Monday, April 29, 2013

The Price is Right?

Ralph and I have previously mentioned the difference between price as a fact and value as an opinion.  (See, for example, Value is Estimated, Price is Paid.)  Nonetheless, many remain rightfully confused by a firm whose stock is trading at $20 p/s receiving a takeover offer for $30 p/s.  Specifically, was the $20 price wrong or is the $30 offer a mistake? While it is possible for either the market price or offer to be wrong-it is also possible they are both right, but under different circumstances.

As an opinion, value is truly in the eyes of the beholder. Equally true, there is no one true intrinsic value based on a firm’s cash flows (magnitude and timing) and risk. Think of valuation as an attempt to price expected operating performance. This in turn depends on the firm’s market environment and the strategy and asset-liability combinations employed by management in the execution of their chosen strategy. Thus, different owner-manager teams can different results from the same firm.

Changes in the industry environment from technology and regulation shifts for example can render existing strategies obsolete. Existing management may be unable or reluctant to change, thinking the changes to be cyclical not structural. Performance under these conditions starts to decline and the firm’s stock price begins to decline as passive minority shareholders begin to vote with their feet by selling their shares. These selling shareholders have priced downward from say $30 p/s to $20 the firm’s expected operating performance based on its current strategies in a changed market. They no longer share management’s expectations.

The price decline attracts the attention of others who see profit opportunities from shifting to alternative higher value strategies, asset -liability combinations and improved management execution of the strategies. These investors are active control shareholders seeking to force a change. This in turn requires a significant ownership position or majority to implement their plans. These investors are prepared to obtain this position by offering a premium to existing shareholders of $30.  Their price is not based on the firm’s expected operating performance as currently configured. Rather, it reflects their view of operating performance under a new higher value strategy and management team.

This illustrates that firms trade in two different financial markets, and at two different prices. The first represents the passive minority interest market, for example, the firm’s current Bloomberg terminal price, based on existing strategies and management. The other is a potentially higher price to alternative owners employing different strategies and management; this price is available in the market for corporate control. Of course, the new investors can be wrong. They are, however, willing to back up their beliefs with real capital. Thus, their position can have more credibility than a simple existing management denial – a management who may be more interested in keeping their jobs than in creating shareholder value.

So next time before assuming the share price is right first make sure you specify which price you mean. The right price depends on the right combination of owners, strategies and management, and this combination changes over time.


Thursday, April 25, 2013

Drexel's Director's Dialogue

I came to Drexel University in 2005 after 20 wonderful years at Ohio State.   While I still miss my colleagues (and the football) at Ohio State, Drexel offered wonderfully unique opportunities to contribute in new ways.  In particular, I was able to found a Center for Corporate Governance.  The primary missions of our Center are twofold: to enhance empirical research in corporate governance and to interact with the business community, being a think tank for the open exchange of ideas about best practices in corporate governance.

The primary assets of our Center are a faculty committed to expanding the frontiers in corporate governance research and an advisory board of leading CEOs and directors.  We host numerous activities during the year but our two signature events are our annual Academic Conference and our annual Director's Dialogue.  I'll write separately about the academic conference.  The Director's Dialogue is just that -  a one dialogue between leading CEOs and directors, coming together to candidly discuss ways to enhance shareholder value.  

Much of my own research focuses on corporate governance and not a small portion of this involved mergers and acquisitions.  You won't be surprised that our recent program involved multiple events related to mergers and acquisitions:

Raj Gupta, former CEO of Rohm and Hass was the keynote speaker the night before the conference.  Raj talked about boards of the future.   Raj led Rohm and Hass through wonderful years of growth and ultimately a very successful acquisition by Dow Chemicals.

Bill McNabb, CEO of Vanguard, gave the luncheon keynote, talking about going global.  

Finally, two panel discussions focused on acquisitions:

In the Throes of the Hunt as an Acquirer or Target 
Companies are returning to growth through acquisition. These panelists have years of m&A experience and understand the critical components of successful acquisitions and the red flags directors should be looking for whether their company is the acquirer or the acquired.
Discussion Leader: michael Carr, Head of m&A, Americas, Goldman, Sachs & Co.

Lessons Learned from Going Global
As companies look for global growth opportunities, they are faced with new organizational, operational, compliance, cultural and leadership challenges. These panelists will share their lessons learned from helping to grow global businesses and from their current perspectives as board members.
Discussion Leader: Lon Greenberg, Chairman and CEO, UGI Corporation, Chairman, Amerigas Propane, Inc. and Director, Aqua America, Inc. and Ameriprise financial, Inc.

The complete program is below.

I can't wait till next year's event.

All the best,


Monday, April 22, 2013

Listening to Shareholders Can Be Hard to Do

Firms compete in two primary markets. The first being in product markets for customers and the second in capital markets for capital. Shareholder activism increases when stock prices fall based on declining product market performance. The stock price decline reflects a value gap between a firm’s current business model and a higher alternative value strategy. This becomes most pronounced during periods of rapid industry changes, a creative destruction, due to technology, regulation and deflation. Currently, the industries with the greatest change and activism are energy (e.g. Hess), tech (e.g. Dell) and banking (e.g. JP Morgan Chase).

Activism is an external mechanism along with hostile takeovers to prod slow changing firms. It usually reflects weak corporate governance. A substantial value gap, usually greater than 30%, is needed to incent a financial activist like Carl Icahn and others to risk their capital. It is frequently a last step before a more serious product market failure like that which occurred at Eastman Kodak.

Understandably, management and their supporters dislike being told they need to change. This attitude was perhaps best expressed by the early 20th century German banker Carl Fuerstenberg who stated:

                  Shareholders are stupid and impertinent-stupid because they gave their money to somebody else without any effective control and impertinent because they ask for a dividend as a reward for their stupidity.

Typically, management alleges the industry changes are cyclical not structural and that consequently, shareholders should be patient. Activist, are frequently attacked as short –term in nature and unable to see the true long term value of the firm they are questioning. This attack is based on the short holding period of the activists as shareholders. Nonetheless, value is based on the market’s investment horizon, not the holding period of a firm’s shareholders. Thus, the key issue is-are firms targeted by activists under-valued, as management believes, or under- managed as the activists contend?

Eventually, change affects all companies-even formerly successful market leaders. As Schumpeter taught us-we are only king for a day. Just look at the turnover in the S&P 500 during the first 12 years of the 21st Century. Over a third of the firms have been replaced through decline, failure or merger. Examples include Texaco, Sears, Circuit City, and Quaker among others. Andy Grove was right-in such a rapidly changing environment only the paranoid survive.

No one likes being questioned. Sometimes, that is exactly what is needed before it becomes too late to change. So, listen to those “stupid and impertinent” shareholders. They may just have something to say that is worth hearing.


Thursday, April 18, 2013

Corporate Governance, Acquisitions and the Interdisciplinary Connections of Business

Corporate Governance and Acquisitions are two distinct topics that cut across countless other topics - and certainly each other.   Acquisitions, for example, encompass so many different aspects of business.  First and foremost is finance.  We need finance to understand our financial projections, to make sure that the net present values are realistic and that the terminal growth and other assumptions are appropriate.  But that present value model of finance is derived from estimates of every other area of business.  Cash flow projections initially depend on sales projections from marketing.  Logistics are part of the marketing estimates as well.  If projections start with sales, they travel through accounting regulations on their way to cash flow.  Information systems are crucial avenue for decision making before, during and after acquisition.  Legal restrictions (regulatory and deal specific) permeate acquisitions.  Behavioral finance and the decision sciences are crucial for informed and unbiased decisions.

Last - and unfortunately often considered least - is the fact that all projections, all synergies, and ultimately all results,  are driven by people.  Numbers are essential, but without the proper personnel they are meaningless.  A business and hence its cash flow, work only through people.  It is true for the goods and services a firm delivers and it is true for the decisions executives make.  Numbers don't make decisions.  People make decisions.

Which brings us to Corporate Governance.  Corporate Governance involves the alignment of owners and managers and like acquisitions impacts (and is impacted by) virtually every area of a business.  It is certainly true that many deals are driven by an opportunity to increase value through better governance.  In private equity, for example, a firm may be taken private to better align incentives for owner-managers.  In other cases, internal governance structures have failed to maximize value - external governance mechanisms (like acquisitions) rush in to fill the vacuum.  

In (a) separate post(s), I'll write about two of Drexel's premier events held recently in Central Philadelphia.  The first is our 6th Annual Academic Conference on Corporate Governance.  The second is our 5th Annual Director's Dialogue, a program on governance by and for practitioners.

All the best,


Monday, April 15, 2013

May the Odds Be With You

This blog has highlighted the difficulty for acquirers to create value for their shareholders. This is due to a variety of factors ranging from behavioral biases to governance breakdowns. This does not mean that all M&A is bad as some do succeed. Those success stories share some common characteristics. A key is the establishment of an appropriate process with effective procedural safeguards.

This process incorporates many of the following steps (my Ten Commandments) :

1)     Avoidance of large transformational transactions-especially when proposed by a new CEO seeking to make a reputation for himself. He usually succeeds in making the reputation-unfortunately, not the one he intended. HP’s Leo Apotheker stands out as the poster boy example with the disastrous Autonomy acquisition.

2)     Actively engage the board in the process from the beginning rather than just asking them to approve a fully cooked deal under a tight deadline.

3)     The board should establish a subcommittee chaired by a knowledgeable outside director to challenge management concerning, inter alia, pricing, valuation, synergies, and alternatives.

4)     Establish a firm up front walk away price before the negotiations begin. Beware having to adjust your price to “win”-AKA the winners curse. This reservation price should reflect your best alternative to a negotiated agreement (BANTA). This protects against accepting an unfavorable agreement compared to a better alternative outside of the negotiations. To paraphrase Warren Buffett-there are no called third strikes in M&A. There is always another opportunity.

5)     Carefully consider the “whole deal” and not just price. Remember, you can name the price if I can name the terms, and I will win every time.

6)     Ask yourself if you are honestly the best owner of the target. This means you can extract the highest value through an optimal mix of strategy and execution. If not, then you are unlikely to extract the premium paid in a competitive bidding situation. As my favorite Chicago mayor Richard Daley Sr. eloquently stated-“don’t play no games you can’t win”.

7)     Make sure you get what you thought you were buying through extensive hands on due diligence(DD). DD is not glamourous and is frequently out sourced to consultants by executives who do not want to get their hands dirty. This leads to failure like those at HP in their failed acquisitions program. The seller enjoys an informational advantage over the buyer. Since they are unlikely to tell, it is up to the buyer to find out. A useful supplement to DD is using the reps and warranties in the sales and purchase (merger agreement) to flesh out matters you should explore more deeply.

8)     Develop a detailed integration plan updated by DD results covering the first 100 days after the closing. You need quick victories and must consider the complex social issues.

9)     Tie management’s incentive compensation to the target’s post close performance.

10)  Conduct a post mortem a year after closing to uncover lessons to be learned.

Of course, there are no guarantees, but the odds for success can be increased through an appropriate process.

Good luck


Monday, April 8, 2013

The Regulatory Shot across the Bow

Leveraged loans (LL) are a key funding source for buyouts. They are similar to high yield bonds. They both involve credit to highly leveraged non investment obligors. LL differ from high yield bonds as they are higher up in the capital structure, senior and secured, and usually lack call protection. Currently, LL yields, although down from the prior year, still exceed 5%, which has attracted investor and bank attention.

Even though banks remain important, the LL investor market has evolved into a largely non bank institutional market. The majority of funding is provided by collateralized loan obligation funds (CLOs). CLOs are structured vehicles designed to buy loans. Loans are structured for bank orientated investors include revolvers and shorter term amortizing term loan As. Institutional investors focus on the longer term loan Bs which have minimal amortization.

CLOs went dormant following the financial crisis, but have returned in the second half of 2012. CLO fund raising volume increased from $ 28B in 2011 to over $ 62B last year. This growth is a major factor supporting the return of large buyout transactions like Dell ($24B) and Heinz ($28B) in the first quarter of 2013.These larger deals underlie the expansion of  1Q13 buyout volume to $78B from $19B in the prior year same period. This represents the highest volume since the boom years of 2006 and 2007.

Regulators are rightly concerned that LL’s high nominal yields may cause an inappropriate growth in bank loans in this area. This is especially true for yield hungry community banks. They are increasing their LL exposure through organizations such as BancAlliance, which now counts more than 100 community bank participants. Consequently, they issued revised regulations last month to control the activity LL GuidanceMarch,2013 .

 Current LL debt levels, as a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA), have increased to over 5 times from around 4 times last year. This increase, while aggressive, appears sustainable given the current low level of interest rates and credit spreads. These developments have reduced yields from 7% to 5% in the past year.

Equally concerning to the regulators is the return of boom era structures like covenant lite and payment in kind (PIK) securities. Covenant lite as its name suggests are loans with minimal or no covenant features. PIK securities are negative amortization instruments in which interest is “paid” by issuing new securities, which is added to the principal balance. Structures like these are usually employed to expand debt capacity reflecting weakening underwriting standards.

The likely consequence of this regulatory shot across the bow, along with possible higher capital charges for LL, is to slow bank LL activity relative to CLOs. Transaction originators will likely respond by increasing non bank orientated term loan Bs at the expense of bank focused revolvers and term loan As. Something to keep an eye on as this is implemented.

Thursday, April 4, 2013

Due Diligence in M&A: HP, Quaker, BMW, Daimler, Mattel, etc.

In our last post, Joe commented that there were No Do Over's in M&A.  Indeed!  Why do disasters occur?  We've discussed many reasons in this blog, from Any Deal is a Bad Deal at Some Price, to The Winner's Curse, and many others.  And we've noted that Value is Estimated, Price is Paid.  But in many cases, errors in estimated value should be caught in the due diligence process.  Due Diligence is a crucial step in verifying assumptions and representations, assessing risks and beginning the integration process.  Too often it is fraught with errors.   Firmex provides the following list of the top ten due diligence disasters in M&A.  Quite an interesting list.

All the best,


Top Due Diligence Disasters

[Via: Firmex: Virtual Data Rooms]

Monday, April 1, 2013

No Do-Over's in M&A

Both Ralph and I have highlighted the perils of bad acquisitions and bad governance. Bad acquisitions share common characteristics including:

1)     Over Priced: reflected in high purchase price premiums and substantial goodwill and earnings per share (EPS) dilution. This is especially true for winning bidders in an auction (AKA the winner’s curse).

2)     Large Transformational Transactions: trophy deals driven by delusional CEOs with weak Board oversight.

3)     Serial Acquisition Program: some initial success breeds hubris. Eventually a “bump-in-the-road” exposes the real risk.

4)     Stock Used to Fund the Transaction

5)     Occurs Later in the M&A Cycle

A near perfect example of bad acquisitions is First Niagara (FN) an acquisitive rapidly growing Buffalo, NY community bank. They replaced their CEO, Koelmel, in mid March. He had embarked upon a serial acquisition program including 4 acquisitions in 3 years upon becoming CEO in 2006. FN grew from $10B to over $35B in assets during his tenure. Unfortunately, his growth for growth’s sake strategy proved disastrous for shareholders. The stock peaked at $15 per share in February, 2011 before falling to its current $8.50 level. During this same period the KBW Bank index rose by over 30%.You know it is bad when your stock increases 4% upon your CEO’s resignation. The stock is trading at 67% of its book value with an equally depressed price-to-earnings ratio.

Koelmels’s first few smaller acquisitions were moderately successful. They occurred during the peak of the 2008/2009 crisis and were attractively priced. Confusing luck with skill, he met his Waterloo with the mid 2011 $1B+ purchase of HSBC’s $10B+ in deposits with 195 branches up state NY franchise. The premium paid for the deposits was 6.67% compared to the expected 3.5-4 % range. Koelmel felt the premium was required to beat the much larger $85B in asset rival Key Bank who was also a bidder. The premium created significant goodwill and depleted FN’s regulatory capital.

Subsequently, FN sold 37 branches to Key Bank to satisfy antitrust concerns. Key paid only a 4.5% premium and turned out to be the real winner. As luck would have it, the market worsened after the announcement due to the beginning of the Euro crisis during the summer of 2011.This caused a substantial decline in operating performance. FN failed to obtain committed financing and decided to postpone a needed equity raise until May, 2012 when the deal eventually closed. Its stock price collapsed during that period resulting in a highly dilutive $467MM common stock raise at a 30% discount to the prior year price. They additionally raised $350MM in preferred stock with an 8.625 dividend rate compared to an expected 6-7% rate.

Integration problems compounded weak operating performance resulting in losses. Their dividend was cut for the first time.Koelmel’s credibility with investors and the Board was shattered and he had to go. He walked away with a $5MM+ severance package after nearly destroying FN in his vain attempt to become the 21st century version of Hugh McColl who created the modern Bank of America through acquisitions in the late 20th century.

Unfortunately for shareholders there are no “do-over” in M&A.Thus, it is critical that Boards have the strength to say “no-do” to strong CEOs before they embark on ill-fated acquisitions.