Shuffleboard, Chess and the Pilgrim, Hillshire Deal

Business strategy can learn much from chess, but in many ways it is considerably more complex.    In chess and in business, it is not enough to envision your next moves, you must anticipate your competitor's response to those moves and the other actions they are taking.  Thus an game theoretic approach is essential.

But the chess analogy only takes us so far.  In business, moves are made simultaneously, not sequentially as in chess.  In addition, the rules of the game (think regulations) are frequently changing and the space (chessboard) on which you play is constantly changing.  Moreover, your competition is not a single opponent but every player in your industry and every player in related industries.  

In today's news, the analogy to shuffleboard also seems appropriate, where a well placed move is slammed aside by a competitor.  Hillshire Brands had wanted to acquire Pinnacle foods for some time.  Recently it made a $4.3 billion bid for the company touting the synergistic possibilities of the deal.  

Those plans were disrupted today as Pilgrim Foods (owned by JBS)  offered to acquire Hillshire for $45. a share, a 25% premium to recent market prices.  However, the deal is contingent on Hillshire abandoning the Pinnacle deal.  The market prices of Pilgrim and Hillshire rose while those of Pinnacle declined.  

Also, of interest, is that Hillshire was aware of the interest by Pilgrim over two months ago.  In chess, white moves first and has a slight advantage.  One can only wonder if the Pinnacle deal was responsive and defensive, designed to thwart the revealed interest from Pilgrim.  

Unlike chess, the market continually appraises the value of the players.  The market price of Hillshire closed above the bid price of $45.  producing a negative speculation spread.  Apparently, the market expects further revisions to the Hillshire bid.  (Additional details are found in the Wall Street Journal.)

All the best,

Ralph

Astrazenca-Pfizer: Bird-in the Hand or Just the Bird?

Ordinarily we focus on buyer value destruction. The Astrazenca (AST) – Pfizer (PF) Drama illustrates sellers are also capable of snatching defeat from the jaws of victory. PF offered $120B - 45% in cash- representing a 45% premium to AST’s pre bid price. PF’s premium was based on cost synergies and tax savings from a planned Tax Inversion. AST claimed the bid undervalued the value of their drug development pipeline and the firm by at least 7% and rejected the offer. AST’s stock price dropped 11% upon the rejection while PF’s rose slightly. (This post will focus on the valuation issues of the bid and ignore the political issues of potential Job Cuts and U.S. taxes.)

AST’s sales and income have fallen from $33.5B and $12.7B in 2011 to $25.7B and $3.7B, respectively, in 2013. The large decline is due to the Patent Cliff faced by many firms in the big phrama industry. AST alleges –warning: hockey stick alert - its new drug pipeline will return sales to 2011 levels by 2017. Furthermore, 2023 sales will increase to $45B - a 75% increase over current levels.

This raises a classic valuation duel. Is a $120B bird in the hand now worth more than a bush containing the promise of something –TBD - larger in 10 years? All valuation questions involve three questions:

1)   How Much: what are the cash flows - not just revenues but the costs and investments associated with a 75% sales increase over 10 years?

2)   How Long: gets to the time value of money- more dollars are needed in 10 years to offset a current dollar.

3)   How Sure: how risky are the cash flows?

The market response to these questions for AST was reflected in the lower pre bid price. Clearly the market did not share AST’s optimistic view of its product pipeline. AST can respond by stating the market did not understand the pipeline - but whose fault is that - investors or AST for not explaining it well enough? More likely, investors are concerned with the high-risk nature of developing drugs as reflected in the continued decline in AST revenues since 2011. So what is going on here? My belief is management is trying to preserve its jobs by staying independent - the shareholders be damned.

Hopefully, shareholder outrage over management’s rejection of a valuable bird in the hand in exchange for receiving a management bird in the face will result in one of the following:

1)   Shareholder Action will force management to reconsider the bid

2)   Replace management and the board - bring in the lawyers

3)   Tie management’s compensation to the targets they believe justify the rejection. If management wants shareholders to roll the dice on the new drug pipeline, then management should join the shareholders and put its money where its mouth is and wager their future compensation - ante up boys.

OMG you can’t make this stuff up-

J

Shareholder Lawsuits May Prove More Costly

We've noted the likelihood of being sued after completing a deal, especially a large one.  An article in the Wall Street Journal suggests that a recent court ruling may make those suits less attractive to plaintiffs lawyers.  In particular, companies are adopting a clause that requires plaintiffs to pay the firms legal fees if a suit fails.  The court upheld a bylaw a company had adopted requiring such payments.   The article also reveals declining awards for plaintiffs' attorneys over recent years. 

All the best,

Ralph

Cooked Geese and Boiled Frogs

We have discussed how the worst deals are done in the best of times. It reflects the pro-cyclical nature or M&A-merger waves. This in turn highlights a pro-cyclical risk appetite of managers. Deal volume and prices plummet during a market downturn. Some managers complete some smaller transactions which are successful, and M&A interest is rekindled. An improving economy and rising stock market add fuel to growing volumes. Herding in the final stages of the cycle completes the process.

Unfortunately as we get further into the cycle, deals become more expensive and somewhat more risky. The changes at first are small and frequently ignored - like frog placed into a pot of water which is slowly heated. Attached is a recent American Banker Article on the subject which provides more details on the phenomena in the debt markets.

Preventing your goose from being cooked requires a disciplined process. This is especially true for large complex deals with high levels of Shareholder Value at Risk due to high premiums and integration issues.

J

Dual Ownership, Returns, and Voting in Merger

Among the major events of Drexel's Center for Corporate Governance is our annual academic conference featuring scholarly papers from top researchers around the world.  This year we had over 60 submissions competing for just 5 slots.  

One of the five papers selected for the conference is particularly relevant for our readers.  

Suppose you owned shares of a target firm and you were offered a healthy premia for your shares.  You might be inclined to vote for the deal.  Now suppose you also own the bonds of the target.  Before voting you'd need to consider the effects of the deal on your combined portfolio of the target's stocks and bonds.  The way you vote wouldn't just be influenced by your equity position.  Interestingly, there may be cases where your thoughts on the deal are different from that of a pure equity owner.  In particular, you might be willing to accept a lower premium for the equity if you also gained on the debt.

Now consider the fact that institutions are major  holder of a firms equity (typically more than 70% of a large firm) and that these institutions can also hold the target firm's debt.   You have the motivation for the paper  Dual Ownership, Returns, and Voting in Mergers by Andriy Bodnaruk and Marco Rossi  The abstract of the paper is below.  

 Dual Ownership, Returns, and Voting in Mergers 

Abstract 

We document that in M&As a significant proportion of targets’ equity is owned by financial institutions that simultaneously own targets’ bonds (“dual holders”). Targets with larger equity ownership by dual holders have lower M&A equity premia and larger abnormal bond returns, particularly when dual holders stand to benefit more from appreciation of their bond stakes, e.g., when their bond ownership in the target is large and the target credit rating is non-investment grade. Dual holders are more likely to vote in favor of the merger proposal. Our results suggest the presence of coordination of decisions within dual holding financial conglomerates in M&A targets. 

The complete paper can be downloaded here.

All the best,

Ralph

Private Equity Capital Structures

Private Equity (PE) transactions are primarily debt financed. They represent up to 25% of the total M&A. Unlike corporate-strategic buyers (CSB) - they involve temporary capital structures and temporary ownership. They unlikely go to their legal final maturity of 7-10 years. They are either refinanced or sold if they perform well or are restructured if they do not. They reason is their high cost and limited flexibility based on their high debt levels. They typically have non investment grade debt ratings in the BB-B range versus CSB investment grade ratings. This is due to their inverted capital structures which are 30% equity-70% debt. CSB capital structures are usually investment grade-in the BBB-A range with 70% equity-30% debt.

PE firms consider the following when selecting an initial transaction capital structure:

1)     Their financial preferences concerning cost, risk and flexibility. Lower rated firms face higher financing costs and lower flexibility reflected in covenants and amortization schedules. For example, currently a BB+ leveraged loan has a prorate spread of LIBOR+ 165B, while a B+ spread is in the LIBOR+ 265BP range.

2)     Financing need: large needs argue for higher ratings/lower debt levels. The “B” market is smaller and less liquid than the “BB” segment.

3)     Firm specific characteristics concerning leverage levels, cash flow and size. For example, BB+ firms have revenues around $3B and debt to EBITDA of 3X while B firm’s revenues are closer to $1.5B with leverage in the 4.5X+ range.

4)     Market conditions: the non investment debt market is very volatile. The market virtually shut down during the financial crisis. This causes a real risk when attempting to fund a transaction with a capital structure designed for a market which has changed. Unlike CSBs- market, not firm factors are the most important determinants of PE capital structures.

Once they have chosen their rating which reflects their preference they can then determine their debt capacity as reflected in rating agency publications. A sample is reflected below:

So for a B+ target and $100 of EBITDA debt capacity is around $500.This would be fined tuned with cash flow projections to develop the debt amortization schedule. Of course, the level changes based on market conditions.

PE prices transactions off of debt capacity compared to CSB which price off synergies as reflected below:

Assuming an acquisition where the Target’s EBITDA is $100-the maximum that could be paid with a 25% level of equity injection and 4.5X funded debt leverage is $600 for 6X PPX. Currently purchase price multiples are 8+ leaving a significant gap. The PE firm’s options include:

1)     Decline the deal: PE firms are, however, under pressure by LPs to invest. Either you invest the LP’s commitment within an allotted time, usually 5 years, or it expires and with it the PE firm’s fees and carried interest.

2)     Increase the equity %: this reduces the deal’s IRR.  Deal IRRs below target levels reduce the PE firm’s carried interest. Additionally, low overall fund returns complicate future PE firm fund raising efforts. Remember, the deal IRR is the entry equity investment less the exit entry process upon future sale. Assuming the entry PPX equals the exit PPX and no interim dividends-then IRR will fall given increased initial equity unless the target’s EBITDA performance is increased.

3)     Reduce the PPX: unlikely in a competitive bid situation.

4)     Increase leverage by expanding debt capacity: this is achieved thru financial engineering with products that reduce debt service via reduced cash interest (PIK) or extended maturities (bullet maturities). Options include the following:

The availability and cost of the different debt options is subject to market conditions. The key points are that debt capacity is based on only two sets of factors- (1) the debtor’s internal operating cash earnings, EBITDA, and asset collateral values and (2) market conditions which influence debt service-cash interest expense and debt amortization reflected as (where the( I +1/n) term is the funded debt multiple (FDX)):
Debt Capacity= EBITDA/ (i + 1/n) 
        where i is the average interest rate and n is the average debt duration.

PE firms, like real estate developers are driven more by the second part of the equation than the first. This has some interesting implications:

1) PE target demand is driven by financing not price. Demand can actually increase as PPXs increase provided FDXs increase.

2)     Both the financing market and target market are volatile, highly pro-cyclical and amplify each other.

3)     PE fund returns tend to fall for later stage acquisitions. They continue to over pay and buy late in the cycle, provided funding availability, and suffer the return consequences later.

4)     Capital markets have accommodated PE firms by development a suite of debt capacity enhancing products.

5)     PE capital structures are non risk adjusted IRR driven.

6)     The initial projected IRR range( based on varying exit EBITDA, PPX and year of exit) is calculated as:

a)     IRR: (Entry Equity) + Exit Equity Yr t/ (1+IRR) ^t=0. The internal rate of return on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive-exit equity proceeds- and negative-entry equity investment) from a particular investment equal to zero.

b)     Entry Equity=EBITDA Yr0 X PPX Yr0 - FDX Yr0 X EBITDA Yr0. The initial equity investment outflow is equal to the purchase price defined as trailing EBITDA times the PPX less the amount of debt funding defined as trailing EBITDA times FDX all at the time of close.

c)     Exit Equity=EBITDA Yr t x PPX Yr t- FD outstanding Yr t (think of Exit Equity value as terminal value in a traditional DCF analysis). Expected net equity proceeds upon sale in year t are the enterprise value purchase price-exit year EBITDA times PPX-less any remaining outstanding debt.

7)     Viewed in this light PE firms can create value in later cycle acquisitions with high PPX by:

Increasing EBITDA in year t-this is difficult for later stage deals where EBITDA margins are already high

Assuming a higher exit sale PPX or earlier exit

Decreased entry equity from higher initial FDX-the usual choice

                 

PE firms are not stupid or crazy. Rather they have different incentives than CSBs. Hence they have different capital structures.

j