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.


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