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State of Play: The Orthopedic M&A Market and the Credit Crunch
Peter Schmidt
Cronus Partners
The tightening credit markets were the leading financial news story through September and October, including the Federal Reserve’s decision to cut the Federal Funds rate target by a half percentage point at the September meeting. Hedge funds and private equity players who benefited greatly from the lax lending practices of the past few years are still nursing their wounds, but it appears that for orthopedic companies that carefully consider their merger and acquisition (M&A) options, the credit squeeze should not have the dire effect many had expected.
The credit squeeze, a relatively sudden discontinuity in August’s credit markets and its aftershocks, resulted in a dramatic realignment in M&A transaction flow. An understanding of what has happened and careful consideration of the road ahead will be critical to achieving many strategic or financial objectives.
How Did We Get Here?
As is all too frequently seen in financial markets, a sudden correction reversed a multi-year trend, this time reversing a trend for over-generous lending by creditors and over-optimistic ratings of borrowers. Paralleling similar events in 1987, 1997, 1998 and the 2000 Internet crash, analysts failed to consider seriously the potential global, national, market and sector risks. While this failure was most egregious in the housing markets, the correction dramatically hit all questionable, risky or simply unsecured borrowing and forced creditors to take another look at possible correlations in the risk profile of their (assumed diversified) portfolios.
These aftershocks have been felt globally. With bankers afraid that their risk models are defective and this fear itself increasing default risk, credit spreads have risen. The three-month dollar London Inter-Bank Offer rates rose to their highest level since January 2001, and the yield on the US 10-year treasury note fell to a five-month low with volatility in that market remaining near a three-year high; Moody’s anticipates up to six months for the credit markets to return to normal. While equities markets have shown resilience, a major consequence has been the slowdown of M&A activity. Globally, leveraged buyouts have stalled as banks find no markets for the securitized debt. The easy credit market had for years fueled buyouts at an unprecedented rate, but executed deals worldwide were down by two-thirds or more in September.
The Healthcare M&A Market: A Look Back
The healthcare market has mirrored the overall market, with evidence bearing out dramatically reduced M&A activity in recent months. By number of transactions, the sector is down 35% from a year ago, from 189 transactions in September 2006 to 123 in September 2007, a dramatic break from a prolonged positive trend. More recently, during the height of the credit panic, the number of transactions plummeted from 195 in July (before the credit crunch began in mid-August) to 123 in September, a 37% decrease. By total transaction value, September was down a staggering 88% from a year ago ($29.1 billion to $3.5 billion) and stumbled a similarly incredible 91% from July ($36.9 billion to $3.5 billion). September’s transactions represented a toe in the M&A waters: the average transaction was less than one-sixth the size of the average transaction in the preceding 12 months ($426 million versus $64 million).
The Silver Lining
At first blush, the figures on M&A activity throughout the healthcare industry might be seen as an indication for belt-tightening in the orthopedic device industry; after Medtronic’s July announcement of its acquisition of Kyphon for approximately $3.9 billion, or a more than 30% premium over its pre-announcement value, there seems to a marked pullback of large public companies willing to offer windfall valuations. Additionally, private equity firms’ debt-fueled shopping sprees, whose diversification allowed them financing at lower cost and risk than sector-specific strategic buyers, may find themselves less competitive in the tightening credit markets.
However, it is still a good time for companies to fuel growth and leverage efficiencies through strategic alignments. These coinciding movements seemingly are clearing the way for mid-market transactions and a flight from risk to safety. Traditional buyers are buying less, and they are quickly being replaced by the smaller buyer looking for the right strategic acquisition. While the overall the number of transactions is down by 35%, those under $100 million were impacted less. In contrast to large, active, debt-financed buyers, companies making a targeted, mid-market strategic acquisition virtually were unaffected by the credit crunch. The acquisitions of Specialty Surgical Instruments for $15 million, LDR Spine for $25 million and ORTHOsoft for $47 million represent the kind of mid-market transactions that should continue unabated in the coming months. Also, the announced initial public offering for cash-hungry, venture-backed MAKO Surgical could signal the opening of a new capital market for orthopedic device suppliers.
The Road Ahead
Looking forward, the key to strategic alignment and M&A for the near term will be fair and realistic offers for businesses offering strategic or operational synergy, either through improved market position or operational efficiencies. M&A is a key tool for putting available capital to work, especially when opportunities for increased sales, manufacturing or management efficiency can result in greater benefits than a financial investor could realize; strategic capital may come at much more advantageous terms than that from other sources—especially in the current context. For example, the union of complementary product lines clearly motivated the Integra LifeSciences acquisition of IsoTis, allowing Integra’s scale and synergy to improve a worsening revenue-to-operating expense ratio. The key to realizing these benefits is a strong, sector-focused financial intermediary who can provide insight into issues of valuation and managed exposure to potential counterparties.
Peter Schmidt is a director of Cronus Partners LLC, an investment banking firm that specializes in mergers and acquisitions, private placements and financial advisory services, with a particular emphasis on the healthcare industry. Dr. Schmidt can be reached at (203) 642-0200 or PSchmidt@CronusPartners.com.
Author’s Note: Nothing contained in this article is to be considered the rendering of financial, investment or professional advice for specific circumstances. Readers are responsible for obtaining such advice from professional advisors and are encouraged to do so. |
