The Texas Economy - A Special Case

Monday, September 1, 2008 - 00:00

Editor: As head of the firm-wide corporate finance and M&A practice at Akin Gump, you undoubtedly have a broad overview of what Akin Gump's many offices are seeing in terms of the slowing economy. How does Texas compare with the rest of the nation?

Menges: Texas has weathered the recession quite well in several respects. The level of housing-driven declines is much lower in Texas than in other parts of the country. In fact, housing prices have been among the best in the country second only to the Charlotte, North Carolina area in terms of house-price stability. That is directly related to the hot commercial real estate market in the major cities of Texas, especially Dallas and Houston, which indicates corporate growth in both of those areas. The diversified economy here has presented a number of very good acquisition targets in various industries, not just energy - but first and foremost energy.

Editor: The pace of M&A activity has certainly slowed, especially for the large mega-mergers. The number of IPOs has also decreased markedly. What are you seeing by way of the midsize mergers which don't require the high degree of leverage?

Menges: The level of middle-market merger activity is high right now, particularly for strategic and opportunistic buyers. Strategic buyers have historically not relied on as much leverage as the large buyout firms. They either use their own stock or in many cases, they draw upon significant cash resources on their balance sheets that allow them to just buy a company outright. They are what I call "opportunistic buyers," a term I use to describe certain funds such as private equity funds or sovereign wealth funds, that is, foreign- government-sponsored funds to make strategic acquisitions that have billions of dollars of cash to spend. There are also funds that specialize in distress situations which are looking for companies that have stumbled and are in need of a bailout. Another aspect of middle-market M&A deals is that many times it is possible to structure the transaction so that the existing financing that a target company has is able to be assumed by an acquiring company rather than having to be repaid upon the closing of an acquisition. That aspect in and of itself allows companies to more easily be sold.

Editor: How are the financial institutions in Texas adjusting, if at all, in the way in which they are willing to lend?

Menges: The candid answer is that although the financial institutions in Texas are slightly more active in lending money in acquisition transactions, they aren't much more active. The national availability of bank financing is still very tough since banks are very much in a retrenchment mode. They are trying to clean up their balance sheets and are looking for excuses to not do transactions. The most difficult piece of the capital structure to put together in an acquisition today is the senior secured credit component, which is normally supplied by banks. The other parts of the financing for a transaction are put together fairly readily. It is difficult to get banks to play these days because of all of the aftershocks of the credit crisis that began with the subprime mortgage debacle that first surfaced over a year ago. The typical private equity model depends heavily on a high degree of bank leverage - that is how they make their returns. Typically, private equity finances a significant portion of a purchase price with a relatively small percentage of pure equity and if the acquired company can be cleaned up, the private equity buyers can make a significant return on their equity investment. Without the ability to get a significant percentage of the financing from debt, private equity players are not going to be able to achieve the same returns they havehistorically enjoyed.

Editor: Are you seeing financial institutions demanding more due diligence and greater equity contributions in deal structures?

Menges: Financial institutions are absolutely requiring more diligence - I believe that is not only a sign they are exercising greater care than they did twelve to thirty-six months ago but also because they are looking for reasons to not pursue transactions. Many times extensive diligence can turn up potential risks. Financial institutions, mainly banks, are also requiring greater equity contributions from the buyers of companies. A typical financial structure of a middle-marketM&A deal today would have a greater percentage of equity, both in the form of common stock and preferred stock as well as subordinated debt as the layer below the senior secured piece. Because of the lack of accessibility to bank financing for the senior secured piece, what we see today are higher percentages of the financing attributable to subordinated debt and to preferred and common equity.

Editor: Are you experiencing any sovereign wealth funds coming into deals replacing some of the buy-out funds?

Menges:The sovereign wealth funds are very significant players in the U.S. market,including looking at possible transactions in Texas. They have one huge asset and they have one huge liability. Their asset is the fact that they have billions of dollars of cash waiting to be deployed. The liability is the current political environment in the United States. Starting with the potential acquisition of Unocal by the Chinese National Off-Shore Oil Company (CNOOC) that was withdrawn after a lot of political controversy and the sale of port operations to aDubai company, there has been a chilling effect in the eyes of some potential buyers on U.S. deals. Sovereign wealth funds are looking for areas in which to deploy their resources quickly and easily. That being said, the U.S is still a very attractive market. The dollar's decline over the last couple of years has made asset-pricing in the United States relatively favorable to assets available in other parts of the world. The fact that we have the most highly developed legal and commercial structure means that there is certainty about the remedies investors have, unlike in other parts of the world. Sovereign wealth funds are waiting for the political atmosphere to quiet down a bit, but this does not seem to have stopped them from pursuing deals. We are also seeing more sovereign wealth funds considering investing in minority stakes in U.S. companies. This interest in itself has triggered a reaction from Congress, which has specifically acted to eliminate any percentage threshold that would otherwise exempt certain investments in the U.S. Formerly, an investor could acquire a small stake in a U.S. company, a transaction that would not be subject to oversight by the U.S. Committee on Foreign Investments; Congress is acting to eliminate that exemption.

Editor: Why has Texas been spared the distress that seems to permeate other regions of the U.S.?

Menges: It is due to several factors. First, the fact that Texas is the energy capital of the United States has certainly worked to the benefit of Texas as oil prices have gone up so dramatically in the past several years. However, Texas also has one of the most diversified economies in the U.S., which serves as a hedge to fluctuations in the oil industry. Having strong bases intechnology, logistics, healthcare, and manufacturing throughout the state means that it is unlikely that each of those sectors would be on a decline at the same time. There is also a very strong and available labor force here that is generally not unionized and is quite experienced in each of those industries. All of those factors make Texas a very attractive place for companies with operations.

Editor: What makes Texas so attractive to business? What are some recent statistics showing the influx of new businesses into Texas?

Menges:In terms of statistics, the one that is most talked about is the increasing number of national and international headquarters that are moving to Texas. That is due to a variety of reasons - not only the ones mentioned above but also the favorable tax rates both for business and for individuals and the fact that Texas has a well-known and well-deserved reputation for being business friendly and a desire to help businesses expand.

Editor: There has been greater government scrutiny of international investment, particularly in the antitrust area. The Department of Justice has even extended its reach to foreign corporations that are only remotely involved in investing in the U.S. What is your view on how this phenomenon will play out?

Menges:I am hopeful that the current political environment will change to more readily embrace free trade, which our government has consistently embraced for most of the last twenty years - whether Republican or Democratic administrations were in office. A free trade approach allowed the passage of NAFTA. It allowed the passage of a number of free trade agreements with other countries, all of which ultimately helped the U.S economy. The current environment not only is less supportive of free trade but there is greater government scrutiny of international investment in the U.S., especially in the area of antitrust. In this regard, the U.S appears unfortunately to be following the European Union's approach in its opposition to business combinations on antitrust grounds. As the current economic recession plays out, there will be opportunities for businesses to combine. I am hopeful these combinations will be viewed favorably by the various government regulators as a way to help pull the country out of our recession.

Editor: Would you care to comment on the $4.9 billion new wind power development in Texas and what the likelihood will be of its effect on drawing more industry to Texas?

Menges: Texas has a well-deserved reputation for being focused on energy, particularly oil and gas. Many people have only recently heard about the so-called alternative energy opportunities available in Texas. First and foremost, wind power. Texas is second only to California in its investment in wind power, and I believe that the most recently announced deal will put us over the top in terms of exceeding California. There are also Texas companies that are very active internationally, including in China, selling wind turbine blades, so it is not just a Texas-based business in that we have a lot of wind to power turbines; it is the fact that Texas has become a center for companies that do this business all over the world. We also have a lot of companies doing business in the solar energy area, based in part on our being blessed with a very sunny climate. Texas is energy-focused. The growth in natural gas production has been phenomenal, with its price having increased significantly. In an area west of Dallas, called the Barnett Shale, there has been explosive growth in natural gas production.

Editor: What business and economic as well as climatic assets does Texas have that auger well for its future?

Menges:You would have to start with the people in Texas - the educated workforce; the availability of skilled labor; the lack of unionization. Second, our diversified economy allows opportunities for both buyers of companies and for companies that want to expand in any number of areas. Third, our access to a variety of energy sources is also helpful to businesses looking to expand. Fourth, our central location allows companies with a national and international focus to travel much more easily to both coasts and overseas. Finally, that warm weather I mentioned is a factor that makes travel easier and also allows fewer days where businesses are hindered by bad weather. It allows more days where construction is allowed. The Texas infrastructure system of roads allows companies - particularly those specialized in logistics - to much more easily get their goods in and out.

Please email the interviewee at kmenges@akingump.com with questions about this interview.