Subprime Credit Woes Stall Channel Mergers

"It's [subprime concerns] almost flipped a switch in the credit markets overnight," said Mont Phelps, president and CEO of NWN, a solution provider in Waltham, Mass. with 2006 revenues of $118 million. NWN acquired all or part of more than half a dozen solution providers in the past two years and is looking to buy more.

"I just had call with some guys in the capital markets and they are just absolutely locked up now. They are not doing anything. I think they are waiting until post Labor Day and see what happens then. Things are changing almost daily. Everything is on hold like a pause button was pushed," Phelps said.

As a result of lenders' caution, he says channel merger activity is probably on hold for the near term. "What's going to happen is that if you look at mega deals like CDW, cheap money drives those deals and money isn't cheap anymore," he said. "I think it's going to impact the rate of future consolidation because the cost of money has gone up."

CDW shareholders voted August 9 to approve the acquisition of CDW by VH Holdings, which upon closing of the merger will be controlled by investment funds affiliated with private equity firm Madison Dearborn Partners. The CDW deal, however, has yet to close. CDW said expects to complete the merger in the second half of the third quarter or early in the fourth quarter of 2007.

"Deals are still getting done, but credit markets are absolutely tighter," said Joe Mertens, executive vice president of Sirius Computer Solutions, San Antonio, Texas, an IBM solution provider with annual revenues in excess of $600 million.

Last November, private equity firm Thoma Cressey Bravo invested an undisclosed sum in Sirius with the aim of helping Sirius expand its business, in part, by acquiring other solution providers. In May, Sirius acquired DyComp, an IBM solution provider in Clemmons, N.C. and is expected to announce other acquisitions by year's end.

Mertens said that while the subprime phenomenon may be affecting the capital markets, other factors are at work that impact the availability of money. "The volume of private equity deals that are currently under placement is about $330 billion. The ability to syndicate those loans is very challenging," he said.

As a result, Mertens said private equity money is drying up as a source of financing for the short term and companies wanting to do mergers and acquisitions are forced to finance debt on their own paper. "There's just an awful lot of debt that has to be placed and syndicated and there just aren't enough buyers," he said. "It's simple supply and demand and I think it will be at least six months before things calm down."

Marty Wolf, president and managing director of Martin Wolf Securities, a San Ramon, Calif.-based investment banker focusing on solution provider mergers and acquisitions agreed that evaporating credit will slow merger activity.

"This will have a profound impact. It is already having a profound impact," he said.

"You have to understand the concept of a private equity put. Companies with good prospects but bad management can still sell themselves. There are companies in this space traded at values greater than their performance warrants if you take a long-term view. Buyers can realize value within 24 months. So there's a floor for the marketplace, but because of the drying up of credit, the floor is gone."

Wolf says that as a result, some deals that are already in the works may collapse because the credit crunch has lessened the value of the company on the table.

"I know of a couple of companies that positioned themselves for sale to private equity companies. They started getting in shape 60, 90, 120 days before. But it's not unreasonable to assume they have had a 20 percent reduction in value," Wolf said. "What will happen is a delay in many acquisitions because the buyer has a value in mind, and the seller has a value in mind, but the seller's value is based on old data. And price is determined by the buyer, not the seller.

"There are a bunch of sellers today who think they can get the old price. They might be advised to pause. But if you pause, you need to make sure the buyer is still a buyer in 30 to 60 days," Wolf said. "My experience is the people who get close to making a deal may not close the deal at all."