Thursday, June 27, 2013

The Google Waze Acquisition

The proposed Google, Waze acquisition illustrates many of the themes we've developed in previous posts.  First would be motives for acquisition.  In this case, we have acquiring technology, increasing market share and staying relevant - all consistent with increasing shareholder value (see Catalysts for Merger and  Motives for Merger).  But then we also have Merging defensively - (to prevent a competitor from doing the deal and getting an advantage) and the motive of 'eliminating the competition - by acquiring them'.   Now this may also increase shareholder value, but is, of course, frowned upon by the FTC, which is precisely why the FTC is now investigating the issue.  What criteria will the FTC use in deciding whether the deal is in restraint of trade?  See our post concerning the Herfindahl index.  

As the Wall Street Journal reports, 

"The FTC is expected to focus on whether Waze would have become a head-to-head competitor with Google, whose Google Maps software is the dominant digital mapping and navigation service around the world, or whether there is any evidence, such as emails, that show that Google wanted to acquire the company only to keep it out of the hands of rivals."

The complete WSJ article can be downloaded here.  

All the best,


Monday, June 24, 2013

The Power of Subtraction: When 2-1=3

Difficult economic and industry conditions have depressed operating results for many firms. This has stimulated changes in corporate strategy and structure. Fusion based mergers and acquisitions are a means to implement such changes. They are based on the premise of 1+1=3, largely through synergy based improvements. The other side of the merger coin is the less well know fission-based de-mergers approach where 2-1=3. The focus of this post is on voluntary as opposed to imposed de-mergers due to financial distress or bankruptcy issues.

De-merger activity, like its merger related cousin, runs in waves. Currently, the wave is in an upswing. For example:

1)     Smithfield: the friendly acquisition to a Chinese firm is challenged by an activist shareholder claiming a de-merger of the vertically integrated pork producer would create one-third to two-thirds value increase over the acquisition alternative.

2)     Sony: activist investor Daniel Loeb is seeking a 15-20% equity carve-out (partial public offering) of Sony’s entertainment division to unlock value and fund the turnaround of its lagging electronics unit.

3)     Media Industry: McGraw-Hill split of its publishing and ratings units and the Fox spinoff of its print from electronic media just to name a few.

De-mergers, unlike mergers have a surprisingly positive value impact. Despite this, it is not something that comes naturally to most managers. It is seen more as a mark of failure-shrinking versus growing- than as a natural process in portfolio management reflecting changes in market conditions and the firm’s life cycle. Consequently, most firms engage in de-mergers only after being prodded by activist or frustrated shareholders signaling their displeasure with disappointing performance. Also, de-mergers appear to be more about financial engineering than value creation. This is partly true as de-mergers are about releasing trapped value inherent in multi-divisional diversified firms than creating something new.

Typically, such firms suffer from a conglomerate discount, which reflects the difference between the values of the separate individual business units on a standalone basis in a conglomerate from the market value of the parent. This difference is in effect a negative synergy or management as an off- balance- sheet- liability. The negative synergy can result from increased overhead expenses, capital misallocation, cross subsidies, and suboptimal incentives. These suggest that the current parent is not the best owner of the division.

The major de-merger methods include among others:

1)     Divestment: usually taxable sale to a third party. An example is McGraw-Hill’s sale of Business Week to Bloomberg. Getting an acceptable price depends on finding a natural buyer (best owner). As Warren Buffett notes, divestment is not Gin Rummy where discard your worst cards. As you are unlikely to get much for losers. Rather, it is about selling good businesses to someone who pays more to you than the assets are worth to you as a continuing operation.

2)     Spinoff: frequently a tax free distribution of subsidiary shares to the parent shareholders - similar to a stock dividend. They continue to own the same operations, but in a separate form. It can be faster and more assured than a divestment - especially, when no natural buyer can be identified. Can be both leveraged and un-levered. In a leveraged spin-off, the subsidiary borrows to fund a special dividend to the parent before the spin.

3)     Split-off: related to a spinoff, whereby parent shares are exchanged for direct ownership in a subsidiary.

4)     Equity Carve-out: portion (typically 15-20%) of a subsidiary’s shares are sold to the public as a partial public offering. Carve-outs, like spin-offs, can be either leveraged or un-levered.

5)     Tracking Stock: separate classes of parent stock whose dividends depend on the performance of an individual subsidiary.

The relative merits of each method vary are beyond the scope the scope of this post. Nonetheless, it illustrates some of the many ways to unlock trapped value in underperforming diversified firms. The key is to recognize that subsidiaries come with different “sell-by” dates. Management needs to watch and act on these dates as part of it on-going portfolio management process.


Thursday, June 20, 2013

Electing Directors

The board of directors is crucial to the successful governance of the modern corporation.  Directors hire and fire the CEO, monitor performance and compliance with regulations and provide crucial advice on strategic matters.  And, of course, related to this blog, the board also approves or disapproves mergers.  Until recently, however, we didn't know much about director elections.  Jay Cai, Jacqueline Garner and I studied over 2500 director elections to remedy that situation.  The abstract of the article is below.  

Electing Directors
Published in the Journal of Finance

Using a large sample of director elections, we document that shareholder votes are  significantly related to firm performance, governance, director performance, and voting  mechanisms. However, most variables, except meeting attendance and ISS  recommendation, have little economic impact on shareholder votes. Even poorly  performing directors and firms typically receive over 90% of votes cast. Nevertheless,  fewer votes lead to lower 'abnormal' CEO compensation and a higher probability of  removing poison pills, classified boards, and CEOs. Meanwhile, director votes have little  impact on election outcomes, firm performance, or director reputation. These results  provide important benchmarks for the current debate about election reforms.   

The complete article, which was published in the Journal of Finance can be downloaded here.

All the best,


Monday, June 17, 2013

Choose Wisely: Selecting a Capital Structure

The funding requirements for larger merger transactions frequently have important capital structure implications. The portion of debt to equity used is more important for strategic acquirers than private equity firms. Private equity acquisitions usually involve temporary capital structures utilizing the maximum level of debt with rapid debt repayment. Strategic buyers focus on longer term “permanent” capital structures, and are the focus of this post.

Capital structure decisions are usually expressed as credit ratings targets. The ratings are based on industry, firm size, debt-to-capital, and funded debt to EBITDA ratios among other factors. Selection of the appropriate ratings target is based on the following matching process:

                  Financing Need = product market opportunities + operating performance & strategy
                  Capital Structure = capital market conditions + financial preferences

It is important to get this right. Insufficient debt reflected in high investment grade ratings can result in excess taxes, higher agency costs and increased shareholder activism. Excessive debt expressed in non investment grade ratings can reduce flexibility and increase financial distress costs.

Some of the factors affecting the decision process are as follows:

1)    Taxes: are the debt related tax shield benefits important? Can the firm generate sufficient taxable income to utilize the interest deductions? Firms with limited existing or volatile taxable income due to rapid growth, high investment requirements, cyclicality, rapidly changing regulation and technology tend rely on higher equity levels compared to stable cash generating mature firms.

2)    Financial Distress Costs: the major financial distress cost is not bankruptcy, but the impact of higher leverage on the firm’s operations. This includes inability to fund the firm’s strategic plan, and the impact of higher leverage on the firm’s suppliers, customers, employees, competitors, and capital market access. High leverage can scare suppliers, customers, and employees.

3)     Peers: compare target structure against competitors. An overly aggressive debt level relative to peers can encourage adverse competitor responses. We saw this in HP’s comments about Dell’s LBO. HP stated they intended to remind Dell’s P/C customers that HP was investment grade while Dell would be highly leveraged.

4)     Discipline: leverage can motive management to be more efficient to meet debt service requirements. Also, lender covenant restrictions and excess cash flow sweeps requirements in noninvestment grade financings can minimize management prerequisites and empire building which is often at shareholder expense.

5)     Ownership and Control: firms worried about these issues tend to favor debt over equity.

6)     Dividends: higher leverage can pressure dividends. The impact depends on the firm’s shareholder base. Shareholders preferring a steady dividend may favor a more conservative capital structure despite potential ownership and EPS dilution.

7)     Relative Pricing: the Fed’s QEs have altered the relative pricing of debt compared to equity. Excess liquidity and low rates have lowered the cost of debt. The equity risk premium, however, has remained elevated making equity a more expensive funding source (see Cookbook WACC Estimates: Wrong Recipies?).

Many acquirers will undoubtedly use the same pre transaction rating target when setting their funding mix. Nonetheless, it can be useful to revisit the capital structure decision as part of the M&A discussion.

So chose wisely.


P.S. Readers of this post may also find many of our other capital structure posts of interest including: How Much Debt is Right for Your Deal and High Leveraged Deals, Capital Structure, and Common Sense.