Monday, December 30, 2013

Banking 2.0: Disrupting the Industry

Community banking has been called into question again. I agree there are far too many small banks. Of the 6700 banks over 2000 have less than $100MM in assets. Additionally, hundreds of small banks failed or were merged during the financial crisis. Nonetheless, community banking, if not community banks, has a bright future. Changing technology promises to upend the branch orientated delivery-there are over 85,000 domestic branches. The technology will supplant the branch system in ways not yet fully understood.

This disruption will cause a massive change in strategies. Institutions, both bank and non bank will struggle to adjust. Those adapting will probably divest branch networks and acquire new technology and consolidate thru mergers to succeed. See Community Banks recently published in the American Banker for a discussion.

Happy New Year.


Monday, December 23, 2013

Something is happening here-what it is ain’t exactly clear…

(Buffalo Springfield-For What It’s Worth- 1966)

Another question raised at the Amsterdam Acquisition Finance course concerned the persistent muted level of M&A activity. Global 2013 M&A volume, despite a promising start, remains depressed at near 4 year lows.  U.S. volume is up 6% largely driven by the $124B Vodafone-Verizon transaction. Europe had its worst year since 2009. The U.K. market is at its lowest level in over a decade. This is surprising given the following ordinarily supportive factors: 

1)     Rising corporate cash balances and cash flow.

2)     Record private equity (PE) dry power and fund raising. PE firms have over $800B to invest of which $140B expires by YE 2014.

3)     Favorable financing environment.

4)     Positive shareholder responses to recent acquisition announcements.

5)     Limited organic growth opportunities and substantial industrial excess capacity.

6)     Robust stock market with strong buyer stock price performance-the S&P 500 is up over 22% thru early December this year and is trading at record levels.

The possible rationales for this puzzling state of events include:

1)     Buyers lack confidence to make substantial long term commitments due to their uncertainty about the economic recovery and our dysfunctional national government. This becomes less convincing given the steadily improving news about both the economy and the government.

2)     The substantial stock market recovery makes it difficult to find attractively priced targets. This makes some sense, and is reflected in current low premiums being offered. Usually, premiums over the pre-bid price are in the 30% range, whereas currently they are just under 20%. Given the 20%+ recent price increase for targets the effective premium could be viewed as closer to 40%.

3)     Stock repurchases rather than acquisitions have become the preferred corporate finance alternative for many firms. For the LTM stock repurchases have reached almost $450B-the highest level since 2008. Some of this is being driven by activists pressuring firms with bloated cash balances like Apple to use or return the cash.

As previously noted (see Repurchases) I believe stock repurchases are frequently misused. As Warren Buffett notes (see Price Matters) they should only be used if the firm’s stock price is priced below its conservatively determined intrinsic value. The current record stock price level makes it difficult to believe many firms are under priced. Thus, if they want to return excess cash to shareholders they should increase their dividend payout or declare a special dividend. Possible tax benefits of repurchases are probably a secondary consideration given the institutional ownership of most shares. To be fair, some firms like 3M, are using a combination of repurchases and a dividend increase (see 3M).

Many firms may be deferring acquisitions in favor of repurchases for incentive compensations purposes. A successful acquisition typically takes a few years before having positive earnings per share (EPS) impact. A repurchase, however, has an immediate positive EPS impact due to the immediate decline in outstanding shares. This is important as many senior management incentive programs are tied to EPS growth. Managers lacking confidence in EPS growth from acquisitions relative to repurchases will favor repurchases over acquisitions.

 This could be the reason for the depressed level of M&A activity. Researchers like Ralph will need to determine whether this is in fact the case. Perhaps they can see if firms with incentive programs tied to EPS growth are less likely to acquire. I welcome any comments you may have in helping resolve this open question.

Thanks, and I wish you all Happy Holidays.


Thursday, December 19, 2013

Majority Voting: A Paper Tiger?

There has been a tetonic shift for corporations to move from Plurality Voting (where a director can be elected with a single vote) to Majority Voting (where a director not receiving at least 50% of the vote faces repercussions).  In the past few years the number of S&P firms with Majority Voting has risen from 16% to over 67%.  But does this shift have any real effect on how directors are elected?  In the article below, published in the Journal of Corporate Finance we argue that Majority Voting is a Paper Tiger, without great impact in the current boardroom dynamic.  The abstract is below:

A Paper Tiger? An Empirical Analysis of Majority Voting

Drexel University

Mississippi State University - Department of Finance and Economics

Drexel University - Lebow College of Business

December 16, 2012

Journal of Corporate Finance, Vol. 21, 2013 


Majority voting in board elections has emerged as a dominant theme in recent proxy seasons. Analysis of majority voting is important: first, the impact is controversial yet scant empirical evidence exists. Second, Congress is still considering mandating this practice. Third, there has been a tectonic shift in adoptions of majority voting, from 16% to over 67% of S&P 500 firms in just two years. Fourth, the vast majority of shareholder proposals for majority voting are sponsored by unions with little shareholdings. Proponents argue that majority voting aligns shareholder-director interests. Opponents argue that the practice will be disruptive and could result in the failure of boards to meet exchange and SEC requirements. Others assert that majority voting is a paper tiger, amounting to form over substance, particularly since many adoptions are non-binding. We provide an empirical analysis of the wealth effects, characteristics, and efficacy of majority voting. Our results are consistent with the paper tiger hypothesis.

The complete paper may be downloaded here.   

Tuesday, December 17, 2013

Risk Appetite: Eating Well or Sleeping Well

Ralph and enjoyed teaching the December 4-6 Acquisition Finance Course at the Amsterdam Institute of Finance-despite enduring the worst storm in over 60 years while in Amsterdam. The attendees raised some interesting questions, which I will attempt to address in this and upcoming posts.

Readers of MergerProf will note one of the reoccurring themes is how changes in investor risk appetite trigger changes in buyout volume, capital structure, financing instruments and structuring. The attendees inquired about what causes risk appetite changes. This is an important issue for trying to understand markets.

Risk appetite is based on Keynes’ notion of Animal Spirits and included in behavioral finace. My understanding of risk appetite is as follows:

1)   Risk Appetite is driven by changes in investor wealth. When wealth increases it encourage investors to risk their winnings on more adventurous activities. When wealth decreases, in a downturn or market crash, it make us more cautious. This is especially true when the wealth decreases are large enough to cause solvency and liquidity problems which breach our budget constraints.

2)   Risk appetite changes, both up and down, are amplified by leverage and liquidity. Leverage allows us to invest more thereby lifting asset prices and collateral values. This creates a virtuous circle or positive feedback loop. As we all know, when this reverses, the downward price movement can be unpleasant.

3)   Liquidity is driven by rising asset prices and increased credit. It tends to be ephemeral and is never there when you need it as investors learned during the credit crisis. Hence the need to hold negative return assets like cash and treasuries as an insurance policy.

4)   Liquidity shifts as asset correlations change. All asset correlations, except for cash and treasury insurance policy assets, go to one in a crisis. Diversification evaporates just when you need it the most. As prices decline, we tend to liquidate our most liquid assets first, to make margin calls, to minimize capital losses. This triggers a vicious circle further reducing prices, credit and liquidity.

Currently, central bank Quantitative Easing efforts with their massive liquidity injections and falling yields have spurred investor risk appetite-more so in the United States than Europe given the improved domestic economy. Thus, U.S. buyout volume is strong, fueled by investor demand for higher yielding high risk instruments like “CCC” rated debt, high yield bonds, second lien loans, and covenant lite loans used to fund more aggressive higher priced buyouts. Interestingly, we are also seeing more PE sponsored IPO exits like Blackstone’s Hilton Offering. This is a reflection of an exuberant stock market compared to a more subdued M&A-trade sale exit.

We all know how this will end. We just do not know when it will end. We need to structure transactions able to withstand abrupt market changes. Of course, this comes at a cost.


Monday, December 2, 2013

An Inch by Any Other Name Is Still 25 Millimeters

Banks post the 2008 financial crisis, have been priced primarily upon a book or tangible book basis instead of the pre crisis earnings basis Metrics. This was largely due to a lack of earnings and uncertainty over asset quality. A common pricing metric used is P/B (price-to-book) =ROE-growth (g)/Ke (cost of equity)-g.

Asset quality and earnings issues have been largely resolved as banks have recovered. Thus, Price-Earnings (P/E) ratios have returned. Some mistakenly believe that using P/Es will lead to higher M&A  pricing than P/B ratios. Higher pricing may occur, but not because of a switch in pricing metrics. The higher pricing reflects improved fundamentals.

A bank is worth what someone will pay for it. What someone will pay for it is driven by the underlying fundamentals-how much cash is produced, for what period of time and how sure we are about our estimates. The different metrics-P/E and P/B must be equivalent just like an inch must be 25mm (rounding error excepted). Consider:

1)     P/B= ROE-g/Ke-g
2)     P/E=P/B divided by ROE

Thus, for a bank with a 12% ROE, 2% growth and 10% Ke the P/B is 1.25X and its P/E is 1.25/12% is 10.4X. An improving bank with a 15% ROE, 3% growth and 10Ke will generate a P/B of 1.7X and a P/E of 11.3X.Of course there can be divergences of opinion regarding future operating performance especially concerning expected synergies. Nonetheless, large differences need to be reconciled against more detailed discounted cash flow analysis.

For me, the biggest issues in bank M&A pricing is not P/B or P/E, but rather the premium over the pre-bid target trading price. Premiums less than 20% have a much greater chance of adding value for the buyer’s shareholders than those exceeding 40%. If you over pay relative to the cash flow acquired, regardless if expressed in P/E or P/B terms, your shareholders lose.

Ralph and I are on our way to Amsterdam to hold our annual acquisition financing class. Thus, posts next week may be suspended. I always learn something new from the interchange with the attendees, and will share those insights with you.

I hope everyone had a great Thanksgiving Day holiday. As usual, I over ate and watched too much football.