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
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