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May 16, 2007 

 Q&A: Scott H. Lang of S.H. Lang & Co. in Chicago on Middle-Market M&A 5/8/2007
The mission of Going Global, which appears on MidwestBusiness.com on most Tuesdays, is to educate and inform Midwest technology companies on what local technology companies are doing internationally so other firms can learn from the successes of like-minded peers.

CHICAGO – Scott H. Lang is the founder and CEO of S.H. Lang & Co., which is a new middle-market investment banking firm located in Chicago. In part two of a three-part series, Lang sat down with international expert Michael Muth of MidwestBusiness.com to discuss middle-market M&A.

Michael Muth: What are the hot regions for cross-border, middle-market M&A? How does investment banking differ across borders?
Scott Lang: Most of my personal cross-border M&A experience has involved U.S. and European counter parties. That is mainly because the U.S. and European M&A markets are by far the most active cross-border markets for middle-market companies. Over the past few years, it has felt more and more like they are converging into one large homogeneous market.

Still, that process has a ways to go. In the 1980s and 1990s, purchase price multiples, leverage ratios and deal-making styles with respect to middle-market M&A transactions were quite different between the U.S. and Europe.

Generally, our purchase price multiples and leverage ratios in the U.S. domestic M&A market were substantially higher than theirs. We typically sell our companies to the highest bidders using broad auction processes. European sellers are much more discreet and prone to limiting their sale processes to only a handful of prospective buyers.

That has been changing rapidly during this current decade. European purchase price multiples are often as high today as they are in the U.S.

The European debt markets appear to be even more aggressive than ours with respect to providing leverage for middle-market LBO transactions. Moreover, in some countries such as the U.K and other northern European countries, modified auctions are coming increasingly into vogue. I believe the American style auction will ultimately become the norm throughout most of western Europe.

Several forces have been at work to cause the U.S. and European M&A markets to converge. First is globalization. Middle-market companies in any given industry are looking increasingly similar. They are serving similar global customer bases, using similar technologies, competing across borders and outsourcing to the same low labor cost countries. Why should their purchase price multiples not be similar?

Second, private equity firms (which used to primarily be an American phenomenon) have spread to Europe and today are almost as plentiful as they are in the U.S. They are serving very similar industry consolidation and price-setting functions particularly when coupled with the equally if not more aggressive leveraged lending market in Europe today.

Third, U.S. and European middle-market investment banks have been forming increasingly powerful alliances to conduct cross-border transactions. They have been freely exchanging their different deal-making techniques across borders. Several U.S. middle-market investment banks have opened their own operations in Europe where they are deploying U.S. deal-making techniques.

All of this has been resulting in what you might call a “DNA transfer of deal-making techniques” between the U.S. and European M&A markets. This will ultimately spawn more and more U.S.-style auctions in which European middle-market businesses are put on the block and sold to the highest bidder.

There will always be discreet sales of family owned businesses in Europe that are targeted to buyers who will carry on the family traditions and retain managers of the business. This will become less and less frequent. While it may take much longer, a similar DNA transfer is likely to occur in the Asian and Indian M&A markets as their middle-market M&A markets continue to grow and evolve.

What is interesting is that it is not a one-way transfer.

American investment bankers are also finding they have much to learn from their European counterparts. Due diligence techniques, market and buyer research, contractual provisions, labor issues, creditors’ rights and negotiating styles are often handled quite differently. In the U.S., we can and do learn important deal-making techniques from our European counterparts.

MM commentary: International middle-market investment banking reflects world equity markets (i.e. the developed world) with the exception of Japan. The burgeoning BRIC (Brazil, Russia, India and China) countries will come only when their business infrastructures (legal, finance, accounting, etc.) allow them.

MM: How limited is financial restructuring abroad if many countries don’t have the financial options Americans have?
SL: They usually do have options and tools. Still, there may be different laws and customs that govern them. You may not read about them in the business press. They do have restructurings even if they may take different forms.

For example, bankruptcies are much less desirable in countries like Germany where there is greater risk of personal liability. They are avoided at almost all costs in favor of restructurings that may be more consensual.

However, as the number of private equity deals continues to increase in Europe and aggressive leveraged lending continues to push LBO multiples higher, restructurings will increase in Europe. Creditors are likely to insist on having the same or similar rights in Europe as the have today in the U.S. under our bankruptcy code and other laws. This is already starting to occur.

Once again, U.S. deal-making DNA is being embedded into the European restructuring markets as well. Laws don’t change as rapidly as dollars flow and deal techniques do. This will be a slower process. It has the same feeling of inevitability as the changes taking place in the cross-border M&A markets.

MM commentary: The U.S. has been a world leader in creating different financial tools to mitigate risks and create equitable returns for those risks. While others may catch up, I doubt they’ll surpass the U.S.

MM: How important is it for a U.S. middle-market investment bank to have an international marketing capability?
SL: Until the end of the 1990s, it really didn’t seem important to have international marketing capabilities if you were advising a U.S. middle-market business on a possible sale. You knew that most foreign buyers wouldn’t pay the high prices American sellers expected to get for their companies from U.S buyers and that domestic buyers were willing to pay.

Those foreign companies who would pay a U.S.-style market clearing price were typically limited to large strategic buyers or foreign direct competitors. For the most part, they could be identified and approached directly either at their foreign headquarters or through their U.S. representatives.

However, with accelerating globalization, a homogenization of valuation expectations (especially between U.S. and European buyers and sellers), the spread of the U.S. private equity phenomenon to other continents and the high liquidity that exists at all levels of the global capital markets today, this is all rapidly changing.

Today, it is becoming increasingly difficult for any U.S. investment bank to get hired to sell a U.S. middle-market business if the investment bank doesn’t have demonstrable experience and distribution capabilities for conducting a global auction process. In fact, most U.S. middle-market investment banks today claim to have international M&A marketing capabilities or at least the appearance of it.

Some have opened operations in Europe and Asia. Others have entered into formal alliances with groups of similar foreign middle-market investment banks that can cooperate seamlessly across borders and share fees. However they may do it, they can’t compete effectively today for prime M&A mandates without having at least the semblance of international deal-making capabilities.

MM commentary: Like many businesses today, going international is imperative. The question is how one goes about it. Should you do it on your own or with the help of others?

MM: Has the weak dollar made American firms more attractive acquisition targets? Has it hurt the ability of U.S. companies to acquire foreign firms?
SL: These are tricky questions to answer. Since the dollar has declined materially against other major currencies and many believe it will continue to do so, foreign buyers should be licking their lips to grab some bargains in the U.S. because our companies may seem so cheap today.

Ironically, however, this is not necessarily the way they view our market.

Think about it this way: If a foreign purchaser buys a U.S. company for its cash flows and profits and if those cash flows or profits are in U.S. dollars, the value of the repatriated cash flows and profits will also decline when they are converted back to the foreign buyer’s currency.

On the other hand, if an acquired U.S. company’s business is international and likely to become more competitive if the dollar declines, the equation could look quite different.

In my experience, most buyers and sellers of foreign middle-market companies still don’t heavily weight currency risk in making decisions to enter into a cross-border M&A transaction with a U.S. company. While it may be a consideration, it is usually not a primary one today. No one really knows how the currencies will fluctuate over the longer term.

Our dollar has not devalued that dramatically (like the peso devaluation in the early 1990s). It has been a more gradual process and hopefully it will continue to be so.

MM commentary: Currency values are an uncontrollable risk, so unless you’re dealing with a currency that fluctuates wildly, perhaps it shouldn’t be a consideration.

MM: Do you define an attractive deal any differently domestically as opposed to internationally?
SL: Not really. I’m thinking primarily of European opportunities as opposed to Latin American and Asian ones. In Europe, we’re dealing with stable regimes and typically mature economies. It’s a business decision like any other. While it may be more complicated and risky than a strictly domestic deal, it’s not that much more.

You can usually get good financial statements and assess business risks the way you would here. You can hedge against some currency risks. There are insurance products you can buy to minimize other risks. If the business deal is attractive, there is usually a way to work through and resolve the cross-border cultural, legal and accounting issues.

MM commentary: Though GAAP (generally accepted accounting principles) is expanding internationally as well, the rest of the world doesn’t disclose as much as we do in the U.S. Some countries use “active” vs. “passive” divisions in their income statements.

Michael Muth is managing director of GATA, an international business development consultancy that helps technology companies build international partnerships. He can be reached at muth@midwestbusiness.com.
Click here for Muth’s full biography.

Previous Columns in 2007:
Q&A: Scott H. Lang of S.H. Lang & Co. in Chicago on Middle-Market Firms (4/24/2007)
Q&A: George Filley of NAVTEQ in Chicago on Data Localization, Reach (3/27/2007)
Q&A: George Filley of NAVTEQ in Chicago on Partners, Personal Privacy (3/20/2007)
Q&A: George Filley of NAVTEQ in Chicago on Digital Mapping (3/7/2007)
Click for 2006 column archive.
Click for 2005 column archive.
Click for 2004 column archive.

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