage market was the major
catalyst for the 2007 credit crunch and subsequent 2008 global
financial crisis, prompting a loss of confidence in the banking system
and forcing governments to intervene. The unexpected severity of
the credit crunch drove the world’s largest economies into recession,
resulting in what could be the worst downturn since the 1930s.
From the earliest beginnings of the crisis, a number of factors have
compounded to contribute to today’s environment and impact
companies ability to do deals:
• Financing costs increase — Large international banks have
already tightened their lending standards and many smaller
community banks are now doing the same. In the short term,
revolving lines of credit will no longer be renewed as a matter of
course and refinancing existing debt facilities will be more costly.
This is likely to lead both corporate and PE investors to assess new
financing techniques such as vendor financing. Heavily leveraged
companies purchased by PE firms on high multiples may experience
particular challenges in refinancing debt taken on at acquisition. In
2008, a number of PE-backed companies entered Chapter 11
bankruptcy protection in the US.
Nonetheless, companies with strong balance sheets may be in a
position to exploit opportunities within the capital structures of
companies in distress. There have already been examples of PE
firms purchasing leveraged debt at a discount from the banks that
financed the original acquisition.
• Slowing economic growth — The International Monetary Fund
(IMF) has slashed its forecast for world economic growth. It expects
the world economy to grow by only 2.2% in 2009, revising its
forecast down from 4.2%. Developed economies are expected to
contract by 0.3% in 2009, the first such fall since the 1940s. Growth
in emerging economies is slowing but will still reach 5% in 2009. The
US, the UK, the Eurozone and Japan have all entered recession. The
IMF has agreed economic rescue packages for several countries,
including Hungary, Iceland, Ukraine and Pakistan, more are
expected to follow.
Rising unemployment and low consumer confidence - As
companies face the prospect of a prolonged economic recession,
they are increasingly looking to decrease output, reduce overheads
- C R I S I S O F G O V E R N A N C E ?
and minimize losses. The inevitable reduction in workforces will fuel
an increase in unemployment which in itself may have a self-
reinforcing effect on the economy, further weakening consumer
demand and prolonging the recession.
• Falling profits — Wall Street analysts are lowering corporate
earnings forecasts for 2009 as the recession bites. Sectors that are
likely to see sharp falls in profits in 2009 include consumer
products, automotive, energy companies, industrial companies and
materials-producing firms. In addition, retailers, already
contending with falling consumer spending and plummeting
revenues are finding that suppliers of inventory are tightening their
credit terms, squeezing working capital at a time of falling demand.
Indeed, companies that negotiated contracts on pre-financial crisis
terms (based on more optimistic projections) locking them into the
supply of raw materials at specified volumes and prices may now
seek to re-negotiate, but from a position of weakness. This can have
consequences for all participants in the supply chain.
• Government reaction and intervention — In 2008, auto
manufacturers in the US and Europe appealed to receive
government support to help them survive a slump in orders and
overcome financing difficulties. In attempts to stabilize their
economies and stimulate consumer spending, the US and UK
governments have reduced interest rates significantly, and other
countries have followed suit.
• Increase in “stressed” companies — A record number of
companies are expected to go bankrupt in 2009, with 200,000
insolvencies predicted in Europe alone, according to the world’s
largest credit insurer Euler Hermes. In the US, there is likely to be an
“explosion” of failed businesses as an estimated 62,000 firms go
under, compared with 42,000 in 2008. More companies are likely to
breach their loan covenants in 2009 as the slowdown gathers pace,
prompting a surge in company restructuring and failures. Moody’s
Investors Service forecasts that default rates for 2009 could reach
10% if the US sinks into a protracted recession.
“Our research conducted by Oxford Analytica
indicates that there is a body of leading practices
emerging — a set of “10 CDO imperatives” that
provide a framework for taking CDOs beyond
transaction execution to becoming strategic
advisors to the board.” Jens Tholstrup, Oxford Analytica
What’s next for corporate development? Opportunity and risk in the financial crisis
Challenge 1
Liquidity freeze
The credit squeeze and market meltdown have transformed the
corporate finance environment and led to a change in the balance of
power between corporates, banks and investors, putting the brakes
on giant buyouts and paving the way for smaller, strategic
transactions. Before the slowdown, financing terms favored buyers
with “covenant light” deals. Now, more stringent terms are being
added to existing debt agreements.
The slowdown presents a great opportunity for cash-rich
companies who can now compete for deals on an equal footing with
PE. In the past, when debt was easily accessible, PE was willing to
add leverage that was out of the comfort zone for corporate buyers.
Now, corporates can compete for strategic acquisitions, applying
lessons from PE’s playbook.
When markets do return to normal, they may look more like those in
2004 and 2005. Leverage will be harder to obtain, more expensive
and accompanied by tough covenants. The equity component in
deals will increase and purchase price and debt multiples, inflated in
the 12-18 months leading up to the crisis, should ease.
Although predicting a time line is difficult, the financial crisis looks
set to continue through 2009, into 2010, as most investors continue
taking a cautious approach and risk appetite remains very low.
Three factors signal that the financial crisis will last at least another
year, leading to continuing difficulties in raising capital:
1 Expectations of further banking losses. US and European banks
have so far recognized billions of dollars of losses on their loan
portfolios and more losses can be expected, creating greater
demand for capital. The IMF has forecast that the losses on US
commercial and residential real estate could exceed US$1.4 trillion.
2 Deleveraging. Financial institutions and funds are expected to
continue selling assets to cover losses and reduce debts. As
commercial property market prices and asset-backed securities’
prices have fallen, financial institutions have been facing an
increasing number of margin calls, some of which cannot be met,
and lenders are taking further losses on their loan portfolios. This in
turn is forcing financial institutions to sell assets to raise new
capital.
3 The falling US housing market. The credit crisis is unlikely to
improve significantly until the US housing market shows signs of
stabilizing. House prices are still dropping and Standard & Poor’s
has estimated that almost one in four US subprime mortgage
holders have fallen behind on their payments.
Implications for corporate development
The end of cheap and abundant credit. CDOs need to
become more innovative and identify alternative new
partnerships sources of finance for acquisitions. Deal
financing is now scarce and more expensive. The growth in
money supply in recent years was exceptional and neither
regulators nor shareholders will accept the levels of
leverage seen before the crisis. Despite these difficulties,
share prices will remain under pressure in 2009 and this,
coupled with some companies disposing of non-core assets
to raise funds or restructure, will generate opportunities for
27
attentive CDOs. Bargains are likely to be available, although
predicting the bottom of the market and the best time to
invest will be challenging. Falling asset prices mean that
deals done today could be cheaper tomorrow, providing an
incentive for buyers to wait.
Falling consumer confidence impacts revenue growth.
Declining market confidence is slowing M&A activity.
Revenue growth rates are falling and may even become
negative in some sectors and markets. Weak revenues are
generating an extraordinary degreeof risk aversion in the
market and making the short to medium term potential
gains from M&A activity uncertain, with significant downside
risks. Yet deals that appear very risky in the current
environment may prove extremely successful in the longer
term, when the economic outlook improves. CDOs will need
to balance short-term uncertainty with long-term
opportunity.
Capital preservation will lead to divestments. Companies
are now focusing on cost control, combined with the sale of
non-core units to increase liquidity. Headcount reductions
are likely to continue, while functions and processes may be
combined across product lines to make better use of shared
resources. Outsourcing options may be re-assessed, with a
view towards shifting more operations to low-cost
locations. But at the same time, the potential for creating
synergies and economies of scale through M&A will be high
on the agenda for those companies still able to raise
sufficient funds.
Questions to ask about the business
?
What risks and opportunities to the business are posed by the
economic downturn?
?
What is the health of the balance sheet?
?
Is your business showing signs of financial stress?
?
What steps are being taken to manage cash more tightly, improve
cash-flow and forecasting?
?
Who is at risk in the customer base or supply chain?
?
H a s t h e b u s i n e s s p o r t f o l i o b e e n e va l u ate d ? I s t h e
strategic/financial contribution and market value of non-core
assets understood?
?
What are the plans for selling the non-core business units?
?
What are the opportunities for acquisitions?
Challenge 2
Market volatility
Stock, currency and commodity markets have all been extremely
volatile as investors continue to worry about the extent of the
financial crisis, the depth and duration of the global recession and
the responses of policymakers around the world. Equity markets
have seen record volatility as the turbulence spread from banking
into industrial sectors.
Hedge fund selling has amplified the price swings in equities and
other asset classes as fund managers dispose of investments to
meet a wave of redemption requests from their clients.
 What’s next for corporate development? Opportunity and risk in the financial crisis
28
• Corporate bond spreads and rating agencies — Risk spreads on
corporate bonds have soared to record levels and ratings agencies
have downgraded many corporates, greatly increasing financing
costs for firms seeking credit to engage in M&A activity. Recessions
mean lower inflation expectations and hence lower government
bond yields, while at the same time, weak business prospects lead
to higher default rates on corporate bonds, keeping corporate bond
yields high.
• Currency — Many currencies have suffered volatility as global
investors continue to reassess the underlying strength of
economies in light of the crisis, and the way in which respective
governments have responded to challenges in their own markets.
Recent volatility has added risk to financial arbitrage strategies and
made them much less attractive, as demonstrated by the unwinding
of once popular “carry trades.”
• Commodities and energy — The slowdown in global demand has
led to a fall in commodity prices to six-year lows, bringing an
unprecedented boom to an end. Oil has fallen over US$100 a barrel
on the gloomy economic outlook and falling demand, especially in
the US — the world’s largest crude consumer.
Crude prices, which hit a record high of US$147 in July 2008, could
fall further if the recession reduces demand from China, the main
driver of demand growth in recent years.
Companies are making steep cuts in their investments in new
oilfields, mines and farms. Exceptions to this include nuclear power
and renewables which are set for strong growth as a result of worries
about climate change and government drives to diversify their
energy sources. Although the financial crisis has depressed
commodity prices, it could have bullish longer-term implications.
The slump in investment in new production will reduce supply and
could lead potentially to higher prices when demand recovers.
• Deflation — Prices falling over a consistent period of time can
significantly harm economies. US headline consumer prices have
been consistently falling, while core inflation also turned negative.
Despite aggressive fiscal policies, it remains unclear whether major
economies will enter a period of deflation or merely of low inflation.
Either way, prices are likely to be affected:
• Declines in household wealth associated with falling house prices
and fears about employment prospects could lead to wider price
declines as consumer spending stagnates.
• The ongoing deleveraging process places further downward
pressure on asset prices.
Implications for corporate development
Changes in the ways deals are financed and executed — Swings
in commodity prices, currencies and interest rates create a more
challenging environment for M&A activity by reducing investor risk
appetite and increasing the need to preserve capital. Capital will be
rationed wherever possible by partnering with other investors or
pursuing non-cash deals.
Greater due diligence — With growing risk aversion amongst CEOs
and board members, the need for a detailed understanding of the
businesses or assets being acquired will increase. This will require a
detailed investment rationale, and broader and deeper due
diligence to satisfy boards and lenders than was necessary before
the crisis. CDOs will need to strike a balance between assessing risks
and completing deals quickly, particularly distressed assets.
Building mutual trust between sellers and acquirers will be critical.
Strong relationships and face-to-face discussions with target
management will be preferable to the Q&A process favored in
auctions. This also has implications for the vendor, who should
anticipate greater management involvement in the sales process.
The value gap — Market uncertainty has led to a widening of the
bid/ask spread. In part, this is because volatility creates uncertainty
about the reliability of cash-flow forecasts and valuation models.
For example, projected cash flows are falling as revenue
expectations decrease, inventories increase and banks impose
tougher conditions on credit facilities. To close deals in this
environment, it will be necessary to successfully negotiate and
bridge the gap between buyer and seller price expectations. In this
context, earn outs might become an important tool.
Increasing availability of distressed assets — In view of the
difficulties the market is facing, more assets will become available
as companies, notably those in distress, seek to divest assets to
raise capital. The opportunity for CDOs is to identify good quality
assets for sale that might not otherwise have come to market. CDOs
will need to be mindful that historical financial information for
distressed assets is likely to be unreliable and not reflective of the
asset’s potential under new ownership. However, given the decline
in the popularity of auctions, the flow of potential deals is likely to
be unpredictable and many of these deals may be complex given
the deterioration in the asset’s performance. With distressed deals
needing to be struck faster, buyers with cash and a streamlined
approval process may be able to take advantage.
Questions to ask about the business
?
Is your transaction strategy aligned with your business strategy?
?
How detailed is your company’s scenario planning?
?
Do you stress-test the scenarios?
?
What are the risks affecting both supply and demand?
?
Is there a strong strategic rationale for doing deals – both buy and
sell?
?
Are your valuation and asset pricing assumptions realistic given
volatility in global markets?
?
Is your due diligence sufficiently robust and extensive?
?
Does it include adequate face-to-face time with target
management?
?
What new information will your board require to support the
transaction?
?
How streamlined is your deal approval process? Can you move
quickly to sale or close?
Challenge 3
Government intervention
Governments across the globe continue to intervene to shore up
their banking systems and support industries worst hit by the
economic slowdown. State intervention has not been limited to
OECD countries. For example, China, among other measures,
announced a 4 trillion renminbi (US$586b) fiscal stimulus package
and in Russia, the government pledged US$100 billion dollars of
extra liquidity to the banking sector.
• Bailouts — The recent bailouts give government direct influence
over deal making that could distort the prevailing business
environment. While most bailouts have so far taken place in the
finance industry, we can expect a number of corporate bailouts in
What’s next for corporate development? Opportunity and risk in the financial crisis
2009. Although they can provide a stabilizing force by restoring
confidence, bailouts can also be a catalyst for:
• Using the company as an instrument of government policy.
Politicians might demand shifts in company policy or pursue
non commercial policies. There is evidence of this already
happening in the banking sector.
• Changes at board level and within the management team.
In extreme cases, such as the bailout of General Motors and
other automobile companies, governments may demand seats
on the boards of the companies into which it injects funds.
• Structural changes. Bailouts can put governments in the
position of overseeing the restructuring of a firm’s operations
and finances. This has been demonstrated by the bailout of
“the big 3” automotive manufacturers in the US.
• Possible limitations on executive pay and payment of
dividends. So far, provisions have ranged from vague language
to concrete caps on salaries, limitations on cash bonuses,
restrictions on severance payments, and “claw back”
provisions that allow for recouping bonuses granted on the
basis of performance expectations that did not materialize.
From a capital markets perspective, limitations on dividend
payments will be a key issue for both management and
investors.
• Banking sector — The re-emergence of the state as a major
shareholder in the banking sector has created a number of changes
and raised questions about:
• Governments’ objectives. Governments have made it clear
that bank capitalizations aim to generate a healthy return for
taxpayers as they ultimately plan to sell the shares at a
premium. Some countries are advocating a more activist
shareholder role.
• Length of involvement. State involvement in institutions can
often persist longer than initially intended. However, banks
have clear incentives to buy out government ownership as
soon as possible, as the cost of government participation
increases over time and constrains operational flexibility.
• Competition issues. There is potential for tension between
competition authorities over state aid. Governments choosing
not to invoke existing national or regional guidelines on
competition may exacerbate this.
• The universal banking model. The turmoil in the financial
sector has led to the demise of the traditional investment bank
model, with the major Wall Street investment banks having
either failed (Lehman Brothers), been taken over (Bear Stearns
and Merrill Lynch) or become bank holding companies
(Goldman Sachs and Morgan Stanley). Banks are also actively
seeking alternative approaches to the universal banking model
as it was cited as a contributory factor to the current crisis.
Citigroup’s restructuring proposal, including its decision to sell
its Smith Barney brokerage to Morgan Stanley, may indicate
that the banking model is evolving.
• Non-banking sector — Following the financial sector bailouts,
other sectors are calling for “transitional” state aid to offset
liquidity and solvency issues. State aid has already been given to
individual vehicle manufacturers in the US and Europe. Such
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measures are likely to continue to be considered as further sectors
face difficulties that may lead to significant unemployment.
National champions (firms that are seen to represent a country’s
national interest) are likely to be nationalized or re-capitalized if
they face financial difficulties or a falling share price that leaves
them vulnerable to foreign acquisitions.
Implications for corporate development
Industry consolidation expected. 2009 is likely to witness
consolidation in a number of industry sectors. The consolidation will
be shaped by the sector-leading operators that have strong
balance sheets and access to capital. Other companies that remain
vulnerable to takeover or financial distress will most likely seek out
strategic transactions to ensure survival, with the objective o f
achieving cost reductions, securing synergy benefits and building
efficiencies and competitiveness through scale.
Competitors may benefit. Companies subject to government
ownership may become less competitive if they have financial and
operating limitations placed on them. Government involvement
may lead to uneconomic decisions taken for political ends, e.g., on-
commercially viable loans by banks or funding of politically
motivated M&As. Companies in the same sector that can avoid
government ownership may, as a result, face less competition in the
commercial arena, becoming more attractive M&A targets if and
when it becomes clear that they will survive the recession.
Uncertainty about the time frame of government ownership.
There will be opportunities for deals as governments sell off stakes
they have acquired, either as a result of the crisis, or other assets
they held previously. However, the timetable for disposals is
uncertain. Indeed, government involvement may provide breathing
space and delay immediate disposals, but companies should
actively monitor what assets governments may sell that fit their
corporate strategy. One thing is certain, the longer that
governments maintain their stakes, the greater the likelihood that
political rather than commercial factors influence deal making.
Questions to ask about the business
?
Have you analyzed the impact for your company and your
competitors of government bailouts and fiscal stimulus
packages?
?
Are you monitoring which companies might be potential M&A
targets if government bailouts reduce competition in their
sectors?
?
Have you developed good contacts with relevant government
agencies and their advisors so that you are aware of the
timetables for sale of assets and also of any further intervention
planned in sectors?
Challenge 4
Competitive dynamic
The M&A environment is being reshaped as cashrich corporates
move into a position of power while PE, hedge funds and sovereign
wealth funds (SWFs) cautiously remain on the sidelines. Corporate
buyers can now compete for deals from an equal or even
advantageous position relative to PE.
PE funds could benefit from the financial turmoil by partnering with
corporates who are keen to apply lessons from the PE model. The
 What’s next for corporate development? Opportunity and risk in the financial crisis
30
turbulence has brought opportunities for PE to accelerate
investment plans in areas including distressed debt and emerging
economies, in particular India and China. SWFs may also be
potentially valuable partners for corporates as many have large
cash reserves.
While governments continue to implement monetary and fiscal
policy initiatives aimed at bringing stability to the financial system
and softening the economic downturn, it may only be when hedge
funds, PE and SWFs decide the time is right for large-scale
bargainhunting that confidence will be restored in the market.
Hedge funds — Poor investment performance, reduction available
in credit from prime brokers and investor redemptions are
combining to create seismic changes in the hedge fund industry, as
excessive volatility in the market is making it difficult for either
quantitative or fundamentals-driven investment strategies to
succeed. Furthermore, strategies that rely on short selling have
been impacted as temporary, partial, or outright bans on short
selling have been introduced.
There will be a scramble to use so-called “gates” — provisions that
allow managers to limit withdrawals of investor cash — if requests
during a given redemption period exceed a specified percentage of
total assets. There appears to be a growing consensus among
managers that in the future investors will no longer be able to
withdraw their money after notice on a monthly or quarterly basis.
Instead, investors will likely be required to tie up their capital for
much longer periods. This development will call into question the
current industry standard fee structure (known as “two-and-
twenty,” where fees are equivalent to 2% of assets and 20% of
outperformance). Total fees will be lower and may even come to
resemble the structure used by PE funds, where performance fees
are determined by total investment return at the end of a multi-year
period. Some managers are already trying to negotiate such
changes as an alternative to using gates.
Private Equity — PE capital investments during the third quarter of
2008 were about one-third of the amount deployed during the
same period in 2007. This demonstrates the impact that
deleveraging is having. As public equity markets have declined, PE
asset allocation limits at pension funds and endowments have been
breached, necessitating portfolio rebalancing.
With initial public offerings (IPOs) and secondary buyouts almost
out of the question, traditional exit strategies are proving difficult to
implement. Accordingly, PE’s traditional hold period of three-five
years is likely to be extended, leading to a focus on business
improvement initiatives across portfolios in an attempt to deliver
the returns their investors expect. PE funds may also face
difficulties in refinancing a number of portfolio companies, notably
those that are highly leveraged and purchased on high multiples. As
PE funds encounter difficulties refinancing, “vulture” funds could be
expected to increase their activity.
Despite these challenges, some PE funds are expected to pursue
their disciplined approach to acquisitions with a view to deploying
their available capital at or near the bottom of the market. After all,
the profits of the vintage years of 2003-05 were made in
acquisitions before 2003, which were largely years of stagnating
growth as the dot com bubble burst. PE could very well be
positioning itself to do this again.
• Sovereign wealth funds — Early in the financial crisis, SWFs
provided funding to support the Tier 1 capital ratios of major
financial institutions. Other SWF investments at the time included
direct equity investments in a number of PE companies. However,
the steep fall in commodity prices, notably the decline in the oil
price, has hurt the growth outlook for some of the largest SWFs.
Furthermore, mark-to-market losses on early investments in the
financial sector have curtailed the risk appetite of some SWFs.
Investment losses across all asset classes are causing many SWFs
to re-examine their investment processes, asset allocations and
external fund manager selections.
While investments in US and European financial institutions were
previously viewed as opportunistic plays for cheap assets, SWFs
are now starting to consider foreign investments that are more
strategic in nature and that help to diversify future cash flow
streams away from traditional sources, such as oil revenue. In some
cases, these investments provide natural hedges for domestic
economic deficiencies or risk. At the same time, some SWFs are now
allocating significantly higher percentages of their assets to
domestic investments to counteract domestic financial sector
weakness or wider domestic economic issues.
• Emerging markets: national champions — National champions
are undergoing a revival as competition rules are relaxed in order to
consolidate ailing institutions and prevent foreign takeovers of
companies whose share prices have plummeted.
Some energy sector national champions are facing significant
liquidity issues, which in a number of cases has caused them to
breach triggers in financing agreements, causing their share prices
to fall. Governments have stepped in to relieve the immediate
funding risk.
National champions may currently be weakened by pressure on
their private sector financing; however, it seems likely that some
governments will step in to shore up the balance sheets of the
national champions. Competitors that lack this preferential
treatment will be at a distinct disadvantage and governments may
well encourage and facilitate acquisitions of weakened competitors
by national champions. Indeed, national champions are already
extending domestic dominance to international markets at a time
when liquidity is at a premium.
Implications for corporate development
Return of the strategic corporate acquirer. Cash rich corporates
have become dominant and face much less competition from PE in
the drive to buy strategic assets. The potential for creating
synergies and economies of scale through M&A has been boosted
by falls in share prices and the availability of bargain-price assets.
Corporates will find PE and SWFs more receptive to partnering in the
current environment. Opportunities to engage with SWFs will
remain particularly significant as the funds are cash-rich and will
benefit from any early recovery in commodity prices.
PE as partners. Corporate CDOs should reach out to PE for expertise
as well as resources. Joint ventures between corporates and PE
could work well for both parties, particularly in the current
environment. The ability of PE to create value regardless of
economic conditions has raised the bar for corporate acquisitions
and disposals. Companies, learning more about how PE invests, may
find themselves comfortable with PE partners bringing more cash
and less leverage to a collaborative deal.
PE firms’ longer hold periods may contribute to a greater sense of
alignment for companies that were previously sceptical about PE’s
famous “buy-to-sell” model. Deals are likely to be smaller with a
What’s next for corporate development? Opportunity and risk in the financial crisis
lower debt financing requirement than in the past. Financiers will be
supportive of those deals requiring a lower level of debt funding
which removes the need for syndication, less debt than in the past,
with a focus on emerging sectors including cleantech and
nanotechnology.
PE model still valid. Corporate CDOs should focus on the way PE
creates value in its portfolio companies by improving working
capital and cutting costs. PE investors have become increasingly
forceful, pressuring companies in which they invest to focus even
more on cash flows and value generation. PE is continuing to find
investment opportunities despite the market turmoil, capitalizing
on its ability to move fast and make tough decisions. The PE industry
is known above all for being innovative and successful — seizing
opportunities to strengthen company performance, growing in
emerging markets and taking advantage of opportunities to
acquire distressed debt.
Questions to ask about the business
?
Have you done a thorough review of assets potentially for sale
and their likely valuations?
?
What types of deal structures would you consider in the current
environment?
?
Do you know who the PE players are in your sector?
?
Have you assessed the benefits of a partnership with PE or a
SWF?
?
Do you have sufficient relationships with capital providers?
?
How quickly could you make a strategic acquisition or disposal?
Challenge 5
Governance and regulation
The global financial crisis has exposed the deficiencies of the
financial regulatory system. The effects of globalization and
financial innovation have made a system based on national
regulation partially obsolete.
Financial sector regulation — The G20 Leaders’ summit in
November 2008 marked the start of a process that may lead
towards a new global framework where international bodies —
particularly the International Monetary Fund (IMF) and the
Financial Stability Forum (FSF) — play a larger role. Although the
eventual specificities of cross-border regulatory cooperation
remain uncertain, change is likely in a number of areas that can
affect M&A activity:
• The introduction of stricter statutory rules governing bank
capital ratios seems inevitable. This would impact the volume
and nature of M&A activity. Some form of statutory oversight
could even potentially replace the self-regulated assessment
of credit risk under Basel II.
• Off balance sheet leverage through structured investment
vehicles (SIVs) is likely to be restricted and made more
transparent. This should expose off-balance sheet risks that
have previously been concealed.
• Stricter regulatory standards for complex securities could be
implemented as some have argued that fair value accounting
influenced the credit crisis by reporting a downward spiral in
asset valuations that exposed accelerating solvency problems.
31
• Executive compensation structures, particularly bonus
arrangements, may be regulated, possibly with restrictions on
share options and dependence on longer-term performance.
For governments that have bailed out companies, this measure
will be a popular route to appeasing public opinion, but will be
met with resistance from the financial sector and large
corporations.
• Credit ratings agencies are likely to see a tightening of
controls designed to avoid conflicts of interest. Establishing a
network of state funded ratings agencies is a possibility.
Regulation in the new competitive set. With the exception of a small
number of recent deals, SWFs still appear to be waiting for both
financial markets to stabilize and early protectionist responses
from Western governments to ease.
The IMF-convened International Working Group on Sovereign
Wealth Funds (IWG) released the Santiago Principles — also known
as the Generally Accepted Principles and Practices (GAPP) in
October 2008. The Principles seek to build trust between
governments of recipient countries and SWFs, thereby reducing the
likelihood of governments implementing protectionist policies.
While the Principles are voluntary and could have gone further in
the areas of transparency to the general public and accountability
— and their implementation remains subject to home country laws
— they should help alleviate concerns in Western economies. If
widely adopted, the Principles may obviate the need for further
national level responses. This would make it more likely for SWFs to
increase their investments in Western companies.
There have also been calls from politicians to apply tougher
regulation, particularly to hedge funds, but also to PE.
Changes in Corporate Governance — While the global financial
crisis cannot be attributed to a single cause, it remains clear that
the boards of financial institutions did not do enough to avoid the
financial collapse and that better corporate governance and risk
management needs to be implemented. Lack of transparency,
short-term remuneration packages, and opaque financial
structures all go against good governance standards. In the UK, the
Association of Chartered Certified Accountants has recommended
a series of measures that would impact boards of both financial
institutions and corporates including executive remuneration, and
shareholder protection.
• Climate change and sustainability — Climate change remains an
important issue that companies should not ignore despite the
competing priorities of the financial crisis. The European Union
already has a carbon emissions trading scheme, a similar scheme is
due to be launched in Australia in 2010 and the US is also likely to
introduce carbon trading in the next few years. Companies need to
identify the risks and opportunities across their existing businesses
and consider future investments needed to respond to the global
march toward carbon transformation. Development and execution
of a focused strategy on climate change can create cost cutting
opportunities, new sources of revenue, and prepare organizations
for a changing regulatory landscape as well as acting as a strong
marketing tool. While investors are accustomed to business
uncertainty, climate change policy influences almost all of a
company’s current variables and may introduce new challenges.
Areas of consideration include the effect of global efforts to
decrease greenhouse gas emissions on assets lives, property
portfolios, insurance, as well as water and energy costs.
• Businesses should focus on the following issues:
 What’s next for corporate development? Opportunity and risk in the financial crisis
32
• Building flexibility into the corporate decision-making
process to allow for modifications as emissions trading rules
and costs are clarified. Companies need to understand their
range of options.
• Scenario planning, including projections of carbon prices, will
be critical for valuing assets, developing realistic business
strategies and understanding the new risk threshold.
• Understanding the impact of carbon prices on energy costs
and the need to review energy supply contracts as well as
investigate energy efficiency opportunities.
• Assessing their ability to measure, provide and disclose
expected information on their environmental footprint across
their value chains in financial and non-financial reporting.
Historic, voluntary reporting of corporate and social
responsibility initiatives are likely to continue to be important
and of interest to various stakeholders. However, climate
change and carbon transformation will likely eclipse corporate
and social responsibility initiatives as an area of investor
interest. Investors will need to assess the value implications of
implementing a robust strategic carbon transformation policy,
and/or acquiring assets with strong related credentials, and/or
divesting assets with a poor carbon outlook. This is likely to
involve the implementation of improved practice standards for
investment decision-making and for monitoring investment
results.
Implications for corporate development
Uncertainty about upcoming regulation. There is a recognition that
a global regulatory response is necessary given the complexity
arising from the globalization of markets. Uncertainty about the
nature of new regulatory initiatives, both nationally and globally,
has created a lack of confidence at board level which has
contributed to the slowdown in M&A activity. In the short term, some
areas of regulation could be relaxed to spur entrepreneurial activity
and help lift economies out of recession. This could briefly open the
door for M&A deals that would otherwise not be possible. But in the
longer term, new regulatory efforts are likely to have a significant
impact on previously unregulated sectors such as hedge funds and
PE. Performance and incentive structures.
Growing public focus on the pay and performance of the board and
senior management, especially in the finance sector, will affect the
M&A landscape. Incentive structures linked to long-term corporate
performance may be imposed by regulation or implemented
voluntarily. This could affect the attractiveness of deals for both
buyers and sellers, and elevate talent retention as a key deal issue.
However, it remains to be seen whether support for such changes in
incentive structures will wane once the economy picks up. Climate
change increasingly important. Many companies have not yet fully
addressed the risks and opportunities for business practices and
investments that will be presented by new environmental policies
and developments, such as emissions trading. Portfolios will need
to be rebalanced to take this into account. CDOs need to develop a
detailed understanding of the environmental footprint of potential
acquisition targets. Acquiring first movers in environmentally
friendly technologies can lead to access to new markets and
products, as well as to knowledge transfer of innovative cost-
cutting methodologies, and assist with early adaptation to new
environmental regulation.
Questions to ask about the business
?
Have you considered new regulation and its impact on your
business? Do changes in regulation offer your company new
opportunities while restricting other activities?
?
What assessment of climate change issues will boards require in
due diligence when buying or selling an asset?
?
Have you got a strategy to allow your business to meet the
challenges of climate change?
10 CDO imperatives
The financial crisis will be a catalyst for the evolution of the CDO
role. CDOs must recognize they have a central role to play in guiding
their organizations through the crisis which goes beyond deal
execution.
A more strategic and rigorous approach will be required, supporting
the CEO and the board to ensure that the transaction strategy is
aligned with corporate objectives and transaction risks are
mitigated. In turn, CDOs will need to adapt their current practices
and develop new ones, these being the “10 CDO imperatives,” a
framework for taking the role to the next level:
Impact of the financial crisis on the transaction lifecycle
1 Respond to signs of organizational stress
As the financial crisis continues to evolve, companies need to
secure their positions by identifying and resolving critical issues
quickly to protect against value erosion or position themselves to
take advantage of opportunities. A holistic review of a company’s
ability to access liquidity, manage and release cash and control
costs is essential, before solvency comes into question. CDOs need
to recognize the signs of distress, both within their own
organizations and those of competitors and potential targets.
Within their own companies, CDOs should work with the CEO and
CFO to develop strategies to pre-empt and resolve issues.
Monitoring the signs of distress of companies in their sector, and
even competitors can help CDOs proactively identify opportunities
to acquire targets and grow market share.
Signals of a company in distress include:
• Profit warnings, covenant breaches and credit down-grades
• Major customers seeking alternative sourcing
• Credit lines being withdrawn
• Publicly traded debt selling below face value
• Unexpected boardroom or senior management departures
2 Actively assess your portfolio for strategic fit
Portfolio management — having a well-thought-out and executed
process for assessing and deciding which businesses to buy and sell
— becomes a key component of strategy. Because this analysis
leads to corporate development decisions — and because CDOs are
increasingly involved in strategy, integration and measurement —
the portfolio management process may justly be the CDOs purview.
To support management decision-making, CDOs can add value by
helping their organizations more accurately and routinely assess
the value and performance of their holdings, and their continued
relevance to, and role in, the pursuit of corporate objectives.
• Core assets — those that are revenue and cash-generating, have
What’s next for corporate development? Opportunity and risk in the financial crisis
33

growth potential and operational synergies with other businesses
— will need to be re-evaluated with consideration of competitors’
cost advantages, vulnerability of the supply chain, customers,
sector and market.
• CDOs need to have a clear understanding of those non-core
assets which should be disposed of to rebalance the portfolio
and reallocate capital, or could best be disposed of quickly
should the need to raise capital arise.
In assessing the portfolio, the CDO should ask a number of
questions:
CDOs should also be mindful of assets that may be financially
underperforming but which have long-term strategic
significance in delivering corporate objectives. Acquisitions in
new and emerging markets may take longer to achieve their
financial performance goals. However, to divest assets within
these markets in the current financial environment may mean
exiting the market altogether.
In leading practice companies, the head of strategy and the
CDO work together to balance the strategic and financial
criteria of the portfolio — combining the best strategic insights
and analysis with the discipline of corporate finance.

• What is the overlap between businesses and what synergies
are generated?
• What unique capabilities does the organization currently
have to add value and drive superior performance?
• Have events superseded the rationale for owning certain
businesses, or created the need to acquire new assets?
• What is the pipeline of opportunities relative to the ability to
fund new assets.
• Can newly acquired assets be adequately integrated and
managed?
3 Prepare your team to divest non-core assets
As the financial crisis forces companies to turn their attention to
capital preservation, identification of non-core assets for
divestment has become increasingly significant. Accelerated
divestments to dispose of non-core or underperforming assets can
release cash quickly and be an alternative to refinancing or
restructuring. However, many corporate development teams have
little experience with divestments and lack the skills to prepare
assets for sale and satisfy buyers and lenders expectations.
Furthermore, today’s market calls for creativity, recognizing there
are more sellers than buyers — companies need to be flexible and
should be prepared to consider multiple divestment options.

• What would the assets be worth to another company? CDOs must prepare, manage and execute a rigorous process that
maximizes value, avoids disruption to other businesses, retains

5 economics challenges:
Liquidity freeze
Market volatility
Government intervention
Competitive dynamic
Governance and regulation

Speed Business Transaction Transaction Transaction

Risk
strategy strategy execution effectiveness

10 CDO imperatives:
1 Respond to signs of organizational stress
2 Actively assess your portfolio for strategic fit
3 Prepare your team to divest non-core assets
4 Manage transaction risk
5 Build strategic relationships with alternative capital providers
6 Evaluate new deal & financing structures
7 Create more transparency of information to satisfy buyers,, investors and financiers
8 Pursue strategic acquisitions that can significantly enhance your market share and geographic footprint
9 Build a strong investment case and infrastructure to do deals quickly - both buy and sell
10 Assess impact of regulatory environment
 What’s next for corporate development? Opportunity and risk in the financial crisis
34
control of the divestment and mitigates transaction risk — and all
within the board’s time lines — be it 10 months or 10 days.
Once assets have been identified, the divestment process should
begin with an exit readiness assessment. The primary objectives of
this assessment should be to:
• Gauge the preparation and time frames required to bring the
asset to market
• Assess what additional information is required to satisfy
buyers, boards and capital providers
• Assess the skills and resources required to undertake the
divestment and confirm the availability of the necessary
internal and external resources
• Identify tax implications and the breadth of due-diligence
required
• Identify likely buyers and their appetite and capability to
complete the acquisition
4 Manage transaction risk
Working in conjunction with the company’s chief risk officer (or
equivalent), the CDO should focus on identifying specific risks
presented by a transaction. The risk assessment should quantify the
probable impact and address ways to mitigate the possibility of
negative outcomes. Risks and integration strategies should be
included in the business case.
The CDO should ensure that appropriate transaction risk,
management processes are included in the organizations formal
transaction framework. These will become increasingly important
given the complexity and uncertainty inherent in the current deal
market, and the speed with which decisions will need to be made,
particularly in respect to distressed assets.
To facilitate risk mitigation, CDOs should utilise a risk framework
that includes strategic, financial, commercial, operational,
regulatory and legal risks, leveraging the required expertise from
both within the organisation and from external advisors.
5 Build strategic relationships with alternative capital providers
With banks facing difficulties and rationing credit, organizations
can no longer rely on traditional capital providers they’ve dealt with
in the past. Working closely with their treasury colleagues, CDOs will
need to be at the forefront of identifying alternative sources of
capital and building strategic relationships with the key players.
CDOs should also begin to develop an ongoing dialogue with a
limited number of alternative capital providers including PE and
SWFs, both of whom may consider alternative funding structures
and risk/return models in comparison to commercial lenders. The
time needed to invest in these relationships — particularly with
SWF’s — should not be underestimated.
In seeking new providers of capital, the CDO must recognize that
their organization will be competing with many other investors for
attention. Accordingly, CDOs must look to build a compelling
proposition based on a deep and clear understanding of the
motivations, activities and preferences of the capital providers.
6 Evaluate new deals and financing structures
With cheap debt no longer available, and boards seeking to limit the
capital available to fund M&A activity, CDOs will need to have better
visibility of the financing capability of their organization. A closer
relationship with treasury colleagues will be important when it
comes to understanding deal-specific funding options.
CDOs will need to remain flexible with their approach to the
structuring and financing of deals. Innovative deal structures and
financing techniques are becoming more common in the market
and new approaches and options will need to be scrutinized
carefully. Some all-equity deals have occurred already, with the
possibility of refinancing when debt markets recover, while the use
of preferred securities, vendor financing and asset swaps has
emerged since the financial crisis began. Where a target’s debt is
publicly traded, this may present another option for more flexible
CDOs to take a position within the capital structure of the target with
a view to acquiring control in the event the target becomes
distressed.
7 Create more transparency to satisfy buyers, investors and
financiers
At the height of the M&A boom, in a sellers market, auctions were
the preferred method for divesting, and creating maximum
competition for assets. This led to a structured and impersonal
sales process, where data rooms and Q&A were run by the deal
advisers, with limited access, if any, to management.
With the balance of power now shifting to buyers, CDOs need to be
mindful of the information they will be expected to provide before
an investor will commit to a transaction.
When divesting assets, CDOs will need to be proactive in their
identification, and engagement with potential acquirers, and build a
better understanding of their value drivers and preferences. They
will need to go beyond merely providing information that is readily
available, to selecting the most likely acquirers and working with
them to demonstrate how the potential acquirer can create
sufficient value from the asset to warrant the vendor’s price
expectations. This will involve articulating the synergies between
the asset for sale and the acquirer’s own business, and identifying
operational improvements that could be implemented by the
bidder. This may also require the CDO to provide the information
necessary to support the acquirer’s business case. This targeted
assistance and information will help to bridge the value gap
between the price expectations of buyers and sellers. Particular
attention should be paid in the planning stage of a divestment to the
additional management time required to supply this information.
On the buy side, acquirers will need to manage key stakeholders
carefully and to ensure acquisition propositions receive the
appropriate level of support. This will involve understanding of the
expectations of CEOs, board members, financiers and shareholders
and explaining the rationale for a deal and the proposed financial
basis on which it will be done. The quantity and clarity of
communications to the market will be critical to keeping them both
informed and satisfied, and ultimately to ensuring the deal is
completed.
8 Pursue strategic acquisitions that can significantly enhance
your market share and geographic footprint
Given the increasing levels of company distress and number of
organizations reassessing their portfolio, there are likely to be
significant opportunities in key markets and sectors for the
attentive and well-prepared CDO. Distressed assets aside, it is likely
What’s next for corporate development? Opportunity and risk in the financial crisis
35

that many organizations will be forced to dispose of some high-
quality assets to raise capital, in preference to issuing equity at a
deep discount. CDOs need to be proactively identifying such assets
and assessing the fit with their own portfolio and corporate strategy
so that rapid but well-informed decisions can be made when such
assets do come to market. In some cases CDOs may even consider a
pre-emptive proposition.
CDOs should be wary of apparent “bargains” that are not aligned
with the corporate strategy of their organization. With ongoing
market volatility, limited capital to be invested in M&A activity and
an increase in transaction risk, CDOs need to remain very focused
and disciplined and have a pipeline of opportunities constantly
being assessed, updated and either retained or removed from the
pipeline as events unfold. This will require informed market
intelligence and sufficient due diligence enquiries to satisfy
themselves of the quality and suitability of both the counterparty
and asset.
becomes a major factor.
However, it is likely that governments will increasingly turn their
attention to the underlying causes of the financial crisis and seek to
respond with what they consider to be appropriate regulatory
measures in an attempt to avoid a repeat in the future.
CDOs will need to monitor government announcements and
developments to keep informed of the likely regulatory responses,
notably where it might impact on the sector within which their
organization either operates, or is seeking to expand into. New
regulation can have both positive and negative impacts, and
sometimes unintended consequences. It is critical that the CDO
assesses the value implication of new regulations, from either a
buyor sell-side perspective depending on their focus, and respond
appropriately. For example, this may mean bringing transaction
time lines forward, removing assets from the market or positioning
the organization for deals that might be triggered by any new
regulation.

9 Build a strong investment case and infrastructure to do deals
quickly — both buy and sell
With pressure on companies to justify their transaction outcomes,
the CDO has an important role to play between the investment
propositions of the business units and the ultimate preparation and
presentation of the investment case. CEOs and board members will
be increasingly mindful of shareholder dissatisfaction, leading to
increased scrutiny of major decisions, and will be seeking robust
support before approving transactions. This is likely to involve more
scenario planning and sensitivity analysis than in the past, in an
effort to consider a broader range of outcomes, and the downside
risk involved.
The CDO can play a key role in addressing stakeholder issues and
helping their organizations build support for transactions, clearly
highlighting the alignment between the deal and the organization’s
corporate strategy. Capital providers will also expect a sound
investment case — SWFs in particular will be looking for the
relationship to create value within their own organization and
portfolio of investments whether through a transfer of technology,
management expertise or skilled personnel.
It is likely that climate change regulation will remain at the forefront
of government and international agencies policy making, and CDOs
will need to respond by either understanding the environmental
footprint of possible targets, or the value implications of
environmental regulation on existing assets, particularly if they are
to be sold.
Acknowledgment
The Conference Committee is thankful to the authors and EYGM
Limited for their kind permission to reproduce this publication.
Disclaimer
The views, opinions and conclusions expressed herein are those of
the individual authors. They do not reflect the views of The Institute
of Chartered Accountants of Pakistan. The Institute does not
endorse any views expressed herein.

In addition, CDOs should consider the speed with which some deals,
notably those involving distressed assets, are likely to occur.
Streamlining the approval process ahead of time may put their
organization at a competitive advantage in the case of a fire sale of
distressed assets where timing will be critical and the ability to act
quickly may become a strong negotiating tool. Conversely, some
deals will have an extended time frame and perseverance will be
required. If a debt raising is involved, progress will depend on
satisfying financier requirements, including a more detailed due
diligence effort. Boards will also need to be satisfied about the
impact of any transaction on shareholder value.

CDOs will need to ensure they have the appropriate support and
infrastructure in place to enable them to proactively identify deal
opportunities and to respond quickly. This will require constant
dialogue with business units and virtual teams, and the ability to
mobilize deal team and external advisors quickly.

10 Assess impact of regulatory environment

Governments, notably in Western economies, but increasingly in a

number of emerging economies, are focused on introducing
immediate initiatives to re-inflate their economies in an attempt to
stave off the worst of the downturn and eliminate deflation before it