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• For the second half of 2009, deal activity remains sluggish but is showing signs of modest acceleration.
• Deals continue to get done, but the types of deals that are completed, and the way these deals are financed and executed, has changed significantly.
• The new "normal" is defined by continuing uncertainty, weaker demand and margin erosion, scarcity of capital and more risk-aversion in strategic decision making.
• Managing all aspects of the capital agenda is the best way to manage the new normal.

(NEW YORK, NY) -- There is always hope in everything - even for a plodding U.S. real estate capital market, concludes Ernst & Young LLP's Transaction Advisory Services in a detailed recap of the market's performance in the past 10 years.

Bluntly, the accounting and consulting firm's TAS unit expects capital to remain scarce in 2010 but still sees a modest pickup beginning at some time during the year.

Here is the firm's outlook:

"In this deal environment, the margins for error have narrowed," says Rich Jeanneret, Ernst & Young LLP, Americas Vice-Chair, Transaction Advisory Services.

"Many companies feel inclined to stash cash and be reactive, but winning companies will be those that have the confidence to use their capital to seize opportunities."

Winning companies are looking to mergers and acquisitions (M&A) as a means to generate top-line growth.

According to Ernst & Young's "Why capital matters" survey, 25% of businesses are likely or highly likely to make an acquisition in the next six months, rising to 33% in the next 12 months and 41% over the next 12 to 24 months.

"While it is likely that deal activity may not return to pre-crisis levels within the next few years, there is some cause for optimism when looking at the three drivers of deal activity: confidence, credit and cash," says Steve Krouskos, Americas Markets Leader for Ernst & Young LLP's Transaction Advisory Services.

Confidence

Market confidence, starting with consumer confidence and extending to confidence in the credit markets and confidence on the part of investors, is the primary driver of deal activity.

The Dow Jones industrial average, which measures this idea of market confidence, has tracked to the M&A market for more than a decade.

With the Dow reaching a 14-month high in December of this year, higher levels of deal activity may be expected to follow.

Credit

Credit has been the primary restraining factor in deal activity over the past year.

In an Ernst & Young survey, 62% cite insufficient financing as a key issue preventing deals from getting done.

During the second half of 2009, there was a slight resurgence in the credit markets, spurring select deals, although for the most part, continued market uncertainty has left banks hesitant to lend.

Cash

Shaken by the financial crisis, companies are holding on to more cash - and a greater percentage of assets in cash - than at any time in the past 40 years, The Wall Street Journal reported in November 2009. Fortune 1000 companies have more than $1.8 trillion in cash on hand, an increase of $271 billion over last year.

"With the levels of cash companies have on hand, once confidence returns, companies will be well-positioned to start buying," says Krouskos.

The new transactions landscape is defined by the following factors:

Smaller deals: The $5 billion or more mega deals of previous years will now most likely be few and far between. In fact, only 145 completed deals broke the $1 billion mark over the past year, versus 400 in 2008 and 609 in 2007.

Quickly moving environment: Deal windows are opening more quickly but closing just as fast. Winning companies are taking steps to become more nimble.

More intense due diligence: Fifty-three percent of companies are conducting more rigorous due diligence.

Aspiring buyers want to make absolutely sure of the strategic fit before embarking upon an acquisition.

A rise in non-traditional deal structures: Includes the use of seller paper to close the deal and the use of private placements for cash infusions.

There has also been a rise in earn-outs - a structure that helps mitigate the risks associated with accurate valuation in today's volatile market by allowing for contingent payments dependent upon future performance objectives.

Fifty percent are exploring innovative and alternative sources of funding and an additional 25% are considering doing so.

Looking for growth abroad: Fifty percent of those companies considering acquisitions are doing so in order to enter new geographic markets.

Emerging economies, which are expected to grow by 5% in 2010 versus 1.25% growth in advanced economies, are particularly appealing to companies trying to achieve growth in an otherwise flat market.

Brazil

Aided by improved monetary and fiscal policies, robust financial sectors, and macroeconomic strengths built up in the boom cycle of 2003-2007, Brazil is an economy that has weathered the recent economic storms very well.

As a result, there has been a lot of interest in Brazil from PE and corporate buyers in the US and around the world, and there is an expectation that Brazil will continue to be attractive to investors for the long term. The country's gross domestic product (GDP) is expected to grow 5% in 2010.

In addition, recent oil discoveries in Brazil suggest that the energy sector is likely to flourish over the next few years.

And, recent improvement to its investment grade by the three main rating agencies for the country has attracted many foreign investors to the market, including an uptick in interest from China.

The developing middle class' purchasing power has also fueled growth in consumer demand. The country's infrastructure is primed for growth, with development under way for the soccer World Cup in 2014 and the Olympics in 2016.

China

Even as the financial crisis shakes the rest of the world, China's economy has picked up over the course of the year, and inbound deal value jumped 75% in 2009 over the prior year.

This primarily reflects strong domestic demand across many sectors, largely influenced by the government's stimulus plans particularly into the infrastructure and construction sectors.

Real estate values have remained robust, promoting confidence in the overall economy and leading to strong consumer demand. The government's monetary policy has also allowed significant liquidity to exist, providing further stimuli across most sectors.

A dramatic decade in deals

2000-2009 has been filled with dramatic ups and downs.

The technology boom sent global deal volume skyrocketing, reaching a record-breaking $1.2 trillion in completed deal volume during the second quarter of 2000---the highest quarterly volume on record.

The subsequent technology bust affected the US and global economies.

This turmoil was compounded when the events of September 11, 2001 sent markets into turmoil, tanking global deal volume by more than 60% versus the highs of the prior year.

The global economy began to rebuild, and in 2004 deal activity began to pick up.

In 2005, fueled by cheap, easily accessible debt, we saw the re-emergence of the mega deals. This momentum continued to build through 2007 until it peaked during the fourth quarter of the year, with deal volume almost hitting $1.2 trillion.

One of the pistons behind the engine of deal growth was the PE industry, which flourished during the decade.

This class of investor put a record amount of capital to work during the early to mid-portion of the decade.

Fueled by easy-to-raise leverage, increasing leverage multiples, and larger fund sizes, PE acquisition volume grew to new heights.  PE-backed businesses divested in this period delivered impressive returns to its investors.

The activity continued unabated as PE buyout activity peaked in 2007, with $794 billion in buyouts recorded.

In 2007, exuberance ran at an all-time high. Corporates and PE firms profited greatly, as did their shareholders, leading to a sort of market amnesia with even the most hardened professionals forgetting that markets run in cycles.

As we moved in to 2008, the notion of this cyclical reality became front-page news.

The decline in the housing market accelerated. As equity markets dropped and margins were called, credit and paper seized.

Bankruptcies rose and high-yield bond issuance soared as struggling companies sought to stay afloat by raising cash to pay down or refinance their debt.

A steep decline in PE deal activity followed, as the transaction market effectively ground to a halt.

As noted in last year's Ernst & Young transactions recap, this slowing trend continued into 2009 when only 184 US PE deals were announced during the first three months of the year---the lowest quarterly volume since the fourth quarter of 2002.

And with deal value at $5.5 billion, it was the lowest reported quarterly deal value this decade.

Corporate M&A also came to a virtual standstill, with only a little more than $1 trillion in global deal value completed during the second half 2008 --- a 42% drop below the same period in 2007.

This trend continued well into the first half of 2009 as Ernst & Young predicted last year, with prospective buyers shifting their focus to cash conservation and, at the same time, struggling with higher borrowing costs and lower projected free cash flows.

During the second half of 2009, we began to see a modest pickup in activity. So far, completed deal value through the end of November for the fourth quarter of 2009 is $275 billion, roughly in line with fourth quarter 2008 deal value of $298 billion.

"We are seeing increased momentum," says Krouskos. "The pipeline is increasing. Market fundamentals are strengthening, and deal activity is stabilizing. Still, the market is full of mixed signals, which are expected to temper recovery."

Valuations are lower than they have been for many years, providing significant opportunities for well-capitalized companies that are looking to drive revenue growth through M&A, strengthen core operations, pursue synergies to achieve cost reduction, or enter new markets.

"We are seeing an unquestionable pick up in target monitoring, and there is a growing sense of optimism about M&A activity," says Jeanneret.

Fifty-seven percent of respondents would consider the M&A environment to be favorable.

Private Equity

As 2009 comes to a close, PE is well-positioned to take advantage of deal opportunities with $400 billion in dry powder.

"PE firms have a history of being adaptive and innovative in volatile markets," said Jeff Bunder, Americas Private Equity leader, Ernst & Young LLP.

"Past recessions have provided some of the industry's highest vintage returns, and with capital to deploy we should see an increased pace of investing in the next couple of years."

With the return of a more stable capital markets environment, many PE funds have turned their focus toward taking advantage of exit opportunities in their portfolio.

This effort has been helped by the availability of financing and the improvement in performance of the equity markets.

The uptick in the stock market has provided an appetite for initial public offerings (IPO) and a number of PE-backed companies have gone public in the past six months, and the pipeline of offerings continues to build.

The past year could be characterized as one in which funds were focused solely on preserving value in their portfolio companies, many of which were blind-sided by the economic downturn.

However, there are signs that deal volume is slowly returning with a handful of billion dollar-plus deals announced in recent weeks.

The increased availability of financing, at more reasonable leverage ratios, has contributed to the return of deal activity. Funds continue to look for opportunities among the pool of companies with weak balance sheets.

In 2010, from a portfolio perspective, PE funds will look for opportunities to refinance, sell or grow businesses through acquisition.

Divestitures

There has been a notable uptick in global divestitures during the second half of 2009.

Divestiture deal value jumped 62% from Q2 2009 to Q3 2009, and is on track to continue to rise in Q4 2009 as companies seek to shed under--performers or non-core businesses to raise cash or stop cash drain.

"Non-performing or non-strategic businesses which were given a pass over the downturn's darkest days are undergoing greater scrutiny today," says Paul Hammes, Americas Divestiture Advisory Services Leader, Ernst & Young LLP Transaction Advisory Services.

"Rigorous portfolio management is now essential for companies across industries."

Restructuring

We are witnessing a highly complex and fast-moving economic environment.

The downturn has businesses looking hard at their operational fitness.

According to an Ernst & Young survey, 60% have an unrelenting focus on driving operational efficiency and 57% have improved cash flow and liquidity.

Still, total bankruptcy filings for the first nine months of 2009 were up 35% versus the same period in 2008, reaching the highest level since 2005.

"Shoring up the cash position has been crucial in keeping many companies afloat over the past year," said David Williams, US Restructuring Services Leader, Ernst & Young LLP Transaction Advisory Services.

 "Still, cost-cutting measures can only go so far, so management must remain diligent in focusing on liquidity.

"We won't see a real turnaround until consumer confidence starts to build and companies start seeing real top-line growth."


Sector Review and Outlook


Health care: life sciences

Global pharmaceutical completed deal value has soared to almost $135 billion for 2009 so far - the highest annual deal value within the industry since 2000.

Over next 12 months and beyond, we expect M&A and alliance activity to continue to be strong across the life sciences sub-sectors, driven by long-term strategic trends and PE's growing interest.

As many blockbuster drugs lose patent protection, large pharmaceutical and biotech companies need to replenish their drug development pipelines and to leverage their regulatory approval and commercialization capabilities.

As long as the IPO market remains unpredictable to development-stage biotech companies and Venture Capital (VC) funding is constrained, M&A may continue to be the primary exit and financing vehicle for biotech companies.

While possible, we do not expect to see another mega deal over the next 12 months. We will see continued asset divestitures from those companies working to integrate the large 2009 mergers.

Health care: provider care

Lenders continue to like health care and have been willing to lend to health care companies.

We expect this trend to continue. Health care reform is driving activity in this sector.

The prospect of reduced reimbursement is driving the need to reduce costs.

Health care information technology (IT) is popular given stimulus money available to providers for meaningful use of electronic health records.

There is also an expected trend toward integrated delivery systems --- for example, hospitals buying nursing homes and health care agencies.

We are seeing more activity in these sectors. Over the next 12 months, provider care deal flow is expected to increase as even greater clarity around health care reform is gained.

Financial services

Although global transaction markets are showing signs of awakening, when it comes to financial services, the prognosis for M&A remains guarded.

Financial services M&A reached record highs in 2007, and has fallen more than 50% since that time.

The exception is the asset management business, where a number of key deals have taken place and many more are likely.

Asset management promises to be the fastest sector within financial services to recover.

The early stages of a rebound are evident, with the enterprise value/EBITDA multiples observed among nine public asset management firms increasing by 170% from January to October 2009.

Consolidation is expected to continue - likely leading to follow-on deals in adjacent industries such as fund administration and custody.

Banking and insurance were among those hardest hit by the current global recession.

Look for any rebound in M&A volumes here to trail those in other sectors by at least six to nine months.

In contrast, larger, diversified asset managers were injured less severely and are recovering more rapidly.

Moreover, major deals already executed are creating pressure for others to respond.

As such, M&A markets here are already recovering, and volume can be expected to grow significantly.

Media & Entertainment

While deal activity in the media and entertainment industry has fallen to the lowest levels since 2000, the outlook is improving.

The continued impact of technology advances and consumer behavioral changes have and continue to dramatically alter the historic business model of the various industry participants.

The view that content is king is very much alive and well.

Distribution platforms have been fractured and expanded on a global scale causing content to now be available to a worldwide audience that historically did not have access before.

Owning content today and into the future will have tremendous value.

The deals getting done are varied.

They include direct independent outright acquisitions, partnering in the form of joint ventures among industry participants, and collaborations between PE and industry to better leverage value propositions through leverage of cost savings through synergy from the industry partner, and liquidity from financial partners with capital to invest.

A component of deals that is appearing more is the use of equity as a currency to accomplish the deal.

Energy

2009 deal volumes were down considerably compared to 2008 with 1,916 energy and power deals completed in 2009 versus 2,351 in 2008.

The oil majors are cautiously appraising M&A opportunities that could add high-quality reserves.

At the same time, these companies are undertaking portfolio restructuring measures -- divesting non-core assets and directing investment to long-term growth projects or regions.

Foreign players are becoming more significant in contrast to the fairly stagnant US transactions environment, particularly as China continues to shore up its energy production capabilities.

Energy M&A is expected to accelerate going into 2010; however, it is unlikely that deal volumes and values will return to the levels of 2006-07 and the first half of 2008 in the near term.

Technology

While technology transactions have slowed in 2009 to levels last seen in 2003 and 2004 after the dot-com bubble burst, the number of announced deals has increased in each quarter of 2009 after reaching a low in the first quarter.

2Q09 and 3Q09 saw five and seven announced deals with values of more than $1 billion after two quarters of no billion dollar deals.

This, the rise in the Nasdaq composite index, current company valuations, and other factors indicate technology deal activity will continue to pick up over the next year.

Most major technology companies have significant cash balances, which they plan to put to use to pursue deals or other investments that will provide them with better returns in the long run and enhance their market position.

In addition, as the tech industry continues to mature, strong companies will be looking for new ways to achieve revenue growth by entering adjacent markets, convergence or outright consolidation.

Software and services companies remain major targets for acquisitions, especially by companies in other technology sectors that are looking to advance their product portfolios, capabilities and margins.

Smaller companies with emerging technologies will provide larger technology players with new opportunities for growth.

Conclusion

2008 was a year of upheaval that left the world reeling through the first half of 2009.

The recession provided opportunity for those with capital to buy stressed or distressed companies.

During the second half of 2009, as a fragile recovery began, deals began to get done, financed mainly by cash or equity.

Some companies have record-breaking levels of cash on hand, and with confidence slowly returning to the markets, we expect to see deal activity slowly come back to life in 2010.

Companies that manage their capital agenda today will define their competitive position tomorrow.

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