Friday, November 30, 2012

Back in Fashion Again: Financial Engineering to Enhance Debt Capacity

Private equity adds value in the following ways:

1) Buying right: reflected in low(er) purchase price multiples due to, for example, proprietary deal sourcing and market timing

2) Improving operating income: based on the sponsor's industry experience and management quality

3) Financial engineering: emphasis on taxes, leveraging and restructuring skills

4) Sell right: achieving multiple expansion based on improved operations and market timing

The focus of this post is on financial engineering to enhance debt capacity. An earlier post discussed internal debt capacity based on a firm's operating cash flow-EBITDA.  We will now examine how to supplement internal debt capacity using alternative financial instruments. These instruments were developed during the 2004/2007 leveraged transaction bull market to support rising purchase price multiples with increased leverage to maintain sponsor IRRs.  These instruments went dormant during the crisis, but have staged a remarkable return this year. Increased investor risk appetite in search for yield in a low rate environment underlies their return.

These instruments bear a strong resemblance to those used in the sub prime mortgage market. This is because they were developed by the same investment banks to solve the same problem; namely how to fund the fully priced deal. Note the comparison:

Private Equity and Subprime Affordability Products

Private Equity
Products Used
Yes – Collateralized
Mortgage obligations
Yes- Collateralized Loan Obligation
Interest Only
Yes- adjustable rate Mortgages

Tranche B Loans
Option Adjustable
Rate Mortgages
Second Mortgage
Equity Loans
Second Lien
Liberal Documentation
Alt A
Covenant Lite

These instruments, along with high yield debt (HYD) and asset based lending (ABL), were directed at identified investor bases, primarily non bank institutional investors, to expand internal debt capacity. Now for a discussion of some of their features:

             Tranche B term loans: They have a higher spread than revolvers and term loan A tranches held by banks. They amortize 1% p.a. with a balloon maturity after the A's are repaid. Spreads vary by debt rating and are currently in the LIBOR plus 350-400bp range.

             Second Lien Loans are designed to utilize any excess collateral value remaining after the first lien loans are fully covered. They are directed at investors requiring secured debt. They are priced at significant premiums to the first lien debt, and present serious inter creditor problems in a workout.

             Alt A is short for Alternative A-paper-alternatives to conforming GSE backed mortgages due lack of traditional financial information.  Cov lite loans have limited financial covenants like fixed charge coverage minimums and maximum debt levels. Debtors dislike the limits on their flexibility. When breached they must amended or waived.

Institutional investors, unlike banks, prefer to sell their loan exposure in the secondary market if the credit worsens rather than dealing with an amendment. Hence they are primary holders of Cov lite. The usage of Cov lite has returned to pre crisis level albeit at lower volumes.

One of the first mega transactions to use an array of these products was the $33B HCA transaction in 2006.This allowed a private equity group to bid an aggressive 7.7X EBITDA purchase price by incurring a high leverage level of funded debt to EBITDA of 6.5X. Using this template, deal structures became progressively more complex and aggressive as sponsors searched for ways to expand debt capacity to support rising purchase price multiples.

Debt instruments (like my ties) go in and out of fashion depending on market conditions. The key is to check their market availability and pricing. Their utilization can provide an inexpensive and flexible means of supplementing debt capacity. They are and will remain essential tools in your financial engineering toolbox.

joe prior Best Buy post was validated by the much weaker financial results released on November 20th.Especially concerning is the over $500MM drop in projected EBITDA. Even though the stock price drop makes the deal "cheaper" the ability to finance a highly leveraged capital structure becomes even more remote.

Wednesday, November 21, 2012

Netflix, Proxy Fights and Activists

We posted recently about  Netflix and the poison pill it issued in response to Carl Icahn's acquisition of a 10% stake.  I confess to a fondness for Netflix.  I was able to buy it around $55/share in the fall of 2009 and sold out at $150 and then $260 a share.  Pretty heady stuff for a guy who believes in efficient markets!  So now, Netflix is back to earth, trading around $80 a share and Carl Icahn thinks more value would be created by selling the company.  What are his likely next steps?

More than likely, he will continue to negotiate with management but simultaneously launch a proxy fight to take control of the board.  But we've noted that the board is elected in staggered terms and that it would generally take at least two years to get control of the board.  That is a long time for an activist to wait.

On Monday Jana Partners, LLC launched a proxy contest to shake up the board of Agrium Inc., a Canadian Firm that makes fertilizer and other agricultural products.  Agrium has responded with a number of moves to placate shareholders, including a $900 million (canadian dollar) share buyback and a doubling of its dividend.

The evidence on activists in general is that they increase shareholder wealth - sometimes by forcing companies themselves to do the very things the activists propose.  It is interesting that it sometimes takes outside forces to unlock value that internal forces ignorned.  It is also ironic that while some players are new on the scene (we didn't talk about Hedge funds in the 80's) some are old hands: one of the the first academic studies of shareholder activism was published in 1985 and featured Carl Icahn. 


In America, we're celebrating Thanksgiving this week, a time for giving thanks and for gathering with friends and family.  Joe and I appreciate your continued comments to us and your interest in our blog.  We'll take Friday and Monday off but look forward to seeing you next week.

Happy Thanksgiving to all,


Monday, November 19, 2012

Not Sold on the Best Buy LBO

Best Buy, the troubled electronics retailer, is rumored to be a LBO candidate. A group led by its founder Richard Schulze is expected to bid soon. If successful, it will be a $10B+ deal, the largest since the financial crisis began over 5 years ago. Increasing capital market investor risk appetite should be sufficient to fund a transaction of this size.

On the surface the basic financial metrics appear reasonable. The estimated equity purchase price based on current price and a premium would be in the $8B range which appears cheap compared to the $3B+ EBITDA. The purchase price should, however, be judged relative to what you receive in return. That is difficult to estimate given the expected 15%+ EBITDA, 2%+ sales and 3-5% same store sales declines expected over the next 5 years.

Typical required equity levels in the current market are around 35% or $3.5B of the $10B price, which includes the refunding of around $2B of existing debt. This is a large number even after Schulze’s rollover equity. Thus, multiple private equity sponsors may be needed. The $6.5B balance could be funded with loans of $4-4.5B(60%) and high yield bonds for the balance.

However, just because something can be done does not mean it should be done. A deeper review shows the following concerns:
  1.                 The large equity need and problematic exit may depress expected private equity returns. The large amount of private equity dry powder may reduce the hurdle rate as PE firms look to invest capital vs. returning it to their investors.
  2.                 Leases represent a large off balance sheet liability at Best Buy. Using the standard rule of thumb of 8X annual rental to calculate lease liabilities yield $9B+. Thus, Total debt will exceed $15B. Compared to EBITDAR (EBITDA + Rent) of around $4.5B this still seems reasonable. Nonetheless, the debt multiple will exceed the current equity multiple. This tends to make new creditors nervous.
  3.                 Industry conditions are brutal with on-line competitors like Amazon and discounters like Wal-Mart stealing share and crushing margins. Best Buy’s largest competitor went bankrupt a few years ago. Both Best Buy and its competitor Radio Shack are suffering continued same store sales declines.
  4.                 Expected core EBITDA(R) is difficult to gauge as Best Buy’s sales and margins are falling. Their entire business model is being questioned given declining sales per store, same store sales and market share deterioration. Best Buy’s high cost structure compared to Amazon and Wal-Mart make it difficult for Best Buy to compete. A major business model change is probable. Absent a reliable core EBITDA(R) it is difficult to build a realistic capital structure.
  5.                 All retailers are experiencing macro head winds from an uncertain economy. This could further pressure sales and margins.
  6.                 The fact that the management team is yet to be decided is a big issue. Look at the sales collapse at JC Penny when a new CEO implemented a substantial high-risk business model change.
  7.                 Vendor impact is yet to be gauged. The substantial losses at Circuit City may cause vendor concern of an LBO. Remember, the senior secured bank debt places vendor inventory shipments into another creditor’s collateral pool. They could respond by curtailing shipment, reducing creditor or shipping “hot” high demand items first to Best Buy’s competitors.
  8.                 Competitor response needs to be considered. They could initiate price wars and talent raids to take share from a highly indebted Best Buy.
  9.                 Retailers need to maintain fresh stores. This requires substantial capital expenditures (CAPEX). Best Buy annual CAPEX is around $750MM.This serves to reduce its debt servicing capacity.
  10.                 Best Buy is already perceived as near noninvestment grade. Its probable post close debt rating would be in the “B” range.  The B market window is currently open. It is, however, subject to unpredictable closures. This could adversely impact  Best Buy’s liquidity should unexpected needs develop.

Bottom line, troubled retailers and high debt do not mix well – there is simply too much business risk. Successful retail LBOs involve firms with strong category positions like Staples who can continue to grow. I believe Best Buy does not make a good LBO candidate - others disagree. Nonetheless, as Warren Buffett notes,  deals may fail in practice, but they never fail in projections. Thus, beware receiving a slick-offering memorandum that proves a Best Buy buyout works. Keep a skeptical eye and question everything.

This will be a developing story. So more to follow.  See Fitch 11-8-12 report entitled “Best Buy LBO Significant Hurdles Remain” for additional details.


Friday, November 16, 2012

Netflix and Some Personal History with the Poison Pill

It will be interesting to follow the battle for Netflix.  The company recently adopted a 'poison pill' in response to Carl Icahn's acquisition of a 10% interest in the company.  Some recent details are contained in this link from MSN Money.

Poison pills are so named because they are designed to make a company indigestible to a hostile bidder.  Typically, a poison pill is a 'springing right' giving shareholders the option of either buying shares in their own firm at a bargain price or buying shares in the bidding firm at a bargain price.  (More on this latter option in a moment.)  Conceptually, this seems like a stock split or a stock dividend where under idealized conditions, the wealth of a shareholder isn't affected.  In the case of the poison pill, however, the 'acquiring or bidding party' is excluded from using the pill.  Hence other shareholders gain at the loss of the potential bidder.

The first poison pill was issued by Enstar in 1982.  By early 1985, there were 12 in existence.  I know, because I was a young assistant professor at the time, visiting at the University of Washington in Seattle.  My colleague, Paul Malatesta and I were intrigued by a Wall Street Journal article describing the pill and we conducted the first empirical examination of their characteristics.  (The original article that came out of this is now dated but for those interested it was published in the Journal of Financial Economics.  It can be viewed here and downloaded at the top left of the page).

Of particular interest to us was the concept that you could 'buy stock in the acquiring party's firm at a reduced rate'.  The last time I checked, I couldn't give you the right to buy someone else's car at a bargain rate.  We wondered how this could work with stock and decided to investigate.  We called Marty Lipton, regarded as the father of the poison pill and he informed us that, yes, the article was correct and that there were now 14 such pills - he had done them all.  So we began our analysis with that small sample.  Soon the sample grew to 30.  By that time, the legality of the pill was being decided in the Delaware Courts.   The courts upheld the legality of the Household International pill in November 1985 and our sample quickly grew to over 120.  By the end of 1986 there were over 300 in existence.

Our main findings at the time:

  • Firms that issued pills had been less profitable than their peers
  • Shareholders of Firms that issued pills suffered wealth losses
  • Executives of these firms owned smaller amounts of shares and hence, were more insulated from the losses

The announcement of a pill can send two messages.  First - wow, the firm's in play!  This would boost stock prices.  Second, is the deterrent effect of the pill itself.  For the very earliest pills, we found the wealth losses to be negative.  In fact the wealth losses were 1% for firms not in play, but if we restricted our analysis to those already in play at the time the pill was announced, (so the positive 'in play' hit was already in the price) the wealth losses were 4%.

The impact and efficacy of the pill has continued to be debated over the past 30 years.  Throughout the rest of the 1980s and 1990s thousands of companies adopted them.  As they became more anticipated, the price reaction was muted.  Advocates argued that they effectively prevented so called 'raiders' from stealing the company.  The pills, it is argued, increase bargaining power.  Detractors counter that the pills can be used to entrench mangement at the expense of shareholders.   It is still felt that the combination of a poison pill with a staggered board (i.e., electing say a third of the directors each year) is a powerful deterrent to acquisition.  The combination is important because pills can be rescinded by the board, so a proxy fight resulting in a takeover of the board would remove the pill.  However, few acquiring firms would be so patient as to wait two or more years to get control of the entire board.  Over the past decade there has been a movement by activists to remove poison pills and staggered boards. Many boards have agreed.

The specific details of Netflix's pill can be found here.  Note: Netflix has a staggered board.  It will be interesting to see how the directors react and whether the pill is used to negotiate or thwart Icahn's bid.

Wednesday, November 14, 2012

How Much Debt is Right for Your Deal?

An important decision in any transaction is how it should be financed. This gets down to the mix between debt and equity. The right amount of debt can optimize the capital structure and create value. Conversely, too much debt reduces flexibility, destroys value and can lead to bankruptcy. Frequently, the decision is framed as do you want to eat well (high leverage) or sleep well (low leverage)?

This post focuses upon determining debt capacity and how much debt the deal can support in noninvestment grade buyout transactions. A critical point is that debt capacity is dynamic. It depends on the interplay of the transaction cash flows with market conditions.  Debt capacity fell from its pre-crisis highs, but is currently staging a recovery in the U.S.. This is largely due to increasing investor risk appetite reflecting the low interest rate environment.

Business risk reflects on the variability of operating cash flow - usually defined as earnings before interest, taxes, depreciation, and amortization (EBITDA). For example, smaller firms operating in cyclical industries usually have greater EBITDA variance than larger firms in stable industries. Financial risk relates to the level of cash flow to principal and interest debt service requirements coverage and to the equity cushion built into the transaction. Structural risk focuses on creditor priority of claims on the deal’s cash flows and assets as reflected in seniority and security arrangements. It also includes control features like covenants.

A deal’s internal debt capacity, exclusive of asset sales and re financings, is based on two factors. The first is cash flow generation based on EBITDA. The other is structure reflected in cash interest and debt amortization. You can “increase” debt capacity by improving projected EBITDA but beware unrealistic “hockey stick” type assumptions.  You can decrease cash interest payments thru non cash paying payment-in-kind debt and extending out amortization. Market related funded debt (interest bearing debt to EBITDA) and interest coverage (EBITDA to projected interest expense) requirements are determined from the interplay of these factors.   Future posts will focus on how to use special structuring products to expand debt capacity.

In practice debt capacity is heavily influenced by the choice of rating targets for your deal. Ratings are critical to access investors to fund your transaction. They are keys to open market doors needed to fund any deal of size. The process first involves selecting a ratings target -usually in the BB or B range for most buyouts - although during the pre-crisis boom period CCC rated deals could also get funded. The ratings choice impacts risk, cost and market depth considerations. The singe B segment is less deep, subject to abrupt closures and more costly than the BB market segment. Next, the financial requirements of the ratings target and the deal’s financial characteristics are compared. A HIGHLY simplified example illustrates the approach:
(A) Ratings choice: BB
            (B) Required interest coverage ratio for BB: 3
            (C) Deal EBITDA: $300
            (D) Blended interest rate for BB rated debt: 10%
            (E) Debt Capacity=(C/B) divided by D= 1000

Of course there many other factors involved, but this illustrates the point. Future posts will further develop and apply debt capacity concepts.


Monday, November 12, 2012

Listening, Understanding and Deal Structure

Continuing our more detailed examination of the 14 keys to acquisition success

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

In the words of Paul Simon, "A man hears what he wants to hear and disregards the rest..."

Anyone who has ever been in a relationship knows that what is said may be different from what is heard.  Moreover, what is said may even be different from what is meant.  It's true in romantic relationships, it is true in parenting, and it is true in negotiating the deal.

We can't structure a deal until we understand the parameters that are important to both sides of the transaction.  To structure a winning deal we have to understand the zone of potential agreement (ZOPA) and exactly what that looks like to all concerned.  That is, what are the specific objectives of the selling and buying parties?  

Remember our previous discussion about the interrelated nature of deal design.  It is not just about price.  There are so many factors that could be important to a buyer or seller and each one of these creates an opportunity for deal design.  Let's think about just a few of the specific factors that could matter to a seller:

  • Price - obviously, more is preferred
  • Taxes - less is preferred
  • Form of payment - cash is certain, stock gives upside and downside potential and creates uncertainty
  • Legacy - founders want to preserve the company name, retiring CEOs want their records intact
  • Employees - executives often want to protect their employees from spinoffs, layoffs and other disruptive actions
  • Control - existing CEOs generally expect additional compensation to relinquish control; boards of directors may be reluctant to give up seats
  • Speed - a fast transition is generally preferred
  • Social terms - where will the new, merged company will be headquartered? who will be CEO?  how will the board be structured? what will it be called?

We could continue for quite some time but let's stop for now.  First, however, note how each of these items influences others.  Form of payment determines the tax structure and affects the speed of the transaction.  Payments to retiring CEOs impact price and ultimately rate of return, etc.  Thus, each of the factors are interrelated.  Recognizing the tradeoffs is the first step to proper deal design. But deal design, in turn, starts with listening.  What are the expectations and desires of the acquiring firm?  What does 'Control' really mean to the selling party?  Plus, in a world of myriad aspects of deal design, which of these are the most important to the other party?  What are the relative weights assigned to each?  In other words, 'What really Matters?'

All of these factors produce a rich palette from which to craft a negotiation that looks like a win on both sides.  It starts, however with listening.  Many of us working in mergers and acquisitions are naturally attracted to numbers.  We enjoy analysis and projection and never saw a spreadsheet or graph that couldn't hold some interest.  But the numbers on our spreadsheets are based on the inputs from people on both sides of the deal - people from finance and accounting but also marketing, law, operations, and management.  Buyers - and sellers.  All people.  Consequently, it is even more important that we stop and remember a quote attributed to author Larry Barker:

""Effective listeners remember that 'words have no meaning - people have meaning'.  The assignment of meaning to a term is an internal process; meaning comes from inside us. And although our experiences, knowledge and attitudes differ, we often misinterpret each other’s messages while under the illusion that a common understanding has been achieved."

Before you structure the deal, remember: what is said is not always what is heard or meant!

All the best,


Friday, November 9, 2012

Beware the Winner's Curse

Many acquisitions fail to create value for the acquirer and in most deals, the benefits go largely to the seller. This reflects the highly competitive nature of the M&A market. It also reflects the large concentrated investment bet at premium prices of M&A transactions. Buyers, in effect, are pre paying for uncertain future revenue and cost synergies. Frequently, buyers over pay for the expected synergies based on managerial optimism, overconfidence and the urge to beat competing bidders.  So it is understandable that the buyer’s shareholders react negatively to acquisition announcements. Many studies indicate that, on average, the acquirer’s share price falls once the transaction becomes public. (For alternative evidence see Ralph's blog on Anticipation). This overpaying is known as the winner’s curse or hubris-when the winning bid in an auction exceeds the target’s value. The absolute dollar loss of acquisition can be huge.  The loss can be estimated by looking at the level of goodwill paid and its subsequent write-off. Goodwill, the amount of the purchase price exceeding the target’s book value, represents a crude measure of over payment. Duff & Phelps estimates the amount of goodwill write offs, a proxy for overpayments which failed to materialize, for the 2007-2011 period to exceed $325B.

The key to avoiding this problem is to make an accurate assessment of the target’s value and to have the discipline not to bid more than that value. This requires establishing a walk-away, or reservation price, before making a bid.  The opening bid should be set at a fraction of that price based on competitive considerations. Ultimately, it is not just what you buy, but what you pay that determines an acquisition’s success. Overpaying for benefits received destroys acquirer shareholder value.

Distinguishing between cheap and frugal is needed when pricing an acquisition. Cheap refers to low value. Frugal, however, represents efficiency. You usually get what you pay for. Equally important is to avoid over paying for what you get. Complicating this matter is that price is fact, representing what the buyer gives up immediately. Value is an opinion concerning what you expect to receive in the future.

A target’s price has two components.  The first is the stand-alone, pre-bid minority ownership price.  It reflects the status quo value of its cash flow under the current strategy and management.  The second is the premium required to persuade the target’s shareholders to sell a control position.  The premium can be estimated from comparable transactions and can vary widely over time, reflecting the economic cycle.

Expected value includes the target’s status quo value plus potential synergy improvements. Value varies by owner depending on strategies pursued and execution of that strategy.  The acquirer’s net value added equals the difference between the expected synergies less the premium paid to acquire them. Buyers lose when the transaction premium exceeds the expected synergies. Thus, the buyer’s maximum price should be less than the seller’s status quo value plus expected synergies.

Projected synergies can represent a form of valuation Viagra used to justify excessive premiums.  As Warren Buffett notes, while deals often fail in practice, they never fail in projections. Buffett continues by noting that any business craving of the leader, however foolish, will be quickly supported by detailed rate of return and strategic studies. Avoiding this trap requires strong board of director oversight. Firms with weak governance and dominated by forceful CEOs are prone to the winner’s curse.

The board needs to consider the risk of an acquisition represented by the shareholder value at risk (SVAR), which represents the premium offered relative to the buyer’s market capitalization.  It measures the impact of failing to achieve the projected synergies. Larger, more competitively priced transaction with high SVAR should receive additional oversight.

Value additive acquisitions are difficult. Growth is not free. Furthermore, acquisitions are subject to behavioral biases like the winner’s curse that frequently override good analysis. Buyers need to exercise pricing discipline based on strong board oversight. There is no right way to do the wrong thing. Overpaying for synergies with an excessive premium is the wrong thing.  Bid wisely to avoid the winner’s curse. Keep in mind that bad bidders make good targets.