Crisis combinations of banks and financial services companies propped up last year’s weak U.S. mergers and acquisitions market, which was battered by volatile stocks markets, the credit crisis and deals that withered before closing.

There was almost a “forced consolidation” of major parts of the banking and insurance sectors due to the economic and credit crisis, said Jim Woolery, a corporate partner at New York’s Cravath, Swaine & Moore.

“It wasn’t your traditional type of M&A, which is driven by long-term, strategic combinations that are done in an orderly way with long-term interests in mind,” Woolery said. “This was a short-term, driven, sell yourself or be seized or go bankrupt story.”

Cravath represented boards of directors in several of last year’s crisis-driven financial sector deals, including the board of Merrill Lynch & Co. Inc. during its $48.8 billion sale to Bank of America Corp. (Unless otherwise specified, deal values are from Thomson Reuters.)

Citigroup Inc.’s board also recently retained Cravath for help evaluating its alternatives in the market. Woolery said the firm’s work for Citigroup began after that company’s bid for Wachovia Corp., which was ultimately bought by Wells Fargo & Co. for $15.1 billion.

“We have a large share of financial deals,” Woolery said. “We were called in by a lot of these boards when [they] were in a crisis mode.”

The financial sector claimed the largest share of deals by dollar volume last year, according to Thomson Reuters numbers, propped up both by crisis deals and minority investments in financial institutions. Financial-sector deals accounted for 21%, or $211.3 million, of last year’s $988.5 million in M&A deals.

Meanwhile, overall deal-making plunged by one-third, or 34%, from the 2007 total of nearly $1.5 billion in deals.

During the first part of 2008, much of the financial-sector M&A activity stemmed from banks and other financial institutions selling sizable minority stakes in their companies to raise much-needed capital, said John Madden, a mergers and acquisitions partner at New York’s Shearman & Sterling.

Many of the investors were sovereign wealth funds, which are governmental or quasi-governmental investment vehicles funded by foreign countries. Middle Eastern countries, such as the United Arab Emirates, and Asian countries, particularly China and Singapore, were the most active, Madden said. “A number of M&A lawyers were involved in these investments” Madden said.

This year, sovereign wealth funds are going to be “substantially more cautious” because the low stock prices of banks have depressed the value of current investments, Madden said.

Deal lawyers at New York’s Sullivan & Cromwell also worked on multibillion- dollar capital raises before the wave of bank and financial services M&A deals, said Mitch Eitel, a partner in the firm’s financial institutions and mergers and acquisitions groups.

Eitel said the firm represented Citigroup, Merrill Lynch and other banks in early 2008 fundraising efforts and investors in Morgan Stanley around the same time frame. The deals were very large, privately negotiated transactions that did not involve a U.S. Securities and Exchange Commission (SEC) registration process, Eitel said.

“That was a very busy time for deal lawyers,” Eitel said. “All of those deals required lawyers both representing issuers of securities and the investors in these institutions.”

Yet the cash infusions from private investors ultimately weren’t enough to keep many banks afloat.

Private-equity funded deals also dwindled, and the liquidity needs of financial institutions and companies in other sectors drove a significant portion of mergers last year, said Gregory Gooding, a corporate partner at New York’s Debevoise & Plimpton and a member of the firm’s mergers and acquisitions group.

The firm advised Bank of America financial adviser J.C. Flowers & Co. during the Merrill Lynch acquisition, but Gooding declined to discuss details of that transaction.

“It felt like for most of the year, much of what we were doing in the financial sector involved distressed situations,” Gooding said.

JPMorgan Chase & Co.’s bargain-basement purchase of The Bear Stearns Cos. Inc., which was announced on March 16 and closed on May 30, foreshadowed a host of such crisis deals that took place later in the year.

“It was an extremely active sector, but the deals were driven mostly by weakness, at institutions where a transaction had to happen,” Eitel said.

Eitel’s firm represented Wachovia in its sale to Wells Fargo and the independent directors of Bear Stearns in its sale to JPMorgan. The firm also represented JPMorgan in its Sept. 25 purchase of deposits, assets and certain liabilities of Washington Mutual’s banking operations from the Federal Deposit Insurance Corp. (FDIC), which JPMorgan bought for $1.9 billion according to a company press release.

Several of the deals, including JPMorgan’s purchase of Bear Stearns, were put together without a lengthy due diligence process, but they were also done without material adverse change clauses that allow buyers to back out if the seller’s business prospects falter, Woolery said. In the JPMorgan/Bear deal, Cravath advised Bear’s financial adviser Lazard Ltd.

Government financial banking and lack of exit clauses for the buyers meant the deals were lockups, he said.

“They had very unique provisions that made the deals almost certain to close, which is not customary,” Woolery said. “Usually there’s a shareholder vote that is risky and there’s a lot of stuff that could happen before closing. These deals were structured so they were almost guaranteed to occur.”

The unique circumstances surrounding the crisis also generated negotiations that added twists to several deals, Eitel said. The FDIC, for example, recently agreed to share losses on some banks’ portfolios, such as for the newly created IndyMac Federal Bank F.S.B. After the Office of Thrift Supervision closed IndyMac Bank on July 11 and named the FDIC conservator, IndyMac Federal Bank assumed the assets of IndyMac Bank F.S.B.

Sullivan & Cromwell represented IndyMac Bank investor J.C. Flowers.

“The FDIC is showing a greater level of innovation, so the [deal] papers do show some variance,” Eitel said.

Many of last year’s financial-sector deals also called on firms’ bankruptcy and litigation teams, Eitel said.

Sullivan & Cromwell’s work representing Barclays PLC in its planned purchase of the North American investment banking and capital markets business of the bankrupt Lehman Brothers is one example, Eitel said. According to a Sept. 17 Barclays press release, the company agreed to buy the Lehman assets for about a quarter of a billion dollars.

“That’s clearly a transaction that involved people from all sorts of areas, including bankruptcy people,” Eitel said. “There are many creditor’s rights issues that come out of a transaction like that.”

The restructuring of the financial sector through M&A dealmaking is expected to continue in 2009 as corporations such as Citigroup and American International Group Inc. (AIG) look to sell assets, Gooding said.

Gooding is representing AIG in its agreement to sell AIG Life Insurance Co. of Canada to BMO Financial Group for about $308 million, a deal announced by AIG on Jan. 13 of this year.

“That will drive part of the M&A activity in 2009,” Gooding said.

‘Busted’ deals

Government guarantees propped up several financial-sector deals, but many other announced M&A transactions crumbled before they were signed, according to lawyers and data from Dealogic Holdings PLC.

Dealogic, which provides software to the investment banking industry, tallied 286 deals in the Americas that were announced and withdrawn in 2008, a 36% jump from the 210 announced then withdrawn deals in 2007. In 2006, 202 such deals were withdrawn.

Corporate attorneys say the prevalence of withdrawn deals means they were busier with M&A than the drop-off in total dealmaking would suggest.

“There were a lot of busted deals,” Woolery said.

A source of litigation

Broken deals also spurred litigation, such as state court cases in Delaware and Texas after private equity firm Apollo Management L.P. and resin maker Hexion Specialty Chemicals Inc. attempted to back out of a $6.5 billion deal to take chemicals manufacturer Huntsman Corp. private. In a December 2008 settlement of a deal first proposed in July 2007, Apollo and Hexion paid Huntsman $1 billion in settlement money and breakup fees.

Harry M. Reasoner, a commercial and business litigation partner at Houston’s Vinson & Elkins who represented Huntsman, said “there’s no question” that Apollo’s interest in Huntsman tapered when the market started to cool off.

“When Apollo first sued in June [2008], trying to terminate the deal, they probably didn’t want to close the transactions due to lower rates of return,” Reasoner said. “They obviously wanted to earn those double-digit rates of return.”

When the Delaware Court of Chancery issued a Sept. 29 order demanding that Apollo and Hexion make their “best efforts” to close the deal, Huntsman would have still been solvent with bank financing, Reasoner said.

But the deal collapsed when the transaction didn’t happen right away, he said.

“The timing was so critical,” Reasoner said. “The last quarter of the year was bad for everyone.” Although Reasoner insists Huntsman was solvent at the time the deal was slated to close, he said many deals scheduled to close at the end of 2008 would not have worked under the proposed financing.

Andy Nussbaum, a corporate partner at New York’s Wachtell, Lipton, Rosen & Katz who represented both Apollo and Hexion, declined to comment on the deal or the litigation.

Nussbaum said deals fell apart for a variety of reasons such as mutual agreement of the parties or one party exercising the right not to close.

The credit markets’ rapid collapse forced parties in leveraged deals to take a second look at the feasibility of various transactions whether they wanted to or not, Nussbaum said.

“Many deals became either not doable or not sensible,” Nussbaum said.

“Unlike in other periods, it sometimes became economically more sensible to pay a substantial break fee than to take the risk of closing the deal.”

Aside from the flurry of financial-sector combinations, a large percentage of last year’s successfully inked deals were in traditional industries. Health care was the second most active sector by dollar volume, followed by consumer staples. That compares with 2007′s industry leader list headed by energy and power, followed by financials and by high-technology deals.

Health care is somewhat immune to economic cycles, so it’s likely to continue the strong dealmaking position it held in 2008, Woolery said.

“It’s a very vibrant sector of the economy because the demand for health care is not driven by the overall economic environment as much as for other sectors,” Woolery said.

Despite individual industry bright spots, and opportunistic deals such as investors buying companies in bankruptcy, the appetite for dealmaking will remain weak until the equity markets stabilize and the credit markets thaw out, Madden predicted.

“In order for companies to have the confidence to move forward with an active M&A program, one needs to achieve some level of stability and equilibrium in the equity markets and some return to normalcy in the credit markets,” Madden said.

IPOs down by 87%

The U.S. initial public offering (IPO) market fared even worse than M&A dealmaking last year, freezing up last summer when signs of the credit crisis surfaced.

IPOs plunged by 87% to just 29 offerings compared with 219 IPOs in 2007 and several similarly robust years.

The May $388.1 million IPO of pump and related products maker Colfax Corp. was one of the last major IPOs to get done last year, said Mike Silver, a Baltimore corporate and securities partner at Washington’s Hogan & Hartson. Silver worked on the issuer’s counsel team for the Colfax deal.

“By midyear there was just a trickle of deals getting done,” Silver said. “I know of a lot of deals, even some we’re working on, that are in the pipeline hoping for a market thaw.”

The firm also served as issuers’ counsel for the $51 million February 2008 IPO of medical device company MAKO Surgical Corp.

The January 2008, $281.8 million IPO of financial data and analysis firm RiskMetrics Group Inc. was the “last gasp” of a really vibrant IPO market, said Richard Gilden, a corporate partner at New York’s Kramer Levin Naftalis & Frankel, which served as issuer’s counsel on the deal.

“If it wasn’t for the fact that it was an extraordinary company with extraordinary backers it wouldn’t [have gotten done],” Gilden said.

Even if the markets open up this year, only companies with a proven track record and good prospects are likely to make the leap from private to public company, Silver said.

“The days when prerevenue venture backed companies could get deals done pretty easily are long gone, and I don’t know when they’re going to return,” Silver said.

Related chart: Top announced U.S. target M&A deals of 2008