European Deal Activity - An Update

Next week, we are offering our Acquisition Finance Course in Amsterdam again.  December is such a festive time to visit Amsterdam - they take the holidays seriously and it seems to be reflected everywhere you look from the Central Station to the Leidsiplein to the Canals to the small villages just outside the city.  I really look forward to being there.

Some of the things we'll be analyzing in detail next include understanding current market activity.  As part of this we'll take a look at trends over time.  The slide below shows the Countries most active as Acquirers and as Targets over the past five years.  The UK heads the list in Deal Value and Number of Deals.  

Leveraged Finance: Best of Times?

Regulators are concerned with the state of credit markets, in general, and the leveraged loan (LL) market, in particular (see Regulators). Market states are driven by changes in investor risk appetite. Rising wealth from the post crisis bull market is fueling increased risk appetite. This, combined with a search for yield in a low interest rate environment, underlies the resurgence of leveraged financing.

This is especially notable in the return of the collateralized loan obligation CLO market. This market shut down during the crisis due to unexpected losses from step market price declines. The activity returned in 2012. CLO investors are the major LL investor base. Their return underlies the spike in 2013 leveraged activity. Note the following:

1)        LBO activity has ballooned this year.

2)        Funded debt multiples of EBITDA have returned to near pre-crisis levels 5.5X v 6.2X.

3)        Purchase price multiples are increasing.

4)        Percentage of contributed equity in LBOs is falling to 32% - near the pre-crisis low.

5)        Financing structures have changed. Balloon based term loan B’s have replaced amortizing term loan A’s.

6)        Loan spreads have fallen to pre-crisis levels. They fell 100BP alone from 2012 levels.

7)        Return of aggressive pre-crisis instruments like Payment-in-Kind-Toggle PIK-T and covenant-lite   loans Cov-lite. In fact, cov-lite now represents a record 52% of LL  issuance.

8)        Surge in higher risk transactions including Public-to-Private (PTP) and Leveraged Recapitalizations (LevR). PTP is at its highest level since the pre-crisis 2007 peak, while LevR have reached record levels.

9)        CLOs issuance for 9 months 2013 is  $57B v $30B for same period 2013.

For issuers it is the return of the good times in terms of funding availability, structure and flexibility. Just because you can do something, however, does not mean you should do it. We are likely to see to higher priced and over leveraged transactions going forward. Yield chasing investors are likely to suffer disappointing pro forma returns once risk appetite peaks and market liquidity falls. We cannot predict when this correction occurs. We can, however, predict that it is closer than where it was at the beginning of 2013.

j

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up. Hope to see you in Amsterdam - one of our favorite cities!

Exit Strategies for Private Equity: US and European Evidence

Last week we outlined exit strategies for private equity investments.  One strategy that we didn't feature is a 'write-off'.  Obviously, write-offs can represent a failed investment and are (generally) undesirable. However, the ability to cut losses early is a healthy trait in any investment strategy.  The article below highlights exit strategies for US and European buyouts over the 1990-2005 period, revealing many interesting aspects of the exit process.  The importance of market sentiment is also noted, making it imperative to ascertain current and projected market conditions in any analysis.

 Exit Strategies of Buyout Investments – An Empirical Analysis 

Daniel Schmidt Sascha Steffen Franziska Szabó 

June 1, 2009 

(Abstract) 

"We analyze the three main exit routes for exiting buyout investments, initial public offerings (IPO), sales and write-offs on, using a unique data set for US and European buyout transactions for the 1990 to 2005 period. We examine the determinants influencing the choice of an exit channel employing a multinomial logit model. The results strongly support the view that private equity investors write-off investments that turn out to be non-performing early, showing their ability to filter out good from bad investments. We further find evidence that exits of buyout investments tend to be driven by market sentiment. We further analyze as to how the internal rate of return (IRR) influences which exit route is chosen. We find supporting results that only the most profitable ventures are taken public. Our results have implications for exiting buyout investments during the current financial crisis. "

The complete paper can be downloaded here.

All the best,

Ralph

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.

Goodwill Hunting Revisited

An earlier Post focused on goodwill Impairments as a measure of M&A value destruction. Duff & Phelps has released a new Study which contains some interesting results:

1)   Goodwill impairment surged 76% from the prior year to $51B.They still remain below the peak 2008 crisis related levels which were centered in the financial services industry.

2)   Buyers paid the lowest premiums in nearly 20 years, less than 20% v a historical 30%+.

3)   Impairments were concentrated in industries and firms undergoing structural change. IT was the industry experiencing the largest share of impairments. Two firms in that industry, Hewlett Packard (HP) and Microsoft (MS) had the largest impairments at $13.7B and $6.2B respectively representing nearly 40% of total annual impairments. HP’s impairment concerned its Autonomy acquisition while MS’s related to aQuantive.

The biggest source of M&A value destruction is overpaying. No matter how good the fit, how good the target, how flawless the integration, or the amount of due diligence, if you overpay, reflected in the amount of goodwill created or earnings and book value dilution, your shareholders will suffer.

Conceptually, the target’s pre bid share price plus the premium equals price paid. The value received is the target’s standalone value (reflected in the pre bid price) plus any synergies. Thus, the acquirer’s net value received is synergies less the premium. Premiums are, however, a fact while synergies are an opinion subject to behavioral bias.

As a rule of thumb, premiums exceeding 40% are prima facie evidence of overpayment. Think about it, a 40%+ premiums means you have to improve the target’s performance by over 40% just to breakeven. Unless, the target was grossly mismanaged, this will be difficult in a low growth highly competitive market.

The HP and MS acquisitions were grossly overpriced with premiums of 64% and 85% respectively. Such actions reflect desperate buyers gambling for redemption (AKA Hail Mary pass). Both HP and MS are former growth stars experiencing slumping sales growth and eroding margins. Their management teams, both of which have or will be replaced following their disastrous acquisitions, believed large transformational acquisitions would serve as a growth elixir. Unfortunately their shareholders were forced to drink from the poisoned chalice of value destruction.

j

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.

Exit Strategies for Private Equity

In our recent post, Business Risk, Financial Risk and Attractive LBO Candidates, we discussed the importance of exit strategies and valuations.  Exit strategies refer to the way private equity sponsors hope to sell and exit from the business.  Typically their time horizons are 5-7 years.  If a deal remains on the books much longer than that, the rate of return to the sponsor declines, sometimes dramatically.

Typical exit strategies involve:

1) An initial public offering
2) Leveraged recap
3) Sale to a strategic buyer (in the same industry)
4) Sale to another private equity firm

An initial public offering or IPO can offer the highest rate of return to sponsors if market conditions are optimal.  Note that we listed these as exit mechanisms, but an IPO doesn't necessarily imply an exit.  The shares of the company become publicly traded and thus liquid.  Sponsors can cash out wholly or partially,  but until shares are sold the private equity investor bears market risk.  Depending on the level of equity held, the sponsor can also retain ownership control.

 Similarly, in a leverage recap, the sponsor is not completely exiting, but merely levering the company back up and (generally) using the proceeds to retire equity.  It may be considered a partial exit as the sponsor is able to recover some additional investment.  An advantage is that while getting a return on investment, the sponsor is keeping ownership control.  There are often tax advantages to this method as well.  The disadvantages of high leverage are the increased risk of bankruptcy and loss of financial flexibility.

Sales to a strategic buyer in the industry can provide an efficient method of exit as you are negotiating with just one buyer who is a knowledgable player in your industry.  The seller usually has greater control over the sales process in a sale to a strategic buyer.  However,  existing management may be reluctant for such a sale as there is an increased chance of a change of control (i.e management being replaced). In addition, the loss of competitive secrets is an issue as you are dealing with another firm in the industry.

Finally, the firm could be sold to a financial buyer such as another private equity firm.  By this time, the major cost savings have typically been realized.  A sale in this manner requires the new PE firm to see possibilities unrealized in the first round buyout.

We'll continue our discussion in another post and, of course, in our upcoming Acquisition Finance Course in Amsterdam.

All the best,

Ralph

Determining Buyout Capital Structures

My prior post on Capital Structure focused on how traditional corporations establish their capital structures. This entry shifts to how highly leveraged buyout capital structures are determined. Little explanation on how private equity funds set leverage levels for their portfolio companies exists despite buyouts composing an important segment of the overall M&A deal market. As previously discussed, corporation capital structures are ratings based and tend to be permanent in nature. The ratings are tied to fundamentals including size, funded debt to EBITDA and interest coverage.

Buyouts have transitory capital structures driven by factors unrelated to corporations with their more permanent capital structures. Buyouts focus more on maximizing debt capacity utilization tied to market conditions. Hence, their capital structures are highly pro cyclical and drive buyout pricing levels.  (See  Buyout Leverage.)  This is based on the limited life of private equity funds (5 year investment period and 10 year overall life) and the compensation of the general partners (GP).

The traditional GP compensation structure is known as ”2 and 20”. This means they receive a 2% management fee on the funds committed by limited partners (LP) during the investment period, and dropping to 1% for the remainder of the fund’s life. Additionally, they receive 20% of the fund’s profits (AKA the carried interest) after a guaranteed minimum return to the LP-usually 8%. The option like carry is not risk adjusted. Like all options its value is positively related to risk. This leads to a GP-LP agency (conflict of interest) problem. GP are incented to take value destroying investments that cover the preferred return requirement, but not the investment’s cost of capital, to maximize their carry. They are further incented to take as much leverage as the market will allow to enhance their carry. The “great moderation” from the mid 1980s thru 2006 (see Moderation) with its falling rates, increasing profits and high exit multiples shrouded the real effects of these facts from many LPs. The facts became evident once the financial crisis occurred and devastated many buyouts and funds.

The evidence indicates that buyout volume, leverage and purchase prices are inversely related to the spread on high yield securities less LIBOR. (see Drivers) Thus, as markets peaked in the 2006-2007 period, debt spreads fell and buyout leverage surged. Once spreads widened during the 2008-2011 crisis, leverage levels collapsed. Currently, the QE based market recovery has lowered spreads to pre crisis levels. Predictably, buyout leverage levels are approaching pre crisis levels.

The standard corporate explanations for capital structures (trade-off and pecking order) have limited ability to explain buyout leverage levels. Buyout capital structures appear to be based more on market timing and agency factors. The unique contractual organizational structure of private equity funds compared to corporations influences the way they raise capital. This is another area where capital structure theory and practice seems to have a divide that needs closing.

J

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.