Hell or High Water Deals

I enjoy reading the M&A Law Professor blog, and often find it quite relevant to the types of things we think about at MergerProf.  Such is the case with last weeks link to another post about Hell or High Water Deals - deals that are designed to close no matter what - once they are signed, they close.  No major MAC clauses, etc.  The post contains a cute animated video illustrating some of the concepts involved and noting some of the great problems from the sellers point, of a deal not closing (loss of morale, loss of employees, uncertainty, etc.) [I know it is a link to a link, but let's give credit to the place where I read this.] The post also notes that deals that close 'no matter what' are extremely rare.  Well, maybe.  It seems to me that the Dow Chemical - Rohm and Hass deal came pretty close.  After the financial crisis Dow tried to walk away from the deal and found that they couldn't.  But anyway, enjoy the post.  You can find it here.

Experience Matters: The Impact of the Financial Crisis on M&A

I have been stumped by the continued low level of M&A activity. Despite improving fundamentals, strong stock market performance and the need for many industries to consolidate, M&A remains stuck in low gear. I understand macro headwinds and political uncertainty still exist. Nonetheless, something else seems to be dogging managerial animal spirits. My concern is the 2008 Financial Crisis may have a long term damping effect on management risk appetite.

The Financial Crisis represented a near death experience for many firms. Stock prices fell by 50%.  Although they have largely recovered over the past 5 years the cumulative return over that period remains flat. The collective memory of this experience may take years to dissipate.   Experiences matter - sometimes even more than fundamentals. Risk tolerance is time varying. Thus, the financial crisis is likely to have a long term negative impact on managers’ willingness to engage in M&A.  See a book chapter I authored on this subject chapter_24_post_crisis_investor_behavior_-_rizzi_-_final_-_05-18-13.pdf.

J

US Air American Airlines Merger Blocked, Implications for European Deals

The Justice department has announced that it is suing to block the USAIR-American Airlines, Merger.  We have previously written about the use of concentration ratios to ascertain the competitive impact of a merger involving Annheuser Busch and Modelo.

The arguments for and against are standard.  On the pro-merger side, the combination is expected to lower costs through economies of scale and permit lower pricing for consumers. In addition, since the service routes of the two airlines are complimentary, the merger could provide better linkage for consumers.

On the anti-merger side is the recognition that with increased market share, especially in selected 'hubs', the airlines will be able to charge higher prices with their more monopolistic standing.

In Europe, airline margins are tighter than the US.  In a very interesting article, the CAPA Center for Aviation discusses concentration ratios and margins around the world focusing on the opportunities for additional concentration in Europe.  See European Airlines, Few Deals to be Done.

All the best,

Ralph

Dynamic Capital Structure: A Long and Winding Road

How you fund an acquisition can have an important value impact. Usually, an acquirer has a static target capital structure tied to a ratings goal. For example, an industrial firm with a BBB ratings goal will keep its Debt to Capital ratio below 40%. Thus, it would either use excess liquidity or seek to raise capital for an acquisition in roughly that proportion to maintain its target.

This is largely the case for large, public, infrequent, strategic acquirers. More aggressive firms with concentrated ownership use transitory or dynamic capital structure which fits their short term needs and market conditions. They deliberately, but temporarily, deviate from their long term capital structure target to fund a particular action. Then, they rebalance to meet their long term target. Basically, debt is used as a plug to meet unanticipated funding needs. This allows them to avoid issuing possibly costly undervalued equity or maintaining extensive cash balances.

We saw this with Hudson Bay (SKS) , which leveraged up to high initial 5.7X FD/EBITDA leverage level to fund the SKS purchase. The expectation is they will rapidly refinance the debt from a REIT/Sale-Leaseback. Private Equity (PE) firms use a similar technique. They use high initial leverage and then rapidly retire the debt through operating cash flow. That is why most LBO related bank loans never go to maturity. They are either refinanced at a lower rate if they work according to projections or are restructured is they do not.

PE also uses capital structure changes as a substitute for an exit. Current weak M&A and IPO markets have complicated PE exits from portfolio companies. The average age of portfolio investments has reached a record 5+ years due to the financial crisis. This hurts IRRs and their limited partner investors (LPs). Thus, PE has re-leveraged portfolio companies to fund recapitalizations-special dividends to return capital to their LPs. The level of recaps is running at record levels. It is likely to exceed the record 2012 level this year. In fact, many deals are being rushed to market before the expected Federal (Fed) Reserve tapering begins.

Firms also deviate from capital structure targets based on market timing considerations. For example, firms will fund acquisitions with equity when they feel their shares are overvalued. Perhaps the best example of this is when AOL used its inflated shares as the acquisition currency in the Time Warner transaction. More recent examples are the MB Financial and PACW transactions (MB). 

IPOs exhibit market timing as well. They tend to occur when valuations are high, as reflected in elevated market-to-book ratios. This is the reason why IPO returns a year after the issuance tend to disappoint (e.g. Facebook).

Market timing related capital structure decisions affect debt as well. Debt issuance is favored when both rates and spreads are low. Post crisis Fed actions kept rates low. They also compressed spreads as investors are searching for yield. Equity costs, as reflected in the equity risk premium, have remained relatively high given macro-economic uncertainty. Thus, many firms engage in debt financed share repurchases whereby,”cheap” debt replaces more “expensive” equity.

Bottom line- the capital structure decision is more complicated than the widely held static view. Managers may have a long term target, but how they get there is a function of unanticipated investment and financing opportunities they encounter along the way. Thus, reaching their capital structure target can be a long and winding road.

J

Find Your Sustainable Competitive Advantage

“In business, I look for economic castles protected byunbreachable ‘moats’.”

Warren Buffett

Famed investor Warren Buffett is known to favor companies with a 'natural moat', a built in protection that gives companies some protection against competition.  Economists call this a sustainable competitive advantage.  The idea is simple, find what you do well, better than anyone else - that is your competitive advantage.  But you need more.  It isn't enough to have a competitive advantage - you need a sustainable competitive advantage.  If someone can start up a new business tomorrow, delivering the same product and service as your company, you don't have a sustainable competitive advantage. 

Sustainable competitive advantages come from many sources.  In some industries, larger companies benefit from economies of scale making it hard for smaller companies to enter. Other advantages are created through access to supplies or raw materials.  This can occur naturally from the physical location of a company or access many be driven by relationships - familiarity with a particular country, etc.  Intellectual benefits occur when a company has a particular patent or copyright that others cannot duplicate.  

On an individual level an example of an intellectual benefit combined with relationships would be the economist Larry Summers, a leading contender to be next chairman of the Federal Reserve.   Obviously a very smart individual, Summers has honed his personal competitive advantage through a career of challenging positions and a myriad of political contacts.  Of course, competitive advantages in politics are often unsustainable, and it is not assured that Summers will be chosen for the Fed post.  Nevertheless, the comparative advantage will serve him well in multiple pursuits and the intellectual capital and connections are indeed sustainable.

In developing business (and personal) strategy, look for situations where barriers of entry exist, or create a sustainable advantage by differentiating your product in ways that are hard to reproduce.  Soft drinks are a good example.  Coke and Pepsi are trademarks that are known throughout the world.  Other soft drink companies come and go - but none have risen to the level of Coke and Pepsi.  Those two brands are the go-to soft drinks of the world.  

This doesn't mean that companies with well established brand names are immune from competition.  Just think of Kodak.  A dramatic catalyst  can easily change the fortunes of a company - or an industry. For Kodak it was technology.  Other catalysts include regulatory shifts, demographic changes, political events, and changes in consumer tastes.  Which brings us back to Coke and Pepsi.  Noticing a shift away from colas, Coke has broadened its product line to include drinks like Dasani water, Powerade and Minute Maid and non-drink products like Dannon that can still benefit from the company's distribution and promotional expertise.  Excellent companies adapt to keep the competitive advantage sustainable.  

Merger of Equals: A Really Bad Idea?

Last month advertising firms Publicis Groupe (PUG) of France and U.S. based Omnicon (OMC) announced a $35B MOE Merger creating the world’s largest advertising firm .The initial market response was positive with Publicis up 6% while Omnicon increased 7.7%. Synergies of $500MM are expected.

The new firm, Publicis Omnicon Group (POG), will be based in both NYC and Paris. POG will have 14 board members - 7 each from PUG and OMC. POG’s CEO and OMC’s CEO will serve as CO-CEOs of the new combined firm for 30 months. Then OMC CEO will then become CEO as PUG’s Levy is set to step down and become Chairman.

MOE share the following characteristics:

1)     Similar sized firms in the same industry

2)     Substantial portion of the new combined firm is held by each firm’s former

        shareholders

3)     Limited or no premium paid

4)     Stock swap using fixed exchange ratio usually with no caps/floors

5)     Sharing of governance between the two former firms-Co Equal CEOs, etc.

Point # 5 is the issue which causes the most danger in successfully implementing a MOE despite their low premium. The Co Equal structure complicates cultural integration and execution making it difficult to realize the promised synergies. M&A already is a risky activity without adding an additional layer of integration barriers. This is why MOE have a checkered record including:

1)     Daimler-Chrysler

2)     Alcatel-Lucent

3)     Citi-Travelers

4)     Morgan Stanley-Discover

5)     First Union-Wachovia

The integration issues are especially acute when the firms have different business models (e.g. Citi-Travelers) and cultures (e.g. Alcatel-Lucent).This is critical for POG regarding client conflict resolution. For example, Coke is a Publicis client while Pepsi is an Omnicon client. How do you do what is best for the client without upsetting either the Publicis or Omnicom account managers? Another issue is handling the different compensation systems - a U.S. style Omnicon and a Euro Publicis without alienating employees.

Typically, MOE are more symbolic than substantive. They are used get approval for a combinations that otherwise would not occur. For example, General Mills had to incorporate a complex governance sharing structure into its Yoplait yogurt acquisition to get French approval. Usually in a MOE, some parties turn out to be more equal than others.

The basic problem with MOEs is they work in theory but not in practice. The numbers seem to work, but the “soft” issues- people, governance and integration frequently do not work once the deal is closed. You can try to let the lawyers work it out with a detailed memorandum of understanding covering items such as:

 1)     Governance: board size, composition, key committees, management team

         compensation, and management succession.

 2)     Surviving name and HQ Location

 3)     Strategic Plan and Direction

 4)     Capital Structure, Ratings Target and Dividend Policy

 5)     Who Will Be the CFO and What IT Systems Will Be Used

 6)     Professionals: who will be the surviving accountant, lawyers, investment

         bankers, etc.?

 7)     Due Diligence

 8)     Identification and Retention of Key Staff

 9)     Investors Relations Strategy

10)    Detailed Integration and 100 Day Plans

The problem with the lawyer approach is that it inhibits flexibility needed to integrate the two firms. The focus on fairness and balance can interfere with making the right business decision. This can lead to frustration and conflict. The danger is this creates an “us v them” mentality leading to in-fighting. Remember, the two firms were formerly rivals. Thus, some bad blood among the staff is likely to exist. This may make it difficult for them to get along in any event.

I wish the Publicis and Omnicom combination the best of luck. My gut tells me this is going to be a bumpy ride. Co-CEOs and dual HQs, especially with organizations having such different cultures (French v American) raise the odds of a disappointing integration.

j

When the Whole is Worth Less Than the Sum of Its Parts

A long time ago, at a university that I won't name,  I attended a faculty meeting where each department head gave a report on their department.  The leaders of each of the five departments (e.g. marketing, accounting, etc.) stood up and demonstrated how their group was, by some convenient statistic, ranked among the top ten departments of the country.  A colleague pointed out that 'It is interesting that each and every department believes it is in the top ten but the U.S. News rankings put the college 27th!' 

Now in the case of the university, the disparity was obviously the result of selective reporting, but the same thing happens in business.  Sometimes the whole is worth less than the sum of its parts!  Joe wrote about this in a previous post The Power of Subtraction.  This week's Wall Street Journal gives two additional examples:

First, Consider Amazon's Jeff Bezos buying the Washington Post.  In an interesting WSJ post, (After the Sale: Unfolding the Washington Post's Inner Value) Miriam Gottfried notes the various parts of the Post enterprise.  The Post was sold for $250 million whereas the entire Post enterprise is valued at $4 billion consisting of TV Broadcasting, Cable TV and Education in addition to Newspaper Publishing.  The article goes on to note the different trading multiples typical of the various business sectors and suggests that continuing to focus the Post (perhaps by spinning off the educational arm, Kaplan) might 'release further value'.  I agree, not because of PE magic (which we'll warn about in a subsequent post)  but because of substantial evidence the companies increase value by focusing  on the core units with the best chance for a sustainable, competitive advantage. 

And speaking of spinoffs, note that TripAdvisor, spun off from Expedia in December 2011 now exceeds the parent in terms of Market Cap.  (See Out of Nest, TripAdvisor Soars Past Expedia).  

All the best,

Ralph

Structuring the Deal: Hudson’s Bay - Saks Acquisition

Canadian based Hudson’s Bay (HBC) agreed to acquire the New York luxury retailer Saks (SKS) for $2.9B ($2.4B equity plus $500MM assumed debt) Deal. The 9X EBITDA ($16 p/s) purchase price multiple represents a 20% premium to pre bid prices, and is consistent with recent transactions. HBC is controlled by NRDC LLC, a U.S. based real estate investment firm which owns Lord & Taylor (LT) department stores. The deal is funded with $1B of new equity supplied by the Ontario Teachers Pension Plan ($500MM), Canadian private equity firm West Face Capital ($250MM) and another $250MM from the public. Also, $1.9B in senior secured loans and $400MM in unsecured notes will be raised. The combined debt will initially exceed 5.7X EBITDA before reducing to a more manageable 4X after synergies. Management will remain in NY and $100MM in synergies are expected. The transaction was positively received with HBC’s shares jumping 6% on the announcement despite the potential dilutive stock placement. This is significant as HBC had a disappointing 2012 IPO. Investors were concerned over the entry of American competitors into HBC’s Canadian market.

Leveraged retailers are always problematic  -especially for those like SKS whose turnarounds are still in progress. Some commentators have rightly questioned the wisdom of the acquisition. They view it similar to the still troubled Eddie Lampert 2004 Sears/Kmart combination Sears.  SKS is a muddled brand lagging behind luxury retailers Nordstrom, which is planning to enter Canada, and private equity owned Neiman Marcus.

Ignored, however, is that the transaction is as much a real estate play as it is retail. SKS’ real estate value is estimated at $1.8B before debt with their signature Fifth Avenue location alone worth over $800MM.  The after debt p/s value of the real estate is $6.  Combined with LT’s real estate NRBC-HBC can monetize and unlock the real estate value thru techniques like a Real Estate Investment Trust (REIT) to create substantial tax benefits. A  Sale Leaseback (SLB) could then be used to raise proceeds to quickly deleverage the transaction from its high initial 5.7X leverage level. The combined LT and SKS real estate assets could support a $3.5B+ REIT, which could then be used to reduce debt. Rents would be stepped-up, and potential conflicts between retail and REIT units will need to be sorted out.

Undoubtedly, this is a high risk transaction given its relative size to HBC. They wisely sought joint venture type equity from sophisticated deep pocket investors to offset the risk. Also, the deal is structured more like an asset based real estate transaction than a traditional strategic retail acquisition. NRDC’s experience adds a degree of comfort in this area. Of course, they still have to complete the turnaround of SKS, achieve the promised synergies and adjust to higher rents. The expected use of clever financial engineering techniques like SLB and REIT appear to have enough value potential that the market awarded HBC a significant price increase. Hopefully, they can successful execute the deal and not disappoint investors. Bottom line-this is deal worth watching.

J

CEO Turnover: The Grass Isn't Always Greener

As many of you know, my day job is as executive director of Drexel's Center for Corporate Governance.  The Center has it's own blog run by center director Patricia Connolly.  This week's post features one of my finance colleague's, Ed Nelling, commenting on CEO Turnover.  He gives some great examples and asks some excellent questions.  I think you will enjoy it.  The post can be found here.