Financial crisis further hinders catalog M&A scene

By Mark Del Franco

An “October surprise” in political terms means unveiling an unflattering allegation against your rival just before the November election. Although that didn’t happen this year, catalogers, along with the rest of the world, experienced quite an October surprise with the world financial crisis.

So a mergers and acquisitions market that was extremely volatile to begin with is shaken to the core. It’s almost impossible for all but the most well-capitalized of marketers to get deals done. The sobering reality is that many will be forced to sell at bargain basement prices or, worse, close their doors.

Amid this bleak backdrop, Lee Helman, a partner with New York-based investment firm Financo, contends, with some caveats, that deals are still getting done; they just take more creativity to find completion.

They entail multichannel marketers shedding assets they consider to be noncore (read expendable), with the cash being put back into the business. Such was the case in September when multichannel teen apparel marketer dELiA*s sold extreme sports marketer CCS to Foot Locker for $102 million in cash. Although a stable business, dELiA*s considered CCS noncore and will use the proceeds to fund its retail strategy.

Small Deals Pose a Challenge
But suppose you don’t have noncore assets; you find it hard enough growing your core business. Sorry. Executing so-called small deals, defined as having $10 million or less in earnings before interest, taxes, depreciation and amortization, is difficult in the current economic climate.

To work today, deals must be more strategic than ever. Buyers need cash in hand to buy because banks are leery about doing deals financed with debt, which typically happens when private equity is involved. So for buyers, cash is king.

In fact, lenders are pulling out of providing debtor in possession (DIP) financing to bankrupt companies. DIP financing — which usually has priority over existing debt, equity and other claims — is arranged by a company while under Chapter 11 bankruptcy protection. To be considered for a cash flow loan, Helman says, there needs to be at least $20 million of cash flow, “and it needs to be relatively certain,” otherwise no deal.

Even in good times, catalog/multichannel marketers struggled with getting funding from banks because banks didn’t truly understand direct marketing. The customer file isn’t worth much as a hard asset to a bank despite being catalogers’ most valuable asset. Banks today require collateral for loans, and catalogers generally have little collateral to offer.

So while lending remains nonexistent and the credit markets have all but dried up, what’s a business in need of capital to do? There are a few options. It all begins with a little creativity.

Find Viable Alternatives
An alternative to outright sale is a sale in disguise. A larger company may buy a significant stake in the smaller marketer with the understanding that the latter has to meet certain goals within a specific time frame. If the cataloger meets the goals, it has to pay back the larger company for its investment. If it doesn’t meet the goals, the larger company takes majority control of the business. For his part, Helman doesn’t see this happening anytime soon.

Credit-hungry catalogers who’ve already tapped their “angel” investors — namely, family and friends — have limited options. Helman’s seen new financing methods wherein there’s only equity going into a deal for a minority recap or growth equity financing.

Private equity firms, Helman explains, assume they can achieve significant top line and bottom line growth if they’re willing to do a deal with all equity. Either that or they intend to refinance with debt when the market turns and might have the opportunity to recycle the equity they take out.

“No debt means a company has a cleaner, stronger balance sheet and doesn’t have to abide by onerous covenants,” Helman says, “which is a good thing when huge growth is in the offing. If there is leverage and huge growth expected, then something below plan happens. Banks today have little to no patience. When covenants are violated, the banks control the situation.”

Judging by the huge federal government bailout, don’t they always? No surprise there.

Mark Del Franco has covered catalog/multichannel mergers and valuations for more than a decade. You can reach him at mark.delfranco@yahoo.com.