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.


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