Capital Structure and the Fictional World of Miller-Modigliani

Capital structure is a key element in any acquisition.  How should a deal be financed?  How much debt can an acquisition support?  What are the resulting shifts in ownership structure?   What debt rating will result from a deal?  These are just a few of the key questions related to capital structure.

In previous posts, we've discussed some basic theories of capital structure (for just two examples see High Leverage Deals, Capital Structure and Common Sense and How Much Debt is Right for your Deal?).  The theoretical foundation for understanding capital structure starts with the classic work by Miller and Modigliani published way back in 1958.  That enormously influential work, showed that the level of debt doesn't matter in a hypothetical world where: taxes don't exist, bankruptcy costs are zero and there are no informational asymmetries (all parties have complete information).

Many of our readers will recall discussing this work in their MBA programs, but for many practitioners the idea of starting with such a hypothetical, completely fictional world seems insane. Wouldn't we all like to live in a world without taxes, bankruptcy costs or informational blockages! But the analysis is not  insane.  Rather it is the starting point for understanding all that matters in capital structure today.

The starting point of Miller and Modigliani can be likened to the scientist who analyzes the properties of some item in a complete vacuum.   He/she starts the analysis in a vacuum, not because it represents the real world, but because if we can't understand how things work in that idealized experiment, we can't hope to understand how things work in our complex environment.

Rather than objecting to the assumptions as ivory tower irrelevancies, consider these assumptions as the starting point for a very important experiment.  For indeed, under these assumptions, the level of debt does not matter.  So ------ if the amount of debt matters --- (and we live in the real world and we know the level of debt matters) --- it matters precisely because of the effects of these assumptions.  Rather than being irrelevant, when we relax the assumptions, debt does indeed affect firm value - and it does so because of the existence of taxes, bankruptcy costs and information.  In future posts we'll explore each of these assumptions and their implications for capital structure in a bit more detail.

All the best,

Ralph

The Jos A Bank- Men’s Warehouse-Eddie Bauer: Poison Pill or Suicide?

Ralph has discussed the agency Problem whereby management acts in its own self interest against the best wishes of shareholders. The current Joseph A Bank -Men's Warehouse- Eddie Bauer ménage a trios provides a vivid example of managers acting badly. The sequence of events is as follows:

1)  October, 2013: Bank offers to acquire its larger competitor Men

2)  November, 2013: Men proposes to acquire Bank for $57.50 per share

3)  December, 2013: Bank rejects Men’s offer

4)  January, 2014: Men begins a hostile takeover of Bank offering $57.50 per share-about a 40% premium to Bank’s pre October price

5)   February, 2014: Bank makes a combined offer to acquire Eddie in a combination cash-stock deal worth $825mln. The $300mln stock portion values the shares at $56 per share. It also offers to repurchase $300mln of its shares at $65 per share. The new offer represents a 52 % premium over Bank pre October price.

6)   February, 2014: Eminence Capital, 4.9% Bank shareholder, objects to Bank’s actions threatening a proxy battle and legal action.

7)   February, 2014: Men revises its offer to $63.50 per share with a further increase to $65 if it is allowed due diligence. The revised offer is conditioned on Bank terminating the Eddie offer. Men offers to cover the Eddie breakup fee up to $48mln. Eminence supports the revised offer.

Both Bank and Men agree the combination makes sense in the slow growth men’s apparel industry. The only issue is which management team survives to run the combined firm.

Bank decided to make itself so ugly that its unwanted suitor would lose interest and their jobs would be safe-shareholders be damned. Here is what they did and it is pretty ugly:

1)  Purchase Price multiple (PPX): They offered a 14X trailing EBITDA for an ill fitting Eddie that had earlier been bought out of bankruptcy by Golden Gate Capital. The going retail PPX is around 8X.

2)  Funding: The share portion of the consideration leaves Gate as Bank’s largest shareholder at around 17%. Bank is borrowing $900mln-$400mln bridge loan and $500mln ABL-arranged by Goldman who is also Bank’s advisor. This will leave Bank in a leveraged state with reduced flexibility.

3)  Share Repurchase: The repurchase is justified as reducing the dilution from the share portion of the consideration. What is especially interesting is they are issuing shares at $56 per share while repurchasing shares at $65. Selling shareholder will benefit at the expense of the remaining shareholders.

This is almost like giving yourself VD to scare off an unwanted lover-the ultimate poison pill I guess. Nonetheless, I would hope there would be less painful alternatives.

The end result is a blatant case of management agency costs at work. Bank management not only failed to capitalize on a favorable buyout offer-made even more favorable by the revised Men offer. They are also attempting an overpriced acquisition with limited synergy potential, which would leave the Bank in a weakened financial state. Just when you thought it could not get any worse, they decided to make an overpriced share repurchase. They should get an award for attempting the shareholder value destruction trifecta. Oh well, what do they care-if they get to keep their jobs. Hopefully, for Bank shareholders, the new Men offer will save them from such actions.

J

Comcast, Time Warner and the Myth of the Cable Industry

Last week Comcast (CMCSA) announced a $45 million dollar acquisition of Time Warner Cable (TWC).   The announcement sent shock waves through financial markets and raised numerous questions.    

For companies that compete in the same market, there are obvious concerns about future strategies.  Charter Communications (CHTR) for example, wanted to buy Time Warner and bid low.  There is some speculation that they would attempt to revise their bid, but it is not clear that Charter could (or would choose to) handle the increased debt that would come with such a revision. 

Other companies that compete in the same space (note I didn't say 'Cable Industry') have to wonder if further consolidations help them achieve their own potential.  Some have suggested CableVision could be a target or even that privately held firms like Cox Communications would be involved in acquisitions.

As investors, we also wonder about the market reactions to rivals of targeted companies and what it means for future acquisitions.  In our research, when a bid like this occurs, the prices of target firms react in direct proportion to the probability that they will become targets themselves. (See Abnormal Returns to Rivals of Acquisition Targets.)  

There has also been much talk about the regulatory issues such a combination would raise.  For regulators the concerns will be whether the merger is a restraint of competition resulting in predatory pricing of consumers.  We have noted in a previous post that one of the main tools for such an analysis is the Hirfindahl Index or the related Concentration Ratio. (See Concentration Ratios: The Case of Anheuser Busch and Modelo.)  

But in that post, we also note that to create a measure of concentration in an industry, one must first define the industry.  And that brings us to the myth of the cable industry.  In a very interesting article entitled, The Comcast-Time Warner Merger Is Not a Sign of Strength, Larry Downes makes a convincing argument that fears of market dominance here are overrated.  To quote, 

"There is no cable industry.  Cable is just a technology, increasingly one of many, for transmitting information, whether video, voice or data.

Where cable was once the only technology used to distribute television programming—a vast improvement in speed, quality, and quantity over antennas—it now competes with fiber, copper, satellite, and mobile broadband, each with their own pluses and minuses, and each promoted by companies large and small, who together continue to spend heavily to upgrade their assets."

Indeed, the story is so much more than a merger of cable companies, even well known companies.  It is another event in the evolving battle for the vast market for entertainment.

Stay tuned.

Ralph 

Synergies: Dreams or Nightmares?

Synergies can become one of the four big lies along with “the check is in the mail”. Theoretically, they are just an expression of the extra value a buyer can achieve from an acquisition target. They are key to offsetting the premium paid to make the transaction work from the buyer’s point of view. Unfortunately, they can be easily abused to justify over priced acquisitions. In essence they can become the “plug” to legitimize any transaction. As Warren Buffett notes “although many deals fail in practice-none fail in spreadsheets”.  I use the following tests when evaluating synergies:

1)     Premium: a premium exceeding 40% of the pre bid target price is an indicator of the need for inflated synergies to make the deal work-at least on paper.

2)     Projection Inputs: every valuation and its underlying projections are based on six variables which should be compared against the base rate-historical results and peers. The key variable are:

a)     Revenue Growth: revenue synergies are especially suspect. Competitors have a nasty habit of quickly responding to attempted market share gains.

b)     Operating Profit Margin Increases: cost synergies are more believable than revenue growth. Nonetheless, integration expenses and other unplanned items must be considered. Also, competitors may crimp gross margins through decreased prices.

c)     Taxes: lower tax rate assumptions should be questioned.

d)     CAPEX: growth requires supporting investment infrastructure.

e)     Working Capital Increases: additional inventory and receivables from growth should be expected.

f)      Weighted Average Cost of Capital (WACC): beware of financial engineering and other sleights of hand. You should discount the targets cash flows at its unlevered cost of equity relevered for its new target capital structure-not at the acquirer’s WACC, which is usually lower.

3)     Reality Checks

a)     Value the Projections: if the value based on believable inputs substantially exceeds the price, then ask why the acquirer is so lucky to receive this generosity. The M&A market is relatively efficient. Hence bargains are rare.

b)     Compensation: tie the projections into the compensation of the deal’s proponents. They should be at risk just like the acquirer’s shareholders.

c)     Covenants: bank loan covenants tied to the projections for items including leverage and fixed charge ratios may give management reason to reconsider its projections.

d)     Consistency: due diligence and integration plans should support and be consistent with the synergy projections.

As President Reagan noted- trust, but verify. The same goes for synergies.

J

Acquisition Finance: Some background

In over 160 posts, we've explored many ideas, concepts and trends in acquisition finance.  Today I just want to step back and simply talk about the nature of acquisition finance.  Some (or most) of this will be familiar to our readers, but it will nevertheless serve as a context for some of the other discussions.

Acquisition finance is the process of optimizing the capital structure after acquisition, recapitalization, buyouts, MBOs, LBOs corporate restructuring, dividend recapitalization, corporate to corporate deals or some other form of debt refinancing.  Typically there is some change in the ownership structure (if only because the capital structure has shifted) and also typically a high amount of leverage is used.  

Acquisition activity is cyclical in large part because the demand for acquisition finance and the products offered by the market vary over time.  Acquisition finance involves the potential for increased returns, but obviously increased risk.  (There are reasons that we use the term leverage or as the British call it gearing.  See the related posts on High Leverage Deals, Capital Structure and Common Sense and Six Disadvantages of Highly Levered Firms.)  At the same time, acquisition finance provides interesting and potentially profitable opportunities for advisers and lenders.

Typical participants providing capital and advice in acquisition finance include: investment banks, hedge funds, other institutional investors, private equity and financial sponsors.  The products offered in these markets include leveraged finance, high yield bonds, mezzanine debt, revolving credit and other innovative capital structures.  (We'll have much more detail to offer on these participants and products in future posts.   )

In a previous post we noted five ways that acquisition finance creates value including:

1.    Improving incentives

2.    Improving efficiency

3.    Improving governance

4.    Reducing regulatory requirements

5.    Creating tax shields

For more detail, see Five Ways.  In subsequent posts, we'll talk about the KKR model and other approaches to acquisition finance.

All the best,

Ralph

Financing Structure and Banking Regulations

Financial structuring involves two levels of analysis (see the slide below which is part of our Amsterdam Institute of Finance course). 

The first level is the deal environment, which includes:

• Business Considerations - the corporate strategy and plans
• Financial preferences - dilution, control and flexibility (covenants)
• Transaction Characteristics - size, debt rating
• Market Conditions - availability, depth, and pricing

The second level is the institutional level which depends on the domicile of the deal. Factors are as follows:

•               Legal
•               Tax
•               Accounting
•               Regulatory

Acquisition finance, especially leveraged lending to non investment grade obligors has incurred significant domestic banking regulatory changes since the 2008 financial crisis. Regulators are concerned that banks will be attracted to risky deals, buyouts and real estate, given their higher nominal spreads.

Their concerns are not without merit. Leveraged loan activity reached record levels in 2013. Also, leverage levels approached pre crisis levels of 6X EBITDA. Pricing has declined while structures have weakened with the return of Cov-lite and PIK Toggle instruments to further expand debt capacity. Amortization has fallen with only minimal principal reduction during the first 5-7 years. Finally, the percentage of leveraged loans for higher risk recaps in which sponsors pay themselves a debt financed dividend have risen.

Consequently, regulators passed Updated Regulations on bank related leveraged lending in 1Q13 .The regulation highlighted areas of increased concern during subsequent loan reviews in the following areas:

•                Leverage over 6X total or 4X senior
•                Amortization less than 50% over 5-7 years
•                Use of Cov-lite and PIK toggle
•                Recap transactions

A  Shared National Credit Review later that year was especially hard on leveraged loans. Almost 75% of SNC criticized or special mention loans were leveraged loans.  This highlights that the regulators are serious about enforcing the revised regulations. Banks, despite revenue needs, are likely to reduce leveraged loans that are inconsistent with the guidelines to avoid regulatory issues. This means more conservative structures just when buyout prices are reaching high levels due to the 30%+ increases in the stock market in 2013.

The likely market responses include:

1)     Banks continue to lend and incur regulatory issues

2)     Leverage levels decrease putting pressure on private equity buyer returns

3)     Non bank loan investors like CLOs assume a larger buyout financing role. Regulators are likely to be concerned with such a development. It involves the same level of systematic risk, but moves it into shadow banking system. Additionally, other regulations have made it more difficult for banks to invest in the senior tranches of CLOs. This could curtail CLO growth.

4)     Investment grade strategic buyers assume a larger role relative to private equity

5)     Bank leveraged lending by larger arranging banks stalls. Regulators will pay increased attention to the arranger bank underwriting and syndication risks.

6)     Some new structuring instruments are developed to bridge the regulatory gap

7)     Syndication activity involving smaller bank investors may be negatively impacted

The impact on buyouts and leveraged loans of these regulatory developments remains a work in process, which we will be following throughout the year. Financial structuring is a dynamic multi level task, which has become more complicated by these regulatory changes. They affect all members of the buyout eco system-borrowers, lenders, private equity, and private equity targets.

j