USA Inbound Acquisitions & Investments Blog : Inbound Investment Lawyer & Attorney : Sullivan & Worcester Law Firm : Mergers & Acquisitions, Cross Border Investments

Does 2010 mean a renewal of inbound M&A activity? We have put the question to well-qualified investment bankers to get professional views. Brian McDonald, a Managing Director in the M&A Group of Houlihan Lokey, an international investment bank, has some very positive views. Brian has been a banker for over 20 years, advising both publicly traded and privately held companies in various industries. He has advised on numerous cross-border transactions.

USAInbounddeals: Commentators have pointed out that the level of M&A activity in the United States for mid-market businesses was lower in 2009 that it had been for several years. Are you forecasting an increase in M&A activity involving mid-size U.S. businesses for the remainder of 2010 or 2011 over 2009’s activity level? Can you suggest what the reasons for any increase might be? 

Brian McDonald: At Houlihan Lokey, we expect to see an increase in activity in 2010 and beyond, and we have already seen an increase in deal backlog. There is both pent up supply and pent up demand for transactions due to the lull in activity during the recent period of market disruption. Now that equity valuations have stabilized and the financing markets have begun to recover, we expect an uptick in M&A activity as buyers and sellers return to the market.

After the recent volatility in the equity markets, shareholders of family owned businesses are much more cognizant of the risks inherent in holding a significant portion of their net worth in illiquid stock of a single, small private company. Many such shareholders are now considering a sale, even though valuations are down from their pre-crisis highs. Also, long-term capital gains tax rates are expected to increase from 15% currently to at least 20% or 25% in 2011, providing an additional incentive for sellers to sell now rather than later. 

Private equity sponsors with older vintage portfolio companies need to sell those companies to return cash to their limited partners, so the current stabilization in valuations provides an opportunity to market those transactions. Corporates are also rationalizing their portfolios and exploring divestitures to either deleverage or to redeploy capital in their core businesses. 

Buyers also have a strong rationale to transact. Many large corporates have built up significant cash reserves by cutting expenses, reducing capital expenditures and reducing dividends. In 2009, many corporates were able to increase earnings even as revenues declined, because they reduced expenses significantly. This cannot be easily repeated in 2010. And since the economy is not expected to grow rapidly, these corporates will try to grow by using their cash reserves to make acquisitions. 

USAInbounddeals: If you believe that an increase will occur, are you predicting an increase in the activity level of foreign-based buyers (including their existing U.S. businesses) in the U.S. market? Are you willing to estimate how significant this increase might be? 

Brian McDonald: In recent years, foreign buyers have increasingly been active in the U.S. middle market. We believe that their demand for U.S. businesses will further increase in 2010 for a couple of reasons. First, the U.S. economy is expected to recover from its recession sooner and more rapidly than Europe. Therefore, European buyers will likely continue to look to the U.S. for growth acquisitions. Also, the recent sustained appreciation of the Euro relative to the dollar appears to be headed towards a reversal, particularly with the fiscal crisis in Greece. If European buyers conclude that their window for buying U.S. assets at “sale” prices will soon be closing, they may decide to jump in before the window closes. 

Asian buyers, particularly Japanese and Chinese buyers, have also been active, but less consistently. We expect buyers from these countries to continue to appear in select middle market transactions.

USAInbounddeals: Do you believe that specific U.S. industries are more likely to see increased interest from foreign investors or buyers? What might those industries be? 

Brian McDonald: We have seen the most foreign buyer interest in the industrial sector, real estate, and infrastructure services and materials.

USAInbounddeals: Are sell-side clients actively asking you to seek out foreign buyer interest? 

Brian McDonald: Yes. Sell-side clients often seek foreign buyers for several reasons. Most importantly, sellers want to maximize value and they recognize that foreign buyers can often pay more due to a strong currency or unique strategic considerations. If a foreign buyer views a U.S. business as a way to establish a platform in the U.S. or gain access to U.S. distribution channels, they may place a significantly higher value on the acquisition than a U.S. acquirer would.

Another reason sellers like foreign buyers is that they often represent the least disruptive buyer for the employees. If the buyer does not already have a U.S. business with which to integrate the acquisition, the buyer will typically retain most employees.

USAInbounddeals: Are you aware of any concerns in the M&A marketplace that the U.S. government’s screening of inbound deals makes them more difficult to complete?

Brian McDonald: Yes. Companies that service the defense sector or that sell directly to the government are often reluctant to include buyers from sensitive countries on their buyers list. Even if the seller is willing to invite a foreign buyer into the sale process, some buyers are reluctant to participate if they are concerned that the U.S. government may reject the transaction due to national security concerns. We have even seen this behavior by private equity funds that have significant limited partner equity from countries in the Middle East, for example.

This article is intended for informational purposes only and reflects the opinion of Brian McDonald, a Managing Director in the M&A Group of Houlihan Lokey. The material presented reflects information known to the author at the time this article was written, and this information is subject to change. 

About Houlihan Lokey

Houlihan Lokey provides a wide range of advisory services in the areas of mergers and acquisitions, financing, financial restructuring, and valuation. The firm was ranked the No. 1 M&A advisor for U.S. transactions under $3 billion in 2009 and the No. 1 U.S. fairness opinion advisor over the past 10 years by Thomson Reuters. In addition, the firm advised on more than 500 restructuring transactions valued in excess of $1.25 trillion over the past 10 years. Notable engagements cover numerous sectors and virtually all of the largest U.S. corporate bankruptcies, including Lehman Brothers, General Motors, WorldCom and Enron. The firm has more than 800 employees in 14 offices in the United States, Europe and Asia. Each year Houlihan Lokey serves more than 1,000 clients ranging from closely held companies to Global 500 corporations.

For more information on Houlihan Lokey, visit www.HL.com.

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FDI promises to grow in importance to both developed and the developing economies in the new year. The world economy as a whole has not fully recovered from the slowdown of the past three years. What recovery has occurred has been selective, leading to stronger economies in some cases and leaving weaker economies in others. The imbalance suggests that opportunities for cross-border investments and M&A activities will abound and that those businesses, funds and individuals that have available capital will likely pursue them.

Heightened FDI activity will raise issues in the media, in academia and elsewhere. The issues that will garner the greatest attention are likely to be:

• Protectionism. If there is a sudden, large upturn in FDI into developed economies, will more inbound transactions be challenged by regulatory authorities? At the end of 2009, the Obama administration prevented the acquisition of FirstGold by a Chinese acquirer on national security grounds. Will this be interpreted as protectionism disguised? CFIUS has rarely outright blocked deals in the past, so a moderate increase in number of challenged deals may well be interpreted as a change in political attitude. Complicating the assessment is that foreign buyers will likely be shopping for natural resources business and high technology firms – both of which may have assets that are inordinately valuable and difficult to find elsewhere. These values may raise the stakes to investee nations when control of these assets is shifted offshore.
• Credit Squeeze. Buyers and investors with strong credit lines will likely be very attractive to targets who are starved for debt and equity capital. Distressed assets are in strong supply and can often be revitalized with infusions from capital from new owners with adequate capital supplies. Will buyers and investors remain disciplined and limit their capital at risk, or will there be “shopping sprees” as holdout sellers give up, price spreads narrow and well-endowed players run the table?
• FDI Extends the Service Sector. Economies that have built their capacities and economic fortunes on exports of manufactured goods with price advantages will seek to compete more aggressively by incorporating more of the value chain into their enterprises. They may wish to acquire design capability and marketing interface directly with their ultimate customers. Confronted with the question of “buy or build,” some businesses will look to acquire or invest in businesses that provide those services. This means businesses whose assets go home at night. From an operational perspective, this will raise issues of conflicting corporate cultures. Return on investments into service companies can also be more difficult to measure than investments in hard assets. The range of results on these deals will likely be broader than in other investments.
• Developed Assets More Desirable. For investors in the U.S. and Europe, assets – both hard and soft – that are developed and therefore require minimal additional expenditure, are likely to be more desirable than those requiring considerable additional investment. Consequently, in both developed and developing economies, greenfield investments may have a difficult time competing for investment capital. For outbound investors in China – where capital appears to be less constrained and risk tolerance may be greater – greenfield investments in the energy and agricultural sectors will remain top priorities. There may be a strong divergence that is building, with those economies and businesses in need of significant capital infusions turning away from investors in the developed nations and looking almost exclusively to investors in emerging economies.
• What Direction for Global M&A? The year 2009 brought a large number of strategic cross-border mergers and acquisitions, many with high profiles. The trend toward consolidation within industries will accelerate – the Kraft/Cadbury transaction being the poster child for these deals. Absent from the space at this time are the financial players, such as the private equity funds who have relied on leverage to complete their acquisitions and generate their returns. Will private equity and other private investors step back into the ring before credit has become more available, or will financial deals continue to lag strategic deals? The lack of clarity ahead for many businesses also adds uncertainty regarding valuation and pricing. With these factors taken all together, the return of robust cross-border M&A transactions does not seem imminent.

If we gain information on these FDI issues in the next six months, then the last half of 2010 may appear to be more predictable, especially if it is more in line with past trends. Given the change in direction that 2008 and 2009 brought compared to the immediately preceding years, any predictions – at any point – may deny the reality that volatility persists, even in FDI.

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Late last week reports surfaced that the China National Offshore Oil Corporation (Cnooc), China’s state-owned energy company, was in unconfirmed discussions with Norway’s StatoilHydro ASA to acquire oil lease interests in the Gulf of Mexico. A completed transaction would open up oil reserves in the U.S. Gulf to China for the first time. The fact that a Chinese company is involved has led to speculation whether the U.S. will resist this particular foreign direct investment, recalling the political furor that resulted in Cnooc’s unsuccessful 2005 bid to acquire Unocal Corp. 

Environmental Capital blog linked to a Wall Street Journal’s report that StatoilHydro had put five prospects up for sale, a small portion of its Gulf of Mexico assets. The Financial Times wrote that the transaction would have a value of approximately $100 million and that the proceeds would be used to cover the costs of drilling wells rather than to obtain acreage. According to Energy-pedia, StatoilHydro will remain majority owner of any projects for which it brings in partners, noting that oil companies typically offer partnerships in large exploration projects to help pay for drilling and spread risk. 

Generating alarmism, Business Insider first claims that China’s overseas acquisition program is approaching the U.S. and then becomes somewhat more balanced: 

[T]he political tides have changed. In 2005, it was easy to block investments on political grounds, because there was no shortage of cash. Plus, this is just a few leases -- putting their toe in the water, it looks like -- not an $18.5 billion bid for a U.S. company.

Still expect all kinds of howls before this goes through.

Assume that the media has accurately outlined the transaction. Will the transaction between StatoilHydro and Cnooc be a “covered transaction” under the Foreign Investment and National Security Act of 2007 (FINSA)? If so, will the parties then make a voluntary filing with the Committee on Foreign Investment in the United States (CFIUS)?

Not every transaction involving a non-U.S. investor and a U.S. business is subject to FINSA. Only a transaction that “could result in control of a U.S. business by a foreign person” is. A transaction that satisfies this transfer of control test is a “covered transaction.” But not every “covered transaction” is subject to FINSA. The general structure of FINSA is that parties to a covered transaction may file a notice with CFIUS for its review and, possibly, further investigation or Presidential action. If the parties do not file a notice, then CFIUS can block the transaction or later unwind it. The purpose of the CFIUS review and investigation is to determine whether the proposed transaction might impair U.S. national security. 

CFIUS has published regulations that detail the coverage of FINSA, the review process and the contents of the voluntary filing. Applying the facts of the Cnooc discussions to the regulations produces some interesting results:

Does the fact that a Norwegian entity owns the oil leases save the deal from regulatory review? No. A U.S. business is subject to the regulations and to FINSA regardless of the nationality of the person that controls it.^[1]

Are the oil leases a U.S. business? To be a U.S. business, the leases must be an entity engaged in interstate commerce in the United States.^[2] Are they? The regulations define “entity” to include “assets (whether or not organized as a separate legal entity) operated by any [other entity] as a business undertaking in a particular location or for particular products or services.”^[3] Therefore, the leases could be an “entity.”

If the leases are an entity, is the entity engaged in interstate commerce in the United States? The wells are offshore, and not located within the boundaries of any state of the United States, as can be seen from the map published by Energy-pedia. The media coverage says that the leases are located in the “U.S. Gulf.” Is that a state or is it not?

Also, since the wells appear to not yet be operating, are the assets engaged in any commerce at all?

Under the regulations, certain transactions are not covered transactions, including the “acquisition of any part of an entity or of assets, if such part of an entity or assets do not constitute a U.S. business.”^[4] There is an example in the regulation of a foreign person acquiring individual discrete assets -- including land -- from a U.S. business. The example concludes that the acquisition is not a covered transaction. 

If its purpose is to finance drilling, rather than to obtain acreage, then the proposed transaction is an investment, not an acquisition. FINSA, however, applies to investments if control is tranferred. The structure of the deal may be that Cnooc will obtain lease interests. If these interests do not have rights to vote for directors or vote on other matters affecting the entity, then the interests are not voting interests and there may be no “control” aspect to the transaction at all.^[5]

Lastly, if Cnooc is acquiring interests from StatoilHydro without any intent to exercise control, then Cnooc may be acquiring the interests or the leases “solely for the purpose of passive investment,” and the investment may be exempt from FINSA on that basis.^[6] The observation that StatoilHydro intends to remain in operating control supports this view. 

Overall, there could be several bases for the legal conclusion that the proposed deal would not be a covered transaction under FINSA. Cnooc and StatoilHydro will no doubt take their own business assessment of their situation. It will be interesting to see if the views coalesce or diverge. 

All references are to Sections of the CFIUS regulations: 

^[1] Section 226

^[2] Section 226

^[3] Section 211

^[4] Section 302(c)

^[5] Section 228

^[6] Section 302(b)

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How much merger and acquisition and other investment activity is directed into the United States? Is the level of foreign direct investment into U.S. businesses increasing or decreasing?

The Commerce Department’s Bureau of Economic Analysis has released three reports that provide measurements. The first, by Thomas Anderson, addresses new investments made to acquire or establish U.S. business in 2008. The chart included in this post shows annual outlays measured by this report. 

Significant findings contained in the report include:

• Foreign direct investors made outlays of $260.4 billion of outlays in 2008 to acquire or establish U.S. businesses. This level is the third highest on record.
•  46% of these outlays were for large-sized transactions ($5 billion or more), double the percentage of large-sized transactions for 2007.
•   2008’s level of these outlays was a 3% increase over 2007’s level of $252 billion. The rate of increase for 2007 over 2006 was 52%.
• Outlays for manufacturing businesses accounted for the majority of spending in 2008, with outlays for financial services businesses a distant second.
•  European investors made 61% of the outlays; Asia and Pacific made 17%. Outlays from Canada and the Middle East fell to 10% and 5% of the total.
•  Of the $260.4 billion total, 93% of the outlays were made to acquire existing businesses, with the balance to start up new businesses.

In April, the BEA had released its report on U.S. international transactions for 2008. Net financial inflows for foreign direct investment into the U.S. were $325.3 billion, an increase of 37% over 2007’s level. These inflows included financing of both existing and new U.S. affiliates and also reflected sell-offs and other subtractions and additions. They also excluded domestic-sourced funds that are used to make new investments. 

Earlier this month, BEA revised the $325.3 billion number for 2008 FDI downward by $5.5 billion to $319.7 billion. Because of a substantial upward revision to FDI reported for 2007, the new 2008 level represented a 16% year-over-year increase.

BEA has discontinued its survey that measures new foreign direct investment. Therefore, there will be no future reports on new FDI comparable to the first report referred to above in this post. Future surveys will collect related information on greenfield investments by foreign direct investors and their U.S. affiliates. BEA will also collect extensive data on FDI in the U.S. through its quarterly and annual surveys.

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Chinese regulatory authorities have taken an important initiative to encourage outbound FDI from China. U.S. private equity funds and other owners of businesses desiring investment should take note of these changes. These developments also are significant for investment bankers and other intermediaries, as the steps should enhance their ability to broker strategic arrangements. 

In June, China’s State Administration of Foreign Exchange (SAFE) announced that new regulations loosening its control on outbound investment procedures would take effect on August 1. SAFE will also modify its controls over foreign exchange management of domestic companies with overseas investments. The announced policy purposes of the modifications are to:

• stabilize external demand for domestic products;
• increase the efficient use of funds by Chinese enterprises; and
• support the “go global move” of enterprises “of diverse ownership” to stimulate exports.

The major changes that SAFE announced are:

•  “qualified enterprises of diverse ownerships” now can make overseas loans;
• sources of funds for overseas ownership are expanded and can include self-owned foreign exchange and foreign exchange purchased with Chinese currency;
• streamlining of procedures for overseas lending, which will be decentralized; and
•  improvements to statistical monitoring of, and risk prevention for, overseas lending.

In a related development, a former assistant professor of economics at an Indiana university has been promoted to chief of SAFE. The appointee, Yi Gang, is also a vice governor of the Peoples Bank of China. Mr. Yi taught at Indiana University-Purdue University Indianapolis from 1986 to 1994.

The changes announced by SAFE are likely connected to China’s accumulation of foreign exchange. The Financial Times reported on July 15 that China’s foreign reserve position had increased beyond $2.1 trillion. The merge results from capital inflows to take advantage of faster economic growth and inflating asset prices. These trends arise from the view that China’s economic recovery will be sustained, with GDP growth for the second quarter of 2009 expected to approximate 8%.

The Contrarian Investor’ Journal has opined that the next logical step will be towards the eventual float of the RMB, cautioning that the float will not happen imminently.  

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Earlier this month the U.S. State Department clarified its position on the importance of inbound foreign direct investment (FDI) to the U.S. economy. State released a fact sheet on July 1 entitled "The State Department, Open Investment, and American Jobs."  The fact sheet underscores the importance of FDI to economic growth and job creation in the U.S.

The fact sheet credits the Committee on Foreign Investment in the United States (CFIUS) with concluding action on over 150 transactions in 2008. This represents an increase of at least 9% over the 138 transactions that CFIUS reviewed in 2007. Of the 2008 transactions, 92% were mergers and acquisitions of U.S. businesses. The balance was likely to have been joint ventures or loan transactions. The State Department points out that, as a result of its membership on CFIUS, it has a direct role in the rulings that the panel makes.

Without doubt, inbound acquisitions and investments are quantitatively significant. In 2006, U.S. inbound FDI totaled $236.7 billion, or 1.8% of GDP. U.S. affiliates of foreign firms spent $395.8 billion on U.S. payrolls and $34.3 billion on U.S. R&D.

Because of these direct economic effects, the State Department wants its message to be crystal clear:

The United States has a significant stake, as both the world’s largest source and recipient of foreign direct investment, in working with our economic partners both multilaterally and bilaterally to implement policies that facilitate global investment flows.

State’s pronouncements and their forceful delivery add to the expectation that inbound FDI will assist in pulling the U.S. economy out of its current slump.

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