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M&A market down, but not all are out

The bright spots in the mergers-and-acquisitions landscape are really happy accidents: Enterprise software companies found themselves amid a downturn and ripe for consolidation.

VeriSign's $1.2 billion merger agreement with Illuminet Holdings this week was a rare win for the beleaguered tech mergers-and-acquisition market, which has slowed to fewer than half the number of deals cut last year at this time.

Compared to the first half of last year, the number of technology mergers has fallen 55 percent and the value of those deals was off 82 percent, according to Broadview International, a mergers-and-acquisitions advisory company. Technology has been hit across the board, with enterprise software faring the best--dropping only 38 percent from the previous period.

"The number of deals has gone way down," said Jason Auerbach, a principal at Broadview, "the amount people paid for the deals has gone way down, and when you look at what is paid for these companies as a multiple of revenue, it's gone down much, much more. The days of a buyer paying 200-times revenues are gone--just like the markets."

The bright spots in the M&A landscape are more like happy accidents: Enterprise software companies, which rushed to go public and created a glut of vendors, found themselves amid a downturn and ripe for consolidation.

"There were a lot of companies that went public that didn't have the scale to weather an economic downturn," Auerbach said. "A lot of those companies are hoping to merge to live and fight another day."

A number of enterprise-software companies are also facing customers that have been given a mandate by their executives to cut their IT budgets--putting a greater squeeze on enterprise vendors who each largely make up a small portion of the funding pie, said Chris Greer, managing director of technology mergers and acquisitions for Robertson Stephens. He added that these small vendors are finding it's often more worthwhile to merge with another company than to restructure their deals, especially if the company is a niche player.

And despite this greater pressure on revenues, this segment holds the greatest chance of moving forward as a larger entity with broader product offerings, given that investors still hold in high regard companies that provide the nuts-and-bolts infrastructure technology, such as systems and network management software and enterprise application tools.

Tech M&A
Despite a 55 percent drop in mergers and acquisitions during the first half of the year, enterprise software companies have managed to stem some of the decline--falling off 38 percent over last year and taking the smallest hit among all tech sectors. Below is an industry breakout of how the various sectors fared in the first half of the year:
Sector % change: Number of deals % change: Value of deals
-58 % -81 %
Enterprise software -38 % -76 %
Semiconductors -48 % -82 %
Internet -68 % -96 %
Tech-based services -57 % -75 %

Source: Broadview International

In the first half of 2001, enterprise-software companies generated 300 deals, compared with 487 deals in the same period in 2000. That was the smallest drop among five tech sectors that included semiconductors, Internet, tech-based services and telecom-datacom companies, according to Broadview.

The Internet sector took the biggest hit, with the number of deals dropping 68 percent and the value of those deals dropping a staggering 96 percent.

Internet companies have seen their public and private valuations drop tremendously since the markets downturn as investors began to question their very existence, citing faulty business models that would never lead to profitability. A number of these companies, from Webvan to Eppraisals.com, ended up folding before they could find a merger partner.

The downward market has also dried up the once popular arrangement of public companies buying up private companies, which was pervasive during the Internet gold rush. Many small companies, from those offering online music to catering to content directed at a specific ethnic audience, were seen as bargains for larger, older companies looking to expand their Internet presence or beef up their technology.

Time Warner, for example, last year acquired Africana.com as a means to reach the ever-growing number of African-Americans online. The deal was announced before it closed on Time Warner's merger with America Online.

Public-to-public deals
Instead, today's deals are more frequently public-to-public deals, which, according to one M&A specialist, at least give the companies a clearer idea of what a deal is worth.

"You can disagree over the value of the deal, but you can't disagree over price. The markets are telling you everyday what your price is," said Karl Will, managing director of mergers and acquisitions for Merrill Lynch. "The valuations for private companies are a little stickier. There's no mark to market, and expectations tend to be a little higher in the private realm than in the public, so that tends to stifle deals with public to private companies."

Private companies acquiring other private companies accounted for 22 percent of the tech mergers and acquisitions this year, compared with 17 percent last year, according to Broadview.

Faced with little hope of launching a public offering, attracting a buyer who is already public, or attracting more capital from their venture investors, these privately held, cash-strapped companies are turning to each other to make the numbers work.

It's a move some investment bankers call an act of desperation that often proves fruitless, while others note it can be the answer to creating a winning company by filling out the technology needs of the buyer and consolidating cash to create a larger nest egg to bankroll the merged company until the markets become more favorable.

"If you have to cross a desert to get to where the customers are, and you have a canteen, the bigger your canteen, the better off you are," said Alex Mendez, a founder and general partner with Storm Ventures.

One Storm portfolio company, photonic switching systems and software maker Calient Networks, flush with cash, acquired Kionix, a micro-electromechanical systems fabricator, in January. And another Storm portfolio company, optical networker Zaffire, was acquired by Centerpoint Broadband Technologies in July.

"Zaffire was close to 'e' on the (cash) tank," Mendez said, "but Centerpoint was building high-capacity broadband wireless systems, and Zaffire's products fit into their metro plans. By combining cash and reducing the work force, they created a company with more cash and a better product offering."

"Putting together two companies with weak balance sheets makes no sense at all," Mendez said. "But putting together a company with a strong or moderate balance sheet with a weak one is OK, if the combined products and cash create a strong revenue stream and can get you across the desert."

With the economy on the cusp of a recession, the desert has become much wider for a number of companies and has created an environment where mergers and acquisitions are likely to decline even further, investment bankers say.

Buyers tend to favor stable stock markets for the stable valuations they usually bring to acquisition targets. And although a stable market is viewed as the catalyst needed to drive an increase in the number of mergers-and-acquisition deals, the outlook remains uncertain since it's tied to the financial performance of companies, bankers said.

"It's very difficult to take on new companies now," Greer said. "And it's likely to get worse if the underlying visibility for companies grows worse."