Friday, September 28, 2012

Six Disadvantages of Highly Levered Firms

In a recent blog I talked about the ways Acquisition Finance creates value.  To be sure, I believe that private equity firms and free enterprise in general have been greatly misunderstood and unfairly criticized in the popular press and in political ads during this election year.  To be fair, however,  I focus this blog on some of the disadvantages of the high leverage often associated with acquisition finance.  Six disadvantages are listed below:

  • ·      Leverage is a double-edged sword
  • ·      Increased risk of default
  • ·      Overpaying
  • ·      Political risks
  • ·      Less access to capital markets
  • ·      The need to cash-out

Put simply, leverage is a double edged sword.  It will magnify owner returns in good times and diminish them in bad times.  It is a sword that cuts both ways.  In general, we have two ways to finance a business: debt or equity.  In a physical sense, debt (leverage) magnifies our ability to lift an object.  Here, that object is the equity rate of return.  In good times, we pay off the fixed cost of debt (interest) and divide the profit pie among fewer shares producing a greater rate of return.  But in bad times, the reverse is true – we must pay the fixed interest charge regardless of profits.  Equity rate of return declines. 

In the U.K., leverage is known as gearing.  Similarly, one can imagine how using the proper or improper gearing on a bicycle could help – or hinder performance.  Correspondingly, increased leverage brings an increased probability of default.

Easy access to debt facilitates overpaying, which is probably the key factor responsible for less than adequate acquisition returns  (the other candidate is lack of proper integration).

Political risks arise as leveraged deals face adverse commentary in the financial press.  The result can be increased costs through higher levels of governmental regulation.

If a highly levered firm is also going private, there is generally less access to capital markets.

Finally, the typical private equity model assumes a five to seven year cycle.  The private equity firm doesn’t want to be a long term owner, but it does want to work its magic (see the blog on the ways acquisition finance creates value) and then cash out.  But cashing out at a desirable price may not be possible for many reasons.  First, anticipated increases in value may not materialize.  Second, the cyclical nature of industry or financial markets may work against a timely sale.  Third, in spite of best efforts, a suitable buyer may not materialize or may disagree on the value of the firm to be acquired. 

All of these factors produce problems for deals involving acquisition finance.  In later blogs, we will talk about ways acquiring and selling firms can a) have more confidence they are using the proper amount of leverage and b) protect themselves against the risks commonly associated with mergers and acquisitions.

All the best,


Wednesday, September 26, 2012

First Things First

This post focuses on strategic versus financial acquirers. A critical decision is how to fund an acquisition.  CFOs need to translate strategy into its financial implications, and then access capital to ensure its realization. There is a temptation to increase leverage to make the deal look better.  While you need to take risk to make money, you do not make money for taking risk. Risk and return are correlated. Risk does not create return. Equally true, leverage does not create value-it just magnifies outcomes.

The real source of acquisition value comes from buying synergies at less than their full value, and not from funding. This requires the ability to realize the potential synergies. This in turn requires the flexibility to operate without tough covenant restrictions. Also, you need to maintain capital market access under most market conditions-good and bad-not just the current conditions. Bad things happen when capital structures collide with markets they were not designed to withstand.

This translates into a mid level "A" type capital structure. Thus, post acquisition funded debt to earnings before interest, taxes and amortization levels should be below 3 times for most firms. If you need to increase leverage to justify a deal, then something is wrong with the deal.  We’ll have more detail on this and the differences for strategic and financial acquirers  later and, of course, in our acquisition finance course.


Monday, September 24, 2012

5 Ways that Acquisition Finance Creates Value

Acquisition Finance typically involves a change in the ownership structure of a company, often accompanied by increased leverage.  The terms MBO, LBO and leveraged recapitalization are typical.  The entire process is often misunderstood and sometimes vilified.  At it's core, however, are changes that increase value through improvements in financing, incentives, strategy and operations to better meet the needs of customers.

Five interrelated ways that acquisition finance creates value include:

  1. Improving incentives
  2. Improving efficiency
  3. Improving governance
  4. Reducing regulatory requirements
  5. Creating tax shields
Incentives are at the heart of acquisition finance.  Typical ways incentives are improved include revising compensation structures as well as capital structure changes.  Compensation structures can be revised to better align pay and performance, focusing on the strategic levers that create value for a particular company.  Capital structure changes involve shifts in managerial ownership levels as well as shifts in debt levels.  These changes can provide  powerful carrot and stick incentives.  In many transactions, managerial stakes are increased which results in more 'skin in the game'.  At the same time, personal and company leverage provide powerful motives to meet regular interest payments.  At the personal level, leverage motivates executives concerned about personal default.  At the business level, the requirement to meet debt payments reduces cash at hand and hence the ability to build the empire using owner's (shareholder's) money.  Executives that want to grow the company must face a market test of raising capital rather than using cash at hand from retained earnings.  

With revised incentives comes a need and a desire to take a fresh look at the strategic and operating position of a company, with a goal of increased efficiency.  While these changes can dramatically improve a company's ability to meet customer needs, they can also be painful.  Change can be difficult and one should not minimize the impact of these events on employees of the company.  We must keep in mind, however, that the marketplace is highly competitive.  It is a cruel and harsh truth but companies (and employees) that fail to adapt ultimately face the realities of a competitive world.  In many cases, painful changes associated with acquisitions would have happened anyway.  

In some cases, acquisition finance involves taking a firm private through a leveraged buyout or a management buyout.  Improved governance is often the result.  Incentives are also at the heart of governance.  A streamlined board of directors, higher levels of managerial ownership and increased focus on the sustainable competitive advantage of a company are just some of the ways that governance can improve value.

Related to this are the reduced regulatory requirements that can be associated with private firms.  Directors of publicly traded companies often tell me of the increased amount of time spent complying with Federally mandated regulations.  They loathe the 'check-box' mentality associated with a 'one-size fits all', requirements.  Directors of privately traded companies (which generally face fewer regulatory requirements) talk about increased time for strategic thinking on behalf of the company.

In addition to the incentive effects mentioned above, increased leverage creates tax shields.  In the current tax code (for the US and many countries), interest is tax deductible.  Increasing the leverage of a firm reduces its tax burden in the same way that individuals 'write-off'' mortgage interest deductions.  The capitalized value of these tax shields can add significantly to the value of a firm.  However, increased leverage brings increased risk.  The challenge is to recognize the optimal level of debt that can be associated with the firm's assets.  More detail on techniques for matching both sides of the balance sheet will be coming in a future blog.

One notes that some of the items mentioned above could be accomplished within the firm, without outside intervention.  Being aware of how acquisition finance can create value should help management and boards better understand ways to keep their companies thriving in a competitive marketplace.  Failure to remain competitive leaves opportunities for improvement and incentives for outside forces to take action.  In this regard, the best takeover defense is to maximize value, but that important concept is also worthy of additional discussion in a later blog.


Friday, September 21, 2012

Behavioral Bias-The Hidden Risk in Mergers and Acquisitions

 Mergers and acquisition decisions are made by humans, not mathematical models. Humans have biases and make mistakes when fear or greed overrides their analysis. Richard Roll noticed this in his 1986 hubris hypothesis. These systematic deviations from rational calculations lead to substantial value destruction. As Warren Buffett notes, any CEO business craving will be quickly supported by detailed financial and strategic studies. Thus, it is better to start our review at the top with the CEO. The issues are understandable given the infrequent nature of acquisitions, limited feedback and the delay between upfront benefits and later costs. The errors can be both failing to make the good acquisition and making the wrong acquisition. Our focus here is on the latter.

Some major senior management biases are as follows:

1) Herding: mindlessly imitating peer actions - the “I have to have one because all the other kids have one” excuse. It gets especially bad as the merger cycle peaks resulting in buying at a high price.

2) Anchoring: overweighing certain information such as the original bid price or locking on to the 52 week high of the target’s shares for the opening bid.

3) Over Optimism and its cousin Over Confidence: this is the “we can do it” attitude to justify any synergy estimate needed to defend the price.

4) Confirmation: over weighting confirming evidence to the exclusion of contradictory facts.  These lead to a win at any cost approach known as the winner’s curse in which the “winner” overpays.  A practical way to handle the winner’s curse problem is to set a maximum price before the bidding starts.  Attempts to increase the price after the bidding starts should be questioned.
Remember we are often:

  •       Guided by selective memories 
  •     Often fail to consider what we believe to be false
  •     Influenced by the actions of others
  •     Confusing preferences with predictions
  •     Engaging in self serving attribution
  •     Denigrating non conforming views
Hopefully, forewarned is forearmed.


Wednesday, September 19, 2012

Sometimes the Best Deals are Those You Don't Attempt

Last week we wrote about 14 keys to acquisition success noting that each of the keys was worthy of extended discussion.  This week we begin that discussion, devoting one day of each week to providing more detail on one of the points we were making about acquisitions.  The first key was:

1.     Sometimes the best deals for your shareholders are those you don’t attempt or complete.

The point here is that not all deals increase shareholder value.  If, after detailed analysis and planning, a deal still doesn't make strategic and financial sense, don't do it.  It may be the best acquisition decision of your career.

The maximum an acquiring firm should pay is the net present value of the deal to their firm.  That is, estimate the present value of the cash flows after the acquisition and then subtract the cost you are paying for the company.  The result is your net present value.  In theory, you should pursue any deal where the NPV is positive.

In view of this logic, why would an acquiring company ever pay more than this estimated value?  The reasons are many, but a partial list includes the following:

  •   The acquiring firm overestimates the synergies, imagining that the target firm is worth much more under their management.  Solution: always ask yourself -why are these synergies unique to our firm and why haven't they been bid away?

  •  The bidding management wants to acquire for the wrong reasons.  For example, the bidding management views size as a reason to acquire, ignoring the impact on shareholders.

  • The bidding management gets caught up in 'deal fever' determined to win at all costs. The phase 'at all costs', obviously, implies a 'win' for the ego of bidding management and a loss for their shareholders. Often this happens after the deal is underway.  A potentially acquiring firm sees an 'opportunity'' escaping because 'someone else is willing to pay more for the firm'.  The acquiring firm ignores the fact that a) another firm may benefit more from increased synergies or b) the other firm is also overpaying.  The result is escalated premia and shareholder loss.

Bottom line: carefully analyze the strategic and financial implications of doing or not doing a deal.  But also recognize that the best deals for your shareholders can be those you walk away from.


Monday, September 17, 2012

Plain Talk About Acquisitions

This continues my effort to establish a practical acquisition framework.  Acquisitions are difficult for several reasons.  Unlike organic investments, they represent infrequent, large and concentrated commitments at premium prices with high transactions costs.  Furthermore, their relative size gives rise to integration issues.  Finally, information problems lead to surprises absent extensive due diligence.  Poor acquisitions are usually centered on poor strategic fit, integration problems, over estimated synergies (AKA over priced) and due diligence failings.  

Successful acquisitions also share some common characteristics.  First, they tend to be small.  Small is defined as something less than 15% of the buyer's total assets.  Small size reduces integration problems.  Next, premiums are modest.  This usually means making acquisitions earlier in the business cycle before prices increases.  Later cycle deals are more competitive and expensive.  Cash financed transactions are more successful for bidders than stock deals.  Finally, the target represents a good fit with the bidder.  Acquisitions are not strategy-they are a tactic to achieve a strategic goal.  

Successful acquirers tend to focus on the following questions:

1) Should I buy?  What strategic goal will be achieved by buying?  

2) What should I buy?  What target characteristics or screens am I seeking-e.  g.  size, location, products, etc.  ?  

3) How much should I pay?  This goes beyond the market price.  This is a question of affordability from a value viewpoint.  A useful measure is shareholder vale at risk (SVAR).  It is the premium offered as a percentage of the buyer's market value.  It represents the impact of failing to achieve the projected results to the buyer's shareholders.  SVAR is the amount of shareholder wealth the bidder's management is wagering on the deal.  

4) How should I pay?  This involves a choice among stock, cash or debt.  The decision has important accounting, legal, accounting, ratings, and regulatory  implications.  Remember, funding with an undervalued stock is just another way to over pay.  

5) How do I integrate after the close?  The basic choices are between absorption and preservation.  The botched Daimler-Chrysler absorption decision is an example of not choosing wisely.  

6) Am I sure to get what I wanted?  Due diligence and proper maintenance provisions in the sale and purchase agreement are critical to ensure you get what you want.  Disciplined, experienced due diligence teams focusing on accounting, tax, legal, and operating issues among others can avoid unpleasant surprises.  Bank of America's due diligence blunders at both Countrywide and Merrill are costly examples of rushed deals with inadequate due diligence.  

7) What is my negotiating  strategy?  Will you engage in auction transactions?  Have you thought through the probable competing bidders and their strategies-including how high they can bid?  Do you have draft term sheet and letter of intent ready?  

8) How do I protect my deal?  Once you have an agreement, you need to protect it against from competitors prior to close.  Citi Corp's failed in the Wachovia transaction to include  lock-up provisions.  This resulted in their losing the deal to Wells Fargo. 

9) What is the risk in the deal?  Assessing how you can get hurt upfront allows you to propose protective provisions.  

Acquisitions can be a valuable, albeit, risky growth supplemental strategy.  The framework discussed above is a way to impose discipline by asking the right questions, and to demand credible evidence of benefits before proceeding.  This, of course, makes it difficult to justify many proposals.  Nonetheless, such caution is warranted given the potential for harm in acquisitions.

Good hunting.  


Friday, September 14, 2012

Golden Parachutes and the Art of the Deal

In structuring any deal it is important to understand the motivations of key players on both sides.  Firms acquiring publicly traded targets must be particularly cognizant of the target firm's CEO - generally the single most important person influencing target reactions and negotiations.  But CEOs are individuals and like all of us have their own personal motivations.  In the case of an acquisition bid for their firm those motivations are influenced by many factors including a desire to do the right thing but also managerial motives like a preference for power, share ownership and the elements of the merger pay package structured by the board.  Indeed, boards must be extremely careful in structuring that package including the design of golden parachutes.  Parachutes too generous could prompt a rush to sale while parachutes too small could produce unyielding resistance to a sale.  Neither is likely to benefit shareholders.  Eli Fich, Ahn Tran and I explore these issues in a sample of 851 acquisitions in an article forthcoming in The Journal of Financial And Quantitative Analysis. We find that parachutes do indeed influence the likelihood of sale as well as the terms of the final deal.  

On the importance of Golden Parachutes
“Companies receiving federal aid are going to have to disclose publicly all the perks and luxuries bestowed upon senior executives, and provide an explanation to the taxpayers and to shareholders as to why these expenses are justified. And we're putting a stop to these kinds of massive severance packages we've all read about with disgust; we're taking the air out of golden parachutes.”
President Barack Obama
February 4, 2009[1]

Golden parachutes are more controversial today than when they first appeared over twenty years ago. Advocates argue that parachutes are a necessary part of a competitive pay package required to attract and retain talented executives. It is also argued that parachutes are beneficial to shareholders since they induce senior managers to “do the right thing” in the event of an acquisition attempt. Opponents object to parachutes because they are linked to a change in control of a company, not to its continuing or past performance. Detractors portray parachutes as guaranteeing managers “pay-for-failure,” regardless of shareholder returns. Headlines from the popular press regularly criticize golden parachutes and express widespread concern about managerial excess and the lack of pay-for-performance related to parachute payments.   Our research analyzes golden parachutes on a sample of 851 acquisitions finding that more important parachutes benefit target shareholders through higher completion probabilities. Conversely, as parachute importance increases, target shareholders receive lower takeover premia while acquirer shareholders capture additional rents from target shareholders.  The results have important implications for boards of potential targets as well as those structuring deals for acquiring firms.

The complete article can be downloaded free of charge here.

Wishing all a great weekend,

 (The full speech by president Obama can be viewed at:

Wednesday, September 12, 2012

It is What You Pay- Not Just What You Buy-That Matters

Corporate profits are strong. Macro uncertainty is high and reinvestment rates are muted. Consequently firms are holding record levels of cash. Managers cannot wait for the last black swan to land before deploying their cash. Nonetheless, organic growth is difficult in the current environment. Acquisitions can be a valuable supplemental growth option. Acquisitions, however, are risky. Much research indicates that the typical acquisition fails to create value for the buyer's shareholders. Buyers can succeed despite the odds if they are disciplined-especially about price.

Pricing-over paying for an acquisition- is the single biggest risk. Even the prefect target becomes bad at some price. The key is to avoid paying more than the value received. Price is a fact. It is what you give up immediately. It reflects the target's standalone value plus a premium. Value is an opinion of what you hope to receive over time represented by the standalone value plus synergies. Therefore, the target's net value added is the premium less expected synergies. The iron law of acquisitions is the buyer's shareholders lose whenever the premium exceeds synergies. Sounds simple, but is complicated by two factors.

The first is the winner's curse. In a competitive market, and the M&A market is highly competitive, the winning bidder tends to over estimate the target's value. The second is what Warren Buffett calls the institutional imperative. Essentially, whatever the CEO wants will be supported by extensive projections and numerous strategic studies. That is why it is critical to establish a reservation or walk away price before the bidding begins to avoid getting carried away during the heat of the battle. This reservation price should be set below the target's estimated net value added. Keep in mind there is no one true intrinsic value. It depends on the buyer's strategy and ability to execute on that strategy. Certain acquirers employing higher value added strategies can extract higher values from an acquisition. They will- in effect- be the natural owner of the targets, and can successfully out bid other interested parties. You need to identify those unique factors allowing you to "win" the bidding and still create value for your shareholders to avoid the winner's curse.

Successful acquisitions are difficult-not hopeless. You need to recognize this fact, and maintain a strong sense of humility. This means keeping your confidence to competence ratio below one. Remember there is no right way to do the wrong thing. If you over pay relative to the target's reasonable expected synergies, then you become a bad bidder. Bad bidders become good targets. So let the buyers beware.

Monday, September 10, 2012

14 Keys to Acquisition Success

The following points are some of the things important to remember in M&A.  Joe and I will be expanding our analysis of each of these points in the coming weeks.  Obviously, the list can also be considerably longer.  What is missing?  Send us your favorites as well as examples of the items listed.

1.     Sometimes the best deals are those you don’t attempt or complete.

2.     Any deal is a bad deal at some price; not every deal is a good deal at some price.

3.     Negotiate the deal on all aspects (price, form of payment, contingencies, etc.)

4.     Listen – and remember what you say may not be what is heard.  Also, what is said may not be what is meant!

5.     Beware of unrealistic projections.  Understand the source of synergies.  Why are these synergies available to you and not other buyers?

6.     Beware the winners curse – you win the auction not because you are the smartest, but because – you paid the highest price.

7.     Most deals fail to reach their full potential because of issues in integration. Don’t underestimate the costs and problems of integration.

8.     In mergers, 2+2 can equal 5, (3 is also a distinct possibility)!

9.     Think strategically, but understand that your competition is doing the same.

10. Value does not equal price.   As our friend Bob Bruner has noted, Price is what you pay, Value is what you estimate.
11. Establish a walk-away price up-front.  Don't be afraid to walk away.  (See point 1!)
12. Do not over borrow.
13. Assess risk not just reward.
14. Due diligence is key, or as President Reagan used to say-trust, but verify.

·      ????  What is missing?  Help add to the list.


Wednesday, September 5, 2012

The Art and Science of M&A

Welcome to!

We begin this blog for several reasons.  First and foremost, we are excited about the topic of mergers and acquisitions.  We’ve spent most of our adult lives pursing the topic, one of us as an academic, one as a practitioner.  We both firmly believe that mergers involve an art and a science.  The art comes from an intuitive understanding of what works and what doesn’t.  It is the creative genius that makes a good deal great and an impossible deal successful.  The science comes from observation and analysis, from a solid understanding of the theory of finance and a belief that empirical evidence is important.

Both the Art and the Science are crucial to success in acquisitions and both depend heavily on one another.  Without a grasp of the science, the art is an unstructured seat of the pants journey.  This may be fine in the world of paintings where one canvas is easily discarded for the next.  It is fatal in the world of mergers and acquisitions, where markets are unforgiving and errors are quickly capitalized into price.  Do-over’s come at a very high cost when selling one company or buying another.

Science without art is a rigid mechanical process that can miss the creative opportunities for greater synergies.  At it’s worst it implies rigid adherence to the rules without realizing when they don’t apply or can be bent. 

The connecting link between the art and science of mergers involves experience.  Nothing is so valuable or so costly as personal experience.  But as professionals, we need not limit ourselves to personal experience.  The Science of M&A involves large-scale empirical analyses of all aspects of mergers.  Fortunately, there are hundreds of empirical analyses already existing and more being created each day.

Just a few of the questions addressed in the empirical literature regarding M&A include:
  • ·      What are the valid motives for mergers from the shareholders point of view? 
  • ·      What techniques create the most value in a deal? 
  • ·      Which attributes are associated with failed deals? 
  • ·      What form of financing is best for creating value? 
  • ·      What determines the percentage bid premium offered to the owners of a company?
  • ·      What determines the market reaction to a bid announcement? 
  • ·      What role does management and the board play in the success or failure of a deal? 

The point is that we need not limit ourselves to our own personal experience.  The evidence of thousands of deals is already available for our understanding.  

Moreover, this evidence is expanding daily.  New techniques are constantly being devised.  New strategies are constantly being employed.  Techniques and laws like poison pills, and modern state anti-takeover amendments were unknown until the 1980’s.   Termination fees and collar transactions became prevalent even more recently.  The financial crisis of the last few years has engendered even more creative techniques. 

The Science and the Art continually evolve.  To get the most from our deals, we need to stay current, to listen and to evaluate.  We hope this blog creates a forum of interest for all those interested in mergers and acquisitions.  We’d like to see it become a resource and a whiteboard for the open exchange of ideas.  We hope our blogs are the catalyst for new ideas - for the sharing of examples and counter examples – for the challenging of best practices and the illustration of what works best.

 The combined experience of our audience is the greatest resource.  Thanks for being part of our journey.  Our next blog: 14 Keys to Acquisition Success

Joe and Ralph