Monday, June 30, 2014

The Hammer and the Nail: An Integrated M&A Approach

M&A involves complex interrelated strategic, financial and risk issues. It should be approached in an integrated multidisciplinary manner. Nonetheless, M&A is usually handled in a disjointed manner by the CEO, CFO and CRO-each with separate agendas. Thus, they fail to appreciate the crossover involved. When all you have is a hammer, then everything looks like a nail.

CEOs drive the investment process focusing on growth to capitalize on perceived product market opportunities. They are focused more at the strategic versus project - capital budgeting level. M&A serves as a means of implementing that strategy. The key principle is whether the acquirer is the best owner of the target’s assets - meaning it can execute the highest value added strategy and use that execution to achieve increased shareholder value.

The CFO focus is more on funding and transactional execution. Additional considerations include the ratings and dividend implications of the acquisition. CROs concentrate on how to manage the transactions incremental risks. The objective is to ensure the acquirer’s capital market access and ability to fund its on-going strategic plan is not interrupted. A key risk management component is having sufficient capital to absorb unexpected “bumps in the road “to avoid post close OMG moments. Other components include risk mitigation (e.g. sprinklers), stress tests and scenario analysis.

Potentially conflicting external stakeholder considerations also must be balanced thru effective Board level governance. Shareholders are concerned with risk adjusted long term returns defined as ROE > Ke. Failure to achieve such results will depress stock prices and attract activists or raiders-especially when the share price drops below 75% of the firm’s comparable firm transaction multiples. The actions of rating agencies impact the acquirer’s capital market access and liquidity as was illustrated in the disastrous RBS-ABNAMRO transaction. Finally, regulatory issues relating to social issues such as jobs, EPA and antitrust must be considered as the GE-Alstom transaction highlighted.

The following illustrates the relationships among the above factors:

Let’s look it now from a financial viewpoint. For me the best valuation equation is the one used by M&M in their classic 1961 dividend irrelevancy Article. A firm’s operating value has two components:

1)     Assets in place: EBIT (1-t) capitalized by WACC. Usually the focus of the COO with an emphasis on efficiency.
2)     Growth Opportunities: I (ROA-WACC) T also capitalized by a WACC factor. The growth can come from internal means or M&A. Usually, the focus of the CEO. Some firms have growth potential-e.g. Facebook, while others have only limited growth opportunities and are valued primarily as dividend machines. The keys are:

a)     I - how much you can invest-scale that impacts NPV v IRR
b)     ROA-WACC-the spread without which growth has no value. In an M&A context it is the difference between the premium and synergies based on the best owner principle.
c)     T - the competitive advantage period which determines how long the growth opportunity exists based on the sustainability of entry barriers. T has dropped dramatically for the big pharma firms whose drugs are going off-patent.
d)     WACC - risk estimate reflecting both business and financial risk. A firm’s risk appetite is cyclical and is tied to it equity value.

So get more tools in your tool belt to insure you use the right tool. Everything is not a nail.


Thursday, June 26, 2014

American Apparel and Lululemon: Sex, Lies and Firm Value Revisited

I've written before about our paper, Sex, Lies, and Firm Value.   Sound corporate governance is immensely important in protecting and creating shareholder value.  Sound governance requires the correct tone of management at the top of the firm, and the boards insistence on this tone.   Our research examines the links between indiscretions in a manger's personal lives and the impact on the firm.  We are continuing our research on the topic, and alas, Wall Street is continuing to provide us data points.  The following quote comes from an interesting article by Matt Egan, writing for CNN Money.  

"Dov Charney, the ousted chairman of American Apparel, is known for walking around his factory in his underwear and talking openly about his sex life. The company's sales have plunged in recent years and its stock now trades for 70 cents, down 96% from its high of nearly $17.
Lululemon founder Dennis "Chip" Wilson imperiled his company's brand last year by making snide remarks about overweight customers. Wilson recently stepped down as chairman after Lululemon's share price plunged in half over the past year."

Read Matt's entire article, and his interview with one of my coauthors here.  Note the incidence of founders in our sample of indiscretions.  Also, while we are revising our research on the subject, the previous version of the paper can be downloaded here.

All the best,


Monday, June 23, 2014

Private Equity Fund Raising: Embarrassment of Riches or Just an Embarrassment?

Ralph’s Post dealt with over capitalized corporate who may misuse their excess capital by making ill advised acquisitions. The same problem exists for private equity firms. Federal Reserve actions created favorable capital market conditions. Private equity capitalized on this development by unloading portfolio investments at attractive prices over the last few years. They returned the cash to their limited partner investors. The result was a reduction in assets under management (AUM) for the general partners. Since their fees depend on AUM general partners began planning on raising new funds. Limited partners saw their investment allocation to the private equity asset class fall post receipt of the distributions and were anxious to reestablish their prior investment allocation by investing in new private equity funds.

The result of these considerations was a strong rebound in private equity fund raising. According to Prequin, 1Q14 private equity fund raising totaled $95B a post crisis high. The pre crisis record was for 1Q08 was $173B so there is still quite a way to go. This follows the usual cycle reflected below:

The amount of private equity dry powder, commitments yet to be invested, has risen from around $940B YE12 to over $1.1T, which represents years of transaction volume. The normal investment period for most funds is around 5 years. Most funds use the traditional 2 and 20 compensation model. General partners receive an annual 2% fee on limited partner commitments for the first 5 years and a 20% carried interest on any realized investment profits. If they invest the commitments then their annual falls to around 1%.They must invest, however, the commitments within 5 years, or the commitments expire and they lose the commitment fee. This “use it or lose it” feature puts extreme pressure to deploy the funds within the investment period.

The problem is the same favorable capital market conditions allowing the funds to liquidate their investments at a profit have caused a raise in purchase price multiples for new investments. Purchase price multiples in terms of EBITDA have increased to over 12X from 8X a few years ago. This complicates the reinvestment process. In fact, the increase and amount of dry powder is inflating pricing multiples throughout the M&A market. The only way to make these deals work at that pricing level, especially when competing against strategic buyers, is for private equity buyers to increase leverage. As previously discussed in Fantasy Finance this option is becoming limited as leverage levels are approaching pre crisis highs of 6X EBITDA.

Just as we saw in the previous cycle, private equity is also searching for new, lower quality, deal sources to offset increasing pressure from strategic buyers. These include the following:

1)    Public-to-Private (P2P): these involve taking a public firm private. They usually involve larger targets. Their purchase prices are higher (priced to perfection?) given the usual competitive bidding requirement for public firms. They fueled the large growth in pre crisis LBO volume. They are also higher risk as illustrated by the two major problems of the last boom- First Data and TXU. As Steven Kaplan has noted, P2P deals are debt market driven-so we can expect a return of these deals.
2)    Sponsor-to Sponsor (S2S or pass the parcel): this is the incestuous practice of private equity buying/trading each others’ portfolio investments. The “juice” has most likely been squeezed out by the first buyer.
3)   Minority Interest Investments: this raises the issue of who is in charge when something goes wrong i.e. governance problems.
I am afraid the agency problem associated with excess cash and capital affects both corporate strategic acquirers and Private Equity.


Thursday, June 19, 2014

Excess Cash, Leftover Wine, and Acquisitions


When a company has excess cash, what is the optimal thing to do?

a) return the cash to shareholders via dividends or repurchases

b) make acquisitions

c) return cash to shareholders only when they have a better use of the funds than the company

d) retire debt

e) save the cash, rainy days are ahead

(f) increased CAPEX.

With some explanation, the only correct answer is (a).

First, let's look at (e) and (c) and (f) which could be the best answers if we hadn't specified  the phrase 'exess cash'.  By definition, 'excess cash' occurs after consideration of the safety and usage reasons for holding cash.  The term 'excess' also implies that management has already taken all positive NPV projects which would seem to rule out any reason for management to keep cash for safety reasons (e) or as in (b) make acquisitions.  If there were good acquisitions to make, the cash would not be 'excess'. The same is true of increased CAPEX. 

Retiring debt (d) might make sense if a firm was over-leveraged and/or interest rates were high, but in general only makes sense if the cost of debt is less than the return shareholders can earn on their funds at risks typical to those of this firm. Typically, this is the cost of equity for the firm which exceeds the cost of debt and especially the after tax cost of debt.  Rule out (d).  

Now lets give greater credence to (b).  Sometimes it is argued that when a firm's stock price is inflated, it makes sense to use that over-priced currency to acquire hard assets.  When the firm's stock price adjusts to reality, the firm will still have acquired the hard assets at inexpensive prices.  This argument may explain why the number and dollar volume of mergers is strongly correlated with the stock market.   When stock prices are high, more deals get done.  The problem with this argument is that the target's stock price is also  likely to be high so the acquiring firm could be purchasing overpriced assets.  

Thus, when a firm truly has 'excess cash' the only correct answer is (a). Nevertheless, when faced with a decision to relinquish cash or build the empire, many managements choose the later. 

And it is well known that deals increase with stock prices.  

Currently stock prices are at or near record highs.  

So are the number of deals being completed.  This graph from Jesse Solomon in  CNN Money reveals that the number of deals completed in the first half of this year outpaces the total number of recent years and is on pace to surpass the all time highs of 2007.  

Why?  Certainly some deals make sense - and the conditions in many industries are demanding consolidation, but for many firms, one can suspect that excess cash, like excess wine is just not that apparent when it is in your hand.  

All the best,


Monday, June 16, 2014

Rhyming or Repeating?

M&A volume is up substantially in 1H14. Some are worried the market may be overheating just as it did prior to financial crisis in 2006 and 2007. My view is this market is in a different stage than the 2006-2007 period. M&A has been depressed following the crisis. Current activity appears more like a return to normal than overheating. Keep in mind, the stock market increased over 30% last year while M&A was flat. The two are usually correlated.

Especially interesting is the increased activity of activist and hostile bids. In fact we are seeing a potentially new development of a combined activist-hostile bid with the Pershing Square-Valeant-Allergan Drama. Shareholders are putting increased pressure on management to do something. You survived the crisis-now do something beyond share repurchases with our excess cash. Thus,they are positively reacting to many announced deals. This factor plus an improving economy, cheap debt and a rising stock market are contributing factors.

Additional observations include:

1)   Deal Quality: deal quality is high. It is primarily larger consolidating and synergistic industrial transactions like 1990s versus the 2006-2007 private equity going private transactions. The deals are concentrated in the telecom and healthcare industries which are undergoing structural changes.

2)   Financial Structure: although debt remains plentiful and cheap strategic acquirers are primarily funding transactions with equity. The percentage of debt financed cash deals has fallen from over 65% in 2006-2007 to around 45%. This helps lower deal risk as sellers are participating in the future prospects of the new entity, and leverage levels remain modest. Sellers are willing to accept buyer stock given increased confidence in markets. They see the potential for a double dip price increase for an appreciating buyer stock post close.

3)   Private Equity (PE): LBO activity remains far below its 25% pre crisis percentage of total M&A. This reflects current high M&A prices and stiff competition from strategic buyers who have better synergy prospects than PE. PE has responded by using increased leverage to help offset higher purchase prices.

Of course, things can change quickly. The impact of the unwinding of the Fed’s quantitative easing program remains an issue. PE, with its large level of dry powder, could become more aggressive and drive up prices and debt levels. Thus, caution is warranted and disciplined bidding is needed by both strategic and PE acquirers. Nevertheless, the current market feels like it is in the early growth phase-not the later overheated stage. History appears to be rhyming - not repeating the overheated 2006-2007 period at this time.