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Steve Krouskos
Global and Americas Markets Leader, Transaction Advisory Services
Ernst & Young

Editor's note: Each month, we ask a Directors & Boards reader to comment on critical issues facing directors today. If you'd like to participate in this section in the future, please email Scott Chase.

What is the outlook for M&A?

Deal activity should pick up, as market fundamentals are strengthening and businesses that have conserved cash are implementing growth plans that were on hold during the recession. Other businesses are looking to sell business units that are more valuable to someone else in order to raise cash. Strong growth prospects in markets such as Brazil and China should also portend a continued rise in deal volume in the second of 2010, despite concerns over instability in other developed markets.

Ernst & Young and the Economist Intelligence Unit recently updated our Capital Confidence Barometer, a survey of over 800 senior executives in major corporations around the world to gauge their confidence in economic recovery, capital availability and other issues pertinent to their capital agendas. Nearly half (47%) of those surveyed in the first Quarter 2010 said they expect to make acquisitions in the next six months and 67% predicted acquiring over the next two years, compared with 25% in the last half of 2009.

What kinds of deals will be done this year?

As companies assess capital allocation options, they are looking to M&A to grow revenue and market share. They are expanding into new customer or geographic markets and investing in new products and services. Emerging markets and smaller, more strategic deals are an increasing focus. They have huge demographic advantages and showed economic resilience during this downturn. We see most deals being funded by cash or with a heavy cash component. As confidence and credit returns to the market, we expect to see smaller, albeit higher quality deals.

There will be more divestitures, as well, and these will feed the appetite for M&A. The number of companies “highly likely” or “likely” to divest businesses in the next six months has doubled since last year, to 38% of companies represented in the Capital Confidence Barometer. Sales meet strategic objectives to pare non-core holdings and raise cash to pay down debt or invest elsewhere. However, an anticipated flood of distressed selling has not materialized, as bank flexibility and a return of the high-yield bond market provides owners a chance to strengthen troubled businesses and postpone transactions.

Which companies are going to be active in the M&A market?

We see three types of companies surfacing. Those with strong balance sheets and abundant cash are actively looking to increase competitive advantage through M&A. These companies will seek transformative and consolidating deals. Certain sectors, such as technology, health care and energy, are already making their presence felt in the M&A market.

A second group withstood the worst of the downturn, may have revamped their organizations or strategies and has the wherewithal to consider transactions to help grow existing products and markets. Many companies, however, are still struggling to compete. This group must continue to primarily focus on preserving capital, rather than investing it.

Over the past two years, companies hunkered down, focused on their balance sheets, cut costs and downsized. How difficult will they find it to become deal makers again?

While 86% of companies in our survey have reviewed or improved working capital processes, many will continue to work on wresting sustainable cash flow and improvements from operations in the coming months. As they begin to balance these efforts with more emphasis on growth, they face challenges in process, governance, deal execution and resources.

Competition for capital within organizations is creating a need for better deal pipelines and allocation decisions. Transaction due diligence must expand to provide a fuller picture of risk, strategic opportunity and synergy. The imperative to optimize capital also places a premium on integration excellence. But some companies that ran lean corporate development and related functions over the past two years may lack the bandwidth to meet the needs of emerging M&A programs. Also, some managers and directors must learn to move beyond the deep caution that may have served them well in a downturn but could inhibit necessary risk-taking in a time of opportunity.

Steve Krouskos is Global and Americas Markets Leader, Transaction Advisory Services, Ernst & Young LLP.