Wednesday, October 31, 2012

Structuring the Deal: Preserving Cash -- Guest Post

Today's blog features a guest post by Thomas Hofmann, former senior vice president and CFO of Sunoco, Inc.  Tom also serves as a director of West Pharmaceuticals and a director of the general partner of Penn Virginia Resource Partners, L.P.  In today's blog, Tom describes the detail and reasoning behind one of their recent transactions.  


Acquisition Financing

Joe’s October 17, 2012 post provided a cautionary tale for acquisition financing.  His concern focused on market conditions changing after the deal is structured but before the deal closes.  An issue Joe did not discuss but is relevant to the following discussion is the preservation of cash subsequent to an acquisition.

In the second quarter of 2012, PVR Partners (PVR) acquired the Marcellus Shale assets of Chief Holding for approximately $1 billion.  As in any acquisition, PVR was faced with the issue of determining how to pay for the acquired assets.  A little background is in order.  PVR is a publicly traded (NYSE) Master Limited Partnership (MLP).   As a result of being structured as a partnership, MLPs pay no US Federal taxes and generally distribute their cash flows (less maintenance capital and some other allowable reserves) to their unitholders (generally on a quarterly basis). Therefore, MLPs don’t accumulate cash nor do they build up unitholder (Shareholder) Equity.  In order to grow the asset base MLPs must access the capital markets.  They also must be mindful of maintaining appropriate debt coverage ratios and maintaining, or growing, their quarterly distributions per unit.  So the acquisitions need to be accretive and MLPs must raise both equity and debt to finance growth.

To eliminate the risk of market conditions changing after the deal was structured but before it closed, PVR embarked on a strategy to place all of the equity required to finance the acquisition prior to the announcement and closing of the deal.  They did the equity raise through three separate but related transactions.  Chief took back approximately $200 million of PVR equity as part of the $1 billion purchase price.   PVR then placed approximately $400 million of equity with Riverstone, a major Private Equity firm.  Finally, PVR sold $180 million of equity through a private placement with a number of major investors.  To preserve cash in the short term, the Chief shares will not receive distributions for the next six quarters and Riverstone will receive Payment in Kind (PIK) distributions for the next eight quarters. The balance of the purchase was financed through long term debt.  The attached slide from PVR’s investor call on April 10, 2012 provides additional detail of the terms of the equity placements. 

Thomas Hofmann  


Friday, October 26, 2012

Dutch Acquisitions

Joe and I are busy preparing for our acquisition finance course next week in Amsterdam.  As part of that preparation, we are looking at some of the deal activity in Europe.*  The slides below are preliminary, and some of the numbers need to be verified but some interesting trends appear.  The United Kingdom leads with the largest dollar volume of deals over the past five years and the largest number of deals.  The Netherlands is second in terms of deal value, a statistic undoubtedly driven by the large deals involving ABN-AMRO, Royal Dutch Petroleum, and Mittal Steel, among others.  We'll be exploring and discussing the implications of various aspects of deal design related to these and other acquisitions in the course.  We will also feature a case analysis of the ABN-AMRO deal.

All the best,


* The negative premia for the ING group is misleading, the result of a large capital infusion by the government.  See

Wednesday, October 24, 2012

Do Onto Yourself, Part II -- ABN AMRO vs. CITI

I commented on October 10 that it is better to do onto yourself before others do onto you. The focus was on enacting business model changes before a hostile takeover forces those changes on you. The 2007 ABNAMRO (ABN) breakup was cited as an example. Little did I know that one week later another bank would have change forced upon It. This time it was not from a hostile bidder, but from a hostile board. Vikram Pandit “resigned” on October 16 following a clash with his board -especially its Chairman- over strategy among other items.

Citi’s problem was very similar to ABN’s-its large universal banking model no longer worked. Both banks adhered to a global financial conglomerate strategy. Both banks’ management teams were psychologically committed to the strategy and unable to breakup their respective institutions. This was despite a 90% value decline since Pandit became CEO. Additionally, Citi continued to lag its competitors and traded at 60% of its tangible book value.

Unlike ABN, Citi faced no hostile bidder. Rather Citi’s board decided to take action. It was largely a new board with most members replaced during the crisis. Thus, it had a reduced commitment to management’s existing strategy. Consequently, it was ready to act if management did not act. ABN, however, lacked an independent board. One could argue if ABN’s board was an independent as Citi’s, the ABN hostile bid and breakup would not have occurred.

Again the lesson is clear. The status quo is not an option in a challenging macro and industry environment with lagging performance. Failure to adjust business models will attract either external or internal forces. The golden rule of doing onto yourself before others do onto you remains in full force. The practical implications for firms are twofold. First, examine all business units to see if any of them are past their “sell by” dates. Second make sure your business still makes sense in the post-crisis market.

Hostile takeovers involve a fight over who is the better manager of corporate assets-you or someone else. It is nothing personal-it is strictly business.


Monday, October 22, 2012

Anticipation, Acquisitions and Bidder Returns

In Friday's post "Acquisition Returns and Unresponsive Toads", I talked about the empirical evidence on acquisition returns and some possible explanations for the fact that most evidence shows that bidding firm shareholders either break even or lose a small amount when deals are announced.  While that is indeed the prevailing wisdom, we have recently published new results which suggest that, when properly measured, the typical bidding firm actually earns significantly positive results.

The measurement problem we recognize is anticipation of the deal.  Markets adjust to anticipated events and anticipated or rumored mergers are no exception.  When deals start happening in an industry, prices adjust to reflect the possibility that a firm will follow with their own deals.  Think of it this way - you have a still pond (representing lack of acquisition activity in an industry).  Someone throws a rock into the pond and ripple effects are created.  (We showed this result for target firms in a paper published some time ago.  When a firm in an industry first becomes a target, the prices of other firms adjust in proportion to the probability that they will also be targets.)

In the current work, we examine bidding firms and calculate their abnormal returns - that is returns controlling for the market movements and risk.  We analyze nearly seven thousand  deals from 1985 to 2009 to determine the effects of anticipation. We define unanticipated deals as those in a particular industry where there has been a lack of bidding activity (a dormant period) for at least the previous 12 months.   Those unanticipated deals earn a 1.5% abnormal return for the bidding firm's shareholders.  In contrast deals following an initial industry bid (dormant period less than 12 months) earn significantly less - only 0.5%.  The results are shown in the graph below. (Here, CAR means cumulative abnormal return over the three day period centered on the announcement day which is day zero.)

But many factors affect bidder returns and we need to control for these factors to properly interpret our results.  For example, the factors we've analyzed include public and private targets, form of payment, horizontal or non-horizontal, friendly or hostile and even industry related factors like expansion, contraction, etc.  These analyses are interesting in their own right but for our current purposes, we will just show the differences between acquisitons following long and short dormant periods in their industry.  The chart below shows the difference in returns (long dormant periods minus short dormant periods) for 28 separate categories that have been shown to impact bidder returns.  In all but two categories, the bids that are more of a surprise (i.e., longer dormant period) earn larger returns.  The two categories where the difference is negative are driven by the definition of the category - hostile deals and deals with multiple bidders are soon followed by competing bids with higher price.  The results here, and in the paper provide considerable evidence that acquisitions are anticipated based on previous industry activity and that once you control for this, acquiring firms earn significantly positive abnormal returns.

The paper contains a proper multiple variable framework(regression analysis), and many other results.  It is coauthored with Jay Cai of Drexel and Moon Song of San Diego State.  It can be downloaded here.

All the best,


Friday, October 19, 2012

Acquisition Returns and Unresponsive Toads

Financial academics have been analyzing mergers in a scientific fashion for over 30 years.  One thing that has always puzzled me about this research is the accepted result that bidding firms either break even from acquisitions or lose a few percent on the deals they make.  (This tendency,  incidentally, helps explain one arbitrage strategy in stock deals, buy the target and short the bidder.)

But accepting this result doesn't tell us why bidders would undertake such deals.  Many explanations have been given.  Until recently, the arguments that seemed most plausible were a) that returns were driven down by competition for the target (bidding wars) or b) that the bidding firms get carried away with their own power - believing that they are endowed with greater abilities to manage a target.  Obviously, these two items are related.  The difference is that the explanation under (a) still allows for bidders making profitable deals.  Explanation (b) implies overpaying.

On Monday, I'll present new evidence from research we have conducted showing that bidders do indeed earn significantly positive abnormal returns when deals are announced - we just have to measure them correctly.  But our results don't imply that explanations (a) or (b) are incorrect.  All three explanations can and probably do hold water.  Competition does drive down returns, and while the typical deal is profitable when measured correctly, many deals lose money for bidders.

So today, I focus on the hubris explanation.  This idea was  first mentioned in the academic literature by Richard Roll in 1986 but I conclude with a non-academic and more entertaining analysis of the issue - a quote from Warren Buffett.

"Many managers were apparently over-exposed in impressionable childhood years to the
story in which the imprisoned, handsome prince is released from the toad's body by a kiss
from the beautiful princess.  Consequently they are certain that the managerial kiss will
do wonders for the profitability of the target company.  Such optimism is essential.
Absent that rosy view, why else should the shareholders of company A want to own an
interest in B at a takeover cost that is two times the market price they'd pay if they made
direct purchases on their own?  In other words investors can always buy toads at the
going price for toads.  If investors instead bankroll princesses who wish to pay double
for the right to kiss the toad, those kisses better pack some real dynamite. We've observed
many kisses, but very few miracles.  Nevertheless, many managerial princesses remain
serenely confident about the future potency of their kisses, even after their corporate
backyards are knee-deep in unresponsive toads." 

(Warren Buffett in the 1981  Berkshire Hathaway Annual Report)

On Monday - what impacts returns to acquiring firms and how to measure them more accurately.

Have a great weekend,


Wednesday, October 17, 2012

You Can't Always Get What You Want

Acquisition finance choices depend heavily upon potentially volatile market conditions. The tricky part is when the conditions change after the deal is structured, but before it closes and is funded. This can leave the acquirer-issuer in the uncomfortable position of marketing an out-of-season transaction to investors or pulling the deal.

The match between issuer preferences and market availability looks easy. Issuers seek low pricing, flexibility (i.e. minimal covenant constraints), large levels of debt availability, and high leverage with small equity contributions. The match is easy during bull markets like those we enjoyed prior to 2008.

Investors can pick from the bull market menu to support higher purchase prices, which includes the following:
  •  Tight pricing
  •  Higher leverage-greater than 5X funded debt (FD) to EBITDA
  •  Equity contribution below 35%
  •  Larger, $1B+, deals
  •  Fewer covenants
  •  Plentiful high yield bonds supply
  •  Debt capacity enhancing instruments like payment-in kind (PIK), second lien and covenant lite (cov lite)
The markets essentially shut down during the crisis years of 2008/2009 resulting in busted deals and minimal transaction volume.  This produces a bear market menu.  Bear market menus are less flexible and include 
  •  Higher pricing like today’s LIBOR+ (400-500) bps
  •  Less leverage-less than 4X FD/EBITDA
  •  Higher equity requirements-50%+
  •  Less high yield bonds and more mezzanine debt
  •  Fewer and smaller deals
  •  More covenants
Current conditions have recovered in the U.S. Investors are hungry for yield. Leverage levels are increasing, equity contributions have fallen below 35%, high yield bond issuance is rising, and PIKs, second lien and cov lite are returning. The continuing Euro crisis, however, has dampened deal flow and structures on the continent. A recent example is Stork Technical Services. Stork was launched and then withdrawn in July due to lack of demand. It was restructured and re launched in September with the following changes:
  •  Increased equity
  •  Reduced cash paying debt and increased holding company PIK
  •  Reduced leverage
  •  Higher pricing
The art of structuring is in reading markets to match issuer preferences under different market conditions. In so doing-just as the Rolling Stones once said, you may not get what you want, but if you try real hard you may just get what you need.


Monday, October 15, 2012

High Leverage Deals, Capital Structure and Common Sense

Capital structure theory is too complex for a single blog post, but here are a few intuitive concepts blended with a little common sense.

Many of the practitioners I talk with  proscribe what is called the tradeoff theory of capital structure.  In short, as the proportion of debt in a firm’s capital structure increases, two countervailing forces interact.  First, firm value increases because of the value created by increased debt shields.  However, increased leverage also increases risk and the cost of financial distress also rises with the level of debt.  At some point, the advantage of the debt shields is offset by increased costs of financial distress.  Thus, firm value increases with the proportion of debt in the capital structure, but only to a point.  The chart below shows the basic idea.  The Value of a firm with debt  increases as debt is added to the capital structure but it only increases until we reach maximum value indicated by the top of the curve.  This peak signifies the optimal capital structure for the firm.   Beyond this point value declines as the costs of financial distress more than offset the value added by the tax shields.

The exact point of this optimal structure varies with the nature of the firm’s business, the tangibility of assets and other factors.  For some firms and deals, a mix of 30% debt and 70% equity might be optimal.  It other situations these proportions could be reversed.

The factors that go into these decisions are numerous and beyond the scope of a single blog.  In practice, we often use ratios as a guide to optimal leverage.  For example, we might ask if the ratio of EBIT to interest (the times interest earned ratio) is excessive, etc. 

One other thing to keep in mind in highly leveraged deals is that there is much that we don’t know.  Many of the theoretical assumptions behind capital structure, for example, assume a linear relation between factors with tax shields and financial distress increasing linearly with debt.  A bit of thought will suggest practical limitations: tax shields are only valuable if you are making a profit and certainly financial distress is unlikely to keep increasing linearly beyond some point.  Beyond some tipping point, financial distress costs increase exponentially. 

And so lets conclude with a little bit of common sense.  Joe and I are about to return to Amsterdam to teach Acquisition Finance again (see the link at the right hand side). A few years ago (before the crisis) as we were teaching we noted our concerns about deal fever and extreme leverage along with the admonition:  “Be cautious, we just don’t have a lot of empirical evidence regarding high leverage deals and financial default.”  Unfortunately, we have a lot more evidence now.  And while  understanding the intricacies of capital structure is indeed complex, I’m reminded of a comment my colleague Joe Rizzi made before the crisis, “It doesn’t take a rocket scientist to realize that if you are levered 20 to one, a five percent swing in asset value wipes you out!”

Understand the forces that drive acquisition finance but use common sense as well - and remember leverage is a double edged sword that magnifies outcomes.


Friday, October 12, 2012

The Interrelated Nature of Deal Design

Point 3 of our 14 keys to acquisition success states:

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

In a previous post, we commented that any deal is a bad deal at some price.  But a deal is so much more than price.  If we think about just a few of the decisions made in an acquisition it is clear that any deal involves a busy menu of detailed choices.  One of the things we discuss in the acquisition finance class is the interrelated nature of these choices.  Each deal is a system and each of the choices we make and negotiate has the potential to influence the others.  Wise negotiators consider the whole deal and bargain on multiple fronts.

Let's take just a few factors: price, form of payment, accounting choices, ownership structure, risks to the acquiring and biding firm and the length of the deal.  The price or bid premium over market is known to be related to form of payment.  Premia are known to be higher in cash deals, ostensibly to compensate for the immediate tax effects to the seller - and tax obviously affects the 'real' premia that target shareholders receive.  But form of payment also determines the accounting choices we make and even the form of organization.  And, of course, price and form of payment are related to financing.

A choice of stock as a form of payment affects the resulting ownership structure of the combined firm.  It also affects risk to all parties.  If the stock of the acquiring firm or the target change before the deal is closed the price that is paid and received is different from that originally negotiated.  (One way around this is the use of collars, but more on that in another blog.)  And remember, in terms of risk, who bears the risk ultimately affects the returns of the parties.

The choices we've just described also affect the length of time until a deal closes.  Cash offers tend to be faster (which is why hostile offers favor cash bids); stock bids involve more regulation and tend to take longer and so on.

We begin to see the complications and interdependencies from just the factors we've considered and we haven't even talked about social terms of the deal: where will the firm be headquartered?  What will it be called?  How many directors from the target firm shift to the acquiring firm's board.  Nor have we talked about target management: will they stay with the firm? etc.  etc.

The point is to take a whole deal approach, to recognize the myriad of interrelated choices and to bargain on multiple fronts.  Structuring the most effective deal requires no less.


Wednesday, October 10, 2012

Do Unto Yourself

Ralph’s suggestion to leave nothing on the table to reduce hostile takeover risk is a wise one. Hostile bids are a struggle by competing management groups over the control of corporate assets and strategies. Firms compete in two different markets. The first is the product market for customers and revenues. The second is in the capital markets for capital. Product market changes, such as new regulation, impact firm performance. It requires management and strategic adjustments. Howeverorganizational inertia keeps management from changing strategies that have previously  been  successful. The delayed adjustment depresses returns on equity and equity values relative to underlying asset values. Furthermore, management continues to invest despite the unattractive returns believing the poor operating situation is only temporary, which worsens the problem. The depressed returns and weakening stock price attract bidders who believe they operate the firm more efficiently.
The key characteristics of takeover risk include
  •  Fundamental structural change as opposed to cyclical industry change
  •  ROE less than cost of equity
  •  Sum of the parts exceeds the firm’s market value
Firms operating with these characteristics have two choices. Either adapt yourself or someone else will do it for you. A good example of this was provided by the 2007 takeover of ABN AMRO by a banking consortium of Royal Bank of Scotland (RBS), Banco Stantander (BST) and Fortis (FT). The trigger was an on-going war of words initiated by TCI (The Children’s Investment Fund) a UK hedge fund. TCI had been complaining of ABN’s subpar returns Also, TCI demanded in February, 2007, that bank management should consider a break up the bank as the sum of its parts was worth more that the bank’s current market value. TCI deemed ABN’s response as unsatisfactory and threatened action. TCI lacked the capacity to take over a bank of ABN’s size.They hoped other strategic bidders would join, and they did.

ABN’s suffered for years. It was an unfocused global conglomerate with little synergy among the countries in which it operated. Management was aware of the problem and making some incremental progress. They could not, however, make the difficult psychological choice to break up the bank. 

The consortium was a novel approach to handle the size and complexity of ABN’s business. RBS essentially took the international network (with the exception of Brazil and Italy which went to BST). The Benelux business went to FT. ABN tried to bring in Barclays as a white knight and sold their regional Bank, LaSalle, to B of A as a crown jewel defense to defeat the consortium. It failed and ABN was sold in October 2007 at a substantial premium to its pre TCI price.

One could argue that RBS and FT over paid and conducted inadequate due diligence. The market timing was also unfortunate as the transaction closed shortly before the great financial crisis of 2008 and both RBS and FT failed. Nonetheless, ABN’s sale released billions in trapped shareholder value. Additionally, the consortium did in the end what ABN managers should have done in the beginning-namely break up the bank. This illustrates the principle of doing onto yourself before others do unto you.


Monday, October 8, 2012

The Best Takeover Defense - Don't Leave Money on the Table

Publicly traded firms can be targets for acquisition bids.  Sometimes the bids are welcome and target managements try to understand how to maximize the bid price.  Other times bids are unwelcome and target management seeks to avoid a hostile acquisition.  In both of these cases, target management has a better chance of achieving its objectives if it will follow a simple rule:  maximize value.  In particular, don't leave easy money on the table. Maximize firm value by every means possible.  If target management does seek to sell the firm, this strategy will raise the floor from which premia are added.  If the target firm is trying to avoid takeover, this takes the easy money off the table and makes the firm a less attractive target.

Acquiring firms launch takeover bids for numerous reasons, but most, if not all, reasons can be classified into two broad areas: shareholder welfare and managerial welfare.  The latter set of motives deal with empire building, with overbidding due to hubris and other problems often associated with corporate governance.  We'll have more to say about that in another blog.

In terms of shareholder welfare, one firm bids for another when they believe it is in the best interest of their own shareholders.  In short, the expected net present value from completing the deal is expected to be positive.  Just as there are numerous motives for mergers, there are numerous ways a deal can create value.  For example, gains could accrue because of greater market share and the power associated with that market share or because of synergies that exist between the combined firms.

When the potential acquirer thinks about a bid, they envision the value of the firm under their control.  They also imagine the least amount they could offer for the target to acquire control.  For publicly traded firms, this minimum amount is  the current stock price.  Absent extreme liquidity concerns, rational shareholders would not sell their shares for less than they could get on the open market.  Thus, that market price becomes the floor from which bidders begin their pricing.  If the anticipated gains are insufficient to warrant the risks of the deal, a bid will not materialize.

Maximizing value won't prevent an acquisition bid, but it will put management in the strongest possible position should a bid materialize and in terms of hostile bids, it will discourage bidders looking for easy money left on the table.  Bids that do materialize are more likely to occur because of the synergistic potential of the combination rather than a failure of target management to follow the best value maximizing strategies.  In this regard, one should not disregard the disciplinary force of the takeover market.  In numerous situations, target management faced with a bid decided to implement changes similar to those that would have followed a 'takeover'.  These changes include things like focusing the firm, eliminating redundant assets, spinning off a division that doesn't fit the strategic mission and finding ways to reduce overhead costs.  In other words, taking the easy money off the table.  But it is better to be proactive than reactive.   Don't wait for a hostile bid to force value increasing change.

Incidentally, managements often complain that they are forced to behave in myopic ways to meet quarterly earnings estimates.  But myopic behavior implies overemphasizing the short run and hence producing lower firm value.  Rather than discouraging acquisition, this type of behavior is likely to do the opposite.  Failing to run the firm optimally leaves easy money on the table, inviting acquisition by a management with the proper long term perspective.

Friday, October 5, 2012

Any Deal is a Bad Deal at Some Price; Not Every Deal is a Good Deal at Some Price

We promised to return to the post entitled "14 Keys to Acquisition Success" and elaborate on one of the keys each week.  Today we look at Key 2:

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

The first part of the statement is pure math.  Acquisitions are capital budgeting decisions.  We estimate the cash flows we think we can receive from a potential target and discount those cash flows to the present.  The sum total of these discounted cash flows is our estimate of what the deal is worth.  If we can acquire the firm for less than this our estimated net present value is positive and the deal looks good - it increases our value. When the costs exceed the benefit, the NPV is negative and should be avoided.  

We've written earlier about two behavioral problems with this math.  First, the present value amounts are estimated and can be subject to conscious or unconscious adjustments to justify an acquisition.  Second, even if the value is estimated correctly, potential acquirers can get caught up in bidding wars that escalate the price beyond what it is worth until the firm is acquired - at a loss to the bidding firm's shareholders.

The last part of the phrase is not as obvious.  Doesn't it follow that every deal becomes a good deal at some price?  No.  The reason for this is that the estimated cash flows from a deal can actually be negative once all the costs of integration are considered.  Thus - even a zero price could produce a loss.  (This assumes, of course that one cannot buy the firm and flip it to another buyer at a higher price - in that case, the estimated cash flows would be positive).  Note, it is not hard to find examples of deals that are examples of the principal or at least come close.  Think Sprint/Nextel or AOL/Time Warner or Quaker Oats/Snapple.  In the latter case, Quaker bought Snapple in 1994 for 1.7 billion and was forced to sell it a little over two years later for 300 million.  

Of course, there is much to be said about how cash flows are estimated in the first place.  We'll just note four points for now.  First is the importance of starting with a strategic question: is the acquisition a good fit?  Second is adequate consideration of all of the components that go into cash flow.  On the negative side this includes integration costs (part of which is an allowance for disruption in management during the transition).  On the plus side it means recognizing that cash flows could extend beyond those of the particular deal to new opportunities the project creates.  These are the 'real options' associated with the acquisition.  For example, acquiring a firm in Singapore may look like a zero net present value venture.  But if that venture is successful, it could give you access to the entire South East Asia Market which could be quite profitable.  (Note: be very careful with real options.  They can be quite important, but can easily be manipulated to justify deals.)  Third is the importance of justifying any synergistic cash flows - understanding the source of these synergies and the reasons these synergies accrue to your firm and are not bid away by competition.  This frank analysis will help, but not prevent, your overestimating cash flows.  Fourth is the need to use the proper discount rate - one commensurate with the risk.   

There is much more to the estimation process, but this covers some of the basics.  The point is: any deal is a bad deal at some price but not every deal is a good deal - even if the price were zero.


Wednesday, October 3, 2012

Doing Deals in Tough Markets - It is the Best of Times - It is the Worst of Times

There are plenty of motivated sellers-especially private equity firms seeking to liquefy their portfolios. Debt financing is plentiful-at least in the U.S.  The domestic stock market is rising- at least for now. The financial markets are, however, driven by central bank liquidity injections, and not fundamentals.  Many buyers are hesitant given the troubled world economy. Consequently, M&A volumes are at their lowest levels since late 2009.  Recent goodwill write offs on prior acquisitions and lackluster growth support this hesitancy.  Nonetheless, good deals are often done in tough markets. The key is to employ a cautious policy utilizing a bear deal market menu of options. Unlike the bull market menu which focuses on winning the deal and financial engineering, the bear market menu is more risk management focused.

The key components of this menu include:
  •  smaller fill-in transactions
  •  low leverage with limited amortization during the initial years
  •  limited covenants
  •  seller notes
  •  loss sharing provisions employing contingent consideration to bridge pricing  gaps
  •  strong due diligence
  •  strong lock-up provisions to minimizing losing the deal to competitors
  •  expense reimbursement for legal and due diligence if the seller pulls the deal post letter of intent
  •  detailed integration plans to achieve immediate cost cuts
  •  strong closing conditions allowing you to walk from the deals should conditions worsen.

Beware ordering off the wrong bull market menu to minimize getting indigestion. Many potential sellers may resist some of these buyer-orientated provisions. Prospective buyers need the discipline to terminate discussions and not get carried away.  Discretion is the better part of valor in this market.


Monday, October 1, 2012

Business Risk and Acquisition Finance

There are two main types of risk that companies face: Business Risk and Financial Risk.  A basic tenet of acquisition finance is that companies with less business risk can afford to take more financial risk and vice versa.

Business risk deals with the inherent volatility of measures like sales, revenue,  EBIT or EBITDA.  For example,  Humphrey's (a popular restaurant chain in the Netherlands) has different business risk than say, TransCanada Corporation (a natural gas utility in Canada).  Business risks will be different because of country factors, size, governance and a host of other items.  But business risks are different right from the top of the income statement.  A restaurant chain is more likely to have greater swings in revenue (and the EBIT or EBITDA linked to that revenue) than the utility.  Because of this, the utility can afford more financial risk and is likely to be more highly levered.

How much debt is too much?  That is too complicated an issue to cover in a short blog, but earnings coverage ratios, tied to industry norms, are often used as a guide.  The larger swings in EBIT for the more volatile company mean less ability to safely 'cover' a given amount of interest.  Hence, the lower amount of debt.

Incidentally, as individuals, we face the same logic: you and I could have the same average yearly salary but if mine is based on commissions while yours is fixed, I will be unable to borrow as much as you.

Obviously, there is a lot more to structuring the deal than this, but matching the volatility of the assets to the mix of debt and equity is a fundamental principle.  Incidentally, this matching of asset volatility often extends (or should extend) to the way executive compensation is structured, but that's a subject for some other time.

All the best,