Dragging Heels, Canceling Deals

Skittish investors and execs are making mergers harder to pull off than ever

It was the kind of deal that would once have been wrapped up in the blink of an eye. In May, real estate investment company Elden Holding Group LLC signed a letter of intent to buy one of its affiliate's customers -- Earl Scheib Inc. (ESH ), an auto paint and repair chain based in Sherman Oaks, Calif. -- for $17 million. But four months later the deal was dead. Scheib backed out because it lost patience with how long Elden was taking to go over its books. Christian K. Bement, chief executive of Scheib, says: "It was almost as if [Elden] was afraid." Elden declined to comment.

The ditched deal is yet another sign of the funk clouding one of Wall Street's most profitable businesses: advising on mergers. After doing 19% more deals in the first quarter worth more than double those announced in the same quarter of 2003, Corporate America is losing momentum. In September, companies unveiled deals worth $29 billion, half as much as in the same month in 2003, according to Thomson Financial (TOC ).

This stubborn soft patch in deals is frustrating major firms on the Street. Many expected a burst of mergers to help their earnings this year, but it hasn't happened. "Mergers and acquisitions have yet to really get off the ground," says Richard Strauss, financial-services analyst at Deutsche Bank. Now many bankers are setting their sights on next year.

Even when deals come back, some bankers say, they probably won't be the gold mine they were at their peak in 2000. Because of corporate-governance reforms, executives and board members have become much tougher shoppers. So bankers are having to work longer and harder on deals, only to see more of them abandoned. Says Jack Levy, head of M&A at Goldman, Sachs & Co. (GS ): "Executives pay a lot of attention to valuation and due diligence. That state of mind is not going to change."

Already some 28% of the deals announced this year have bitten the dust or are still pending, the highest percentage since 1996, according to Thomson. Sixteen months and one PeopleSoft CEO later, Oracle Corp's (ORCL ) $6.6 billion bid for the software maker is still in limbo. On Oct. 5, one board member said the company is still willing to entertain a bid from Oracle, but only "at the right price."

A SKITTISH STOCK MARKET

Bankers are trapped between buyers and sellers who are fussier than ever. Although the nonfinancial companies in the Standard & Poor's 500-stock index hold close to $700 billion in cash and short-term investments, many corporate buyers are sidelined, waiting for the uncertainty reflected in a skittish stock market to dissipate. Meanwhile, shareholders are pressuring companies not to gamble away the cash they have on deals. Instead, they want companies to buy back stock, thus pushing up share prices, or to start paying dividends.

Investors and executives are taking far longer to get back in the groove than their investment bankers hoped. Some are backing out of deals once they discover that a takeover target's management is being reshuffled or that the company faces a regulatory probe or lawsuit. On Sept. 21, Leawood (Kan.)-based Gold Banc Corp. announced that a proposed settlement of a lawsuit against the company could throw a wrench in its plans to be acquired by an investor group through Silver Acquisition Corp. Silver asserts that the settlement could damage the bank's financials, which Gold Banc disputes, according to Gold Banc's news release.

Some buyers are avoiding companies that miss their numbers. Carver Bancorp wants to discuss paying less for Independence Federal Savings Bank since, it says, the bank's "financial circumstances" have deteriorated since March, when the two agreed to merge. IFSB rejects Carver's assertions.

Other companies may have troubles as commodity prices rise. Already more than half the companies in the S&P 500 have issued earnings warnings in the third quarter. "Higher raw-material prices will have more bad effects on their margins," says Jack Maier, managing partner at New York financial advisory firm Legacy Partners Group LLC.

Meantime, the stakes for companies that make deals are rising. Executives say holdups due to regulatory hurdles could hurt their stock prices. "Who wants to have an overhang on their stock for 18 months?" asks SBC Communications Inc. CEO Edward E. Whitacre Jr., who is still upset that it took that long to win regulatory approval to buy Ameritech in 1999.

In fact, businesses are seeing their stocks hammered for deals that don't happen as well as for those that do. For example, the stock prices of Comcast (CMCSA ) and Vodafone Group (VOD ) have still not recovered to the levels at which they traded before their failed bids for Walt Disney (DIS ) and AT&T Wireless, respectively, in February.

LENGTHY DISSECTIONS

Buyers and sellers are also haggling over price. "With the perceived margin for error so small, deals are breaking up over as little as 5% differences in price," says Spencer D. Klein, global head of M&A for Chicago law firm McDermott Will & Emery LLP. On Sept. 3 retail software maker QRS Corp. (QRSI ) broke off a deal to be acquired by JDA Software (JDAS ) Group after the bidder's share price fell -- axing the value of the $107 million all-stock transaction by $26 million. Instead, QRS will be bought by privately held Alpharetta (Ga.)-based Internet business-services provider Inovis International Inc. for $114 million in cash.

Corporate-governance reforms are changing the dynamics of dealmaking, too. Board members, worried about personal liability if deals go wrong, are dissecting potential takeover targets for as long as six months before any announcement is made, lawyers say. Directors are routinely ordering up management background checks, which they did less often before. And where directors used to look over any outstanding litigation that a target might face, some are now hiring private investigators to interview potential witnesses to assess how costly the lawsuits might be. "In the past, some directors may have looked at deals with the same level of focus as [they have] watching television at 10 p.m.," says Robert A. Profusek, a partner at law firm Jones Day in New York. "Now they're much more engaged."

Dealmaking involves so much consensus-building now that it's spurring new cottage industries. So many bankers, executives, consultants, accountants, and lawyers doing due diligence want to review documents related to deals that New York-based Intralinks Inc. has made a business of providing them with online data rooms. Participants can log in to see relevant materials. Intralinks says the average number of people who tap in to view each deal has soared to 155 in the third quarter of 2004, up from 75 in the first half of 2003. In one recent session, a record 510 people participated.

Lengthy auctions are fast becoming the new standard. Board members and execs at target companies like them because they can more easily document their efforts to get the best price for shareholders. Many buyers will do big deals only if they share the risks by joining others to make bids, a process that usually takes longer than a solo effort. Comcast teamed with Sony Corp. (SNE ) and several private equity firms to buy Metro-Goldwyn-Mayer Inc. (MGM ) for $5 billion in September. "Companies stretching to do larger deals are more often partnering with private equity firms," says Stefan Selig, vice-chairman of Banc of America Securities (BAC ).

Even with such new tactics, the total value of deals this year is expected to stay stuck at less than half the $1.7 trillion at the 2000 peak. And as the economy and stock market improve, it's far from certain that companies will become big spenders again in a hurry. Some may just go it alone for a stretch. In Earl Scheib's case, the board pulled the plug in part because the company was starting to turn around after painful restructuring. CEO Bement says Scheib wanted to see how it would fare on its own for a while. At the least, Scheib may fetch a better price if it is put in play again.

By Emily Thornton, with Roger O. Crockett, in New York

— With assistance by Roger O Crockett

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