European Private Equity Deal Activity 2014 update; Darden's Takeover Defenses

A key focus of our acquisition finance course is understanding the nature of changing deal markets and incorporating that knowledge into deal structure.  Pitchbook is out with their latest PE report on European Activity and it provides useful updates.  Just a few of the highlights:

For the 6th quarter in a row PE investment in Europe has exceeded 50 billion euros.  Also, the popularity of bolt on investments is increasing, now representing 44% or European buyout activity.  A bolt-on investment is one made through an existing portfolio company rather than a direct investment of funds in a new industry.  Whereas direct investments generally involve new areas of investment, bolt-ons are typically in the same or related industries as the portfolio company.   Further details on these and other highlights can be accessed here.
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Also, in last week's post regarding Allergan and Valeant we noted:

"The Best Takeover Defense: Don't leave Money on the Table.  Anticipate value creating activities and implement them, however painful.  Continuously evaluate your firm's strategy, particularly in light of a changing environment.  Consider Are You a Takeover Target? Take the corresponding action before external markets force change upon you. Don't wait for a hostile bidder to force you into action.  Indeed, Do Unto Thyself."

Allergan was taking a page from their suitors book and slashing R&D.  Another great example is in Bloomberg today.  Darden Restaurants, long facing hostile activist investors, has retired its chairman and CEO and opened the board for activist representation, all actions desired by the activists.  According the story, however, the actions may have been too little, too late.  

As we said, 'Don't wait to implement value increasing actions.'

All the best,

Ralph

The Beautiful Deal

CIT, the commercial finance company that became a bank following the crisis, announced the $3.4B acquisition of One West this week. It is the largest bank deal this year. It also propels CIT over the $50B strategically important financial institution (SIFI) barrier. Thus, CIT will be subject to additional regulatory requirements. Apparently CIT believes the strategic and financial benefits of the deal more than compensate for the incremental burden. Another benefit from becoming SIFI (AKA too-big-to-fail) is the implicit government guaranty which could reduce funding costs.

The market response, along with the simultaneously announced $500mm stock repurchase and substantial beat of the expected 2Q14 performance, was a very positive 14% increase. The deal is a joint cash ($2B) and stock ($1.4B) transaction. The One West shareholders will have a 15% interest in the new CIT post close. CIT’s Ba3/BB- ratings are expected to remain unchanged.

Both CIT and One West (formerly IndyMac) failed during the financial crisis. CIT reorganized in bankruptcy. It was a non bank before the crisis (banks cannot file for bankruptcy). IndyMac failed and was taken over by the FDIC and sold to a group of private investors including among others Michael Dell, John Paulson, George Soros, and Chris Flowers. The FDIC subsidized the deal through a loss share agreement agreeing to cover most of IndyMac’s loan losses. The continuation of the FDIC agreement is a condition of the deal.

This looks like a brilliant deal for the following reasons:

1)     Government subsidies: they get the FDIC and implicit SIFI subsidies. Although hard to quantify they are very real. This may encourage others not to fear the SIFI designation.

2)     Taxes: they get to accelerate utilization of CIT’s substantial NOLs.

3)     Pricing: the trailing P/E is 14X, the P/TBV 1.4X and a deposit premium of 6%. These are lean multiples. I cannot figure out why they got it so cheap except maybe for the historical baggage associated with IndyMac/One West. Another reason might be they are going early in cycle.

4)     Strategic Fit: similar to PACW’s successful 2.3B 2013 Capital Source acquisition-combining a deposit rich bank with a wholesale funded finance company. The deal lowers CIT’s funding costs and funding risk. DISCLOSURE: I am a PACW shareholder.

5)     Funding: the 60-40 cash stock split maintains financial flexibility and preserves ratings. The issue of whether CIT’s stock is undervalued remains open. The share repurchase helps moderate possible undervaluation concerns.

6)     Earnings Accretion: the combination of low price, stock repurchases and large funding costs savings promise significant 2016 15% EPS accretion. Academics frown on EPS as an accounting measure unrelated to value. For me, EPS accretion is a second order pricing indicator. It keeps management from over paying.

7)     Integration: the size seems manageable and the retention of senior One West officers should aid the integration. Also, the 15% ownership stake in CIT by One West shareholders helps cushion the downside if something goes wrong.

8)     Sale Process: negotiated versus auction of a private versus public firm moderates price competition.

An excellent combination of strategic and financial benefits makes this a good deal and an example of the whole deal concept at work. Kudos to the CIT team.

J

Allergan and Valeant - Lessons from the Market for Corporate Control

The current Allergan Inc. case illustrates many points we have made in these posts.  As we start to think about our upcoming Amsterdam class on Structuring the Deal, it is useful to review.  The Allergan situation is an important illustration of the importance of corporate governance and the fact that when internal governance mechanisms (e.g., management and the board) overlook value creating strategies, external governance mechanisms (e.g., hostile bidders, arbitrageurs and the stock market itself) will force that change upon the firm.  It is better to be proactive.

On April 22, 2014 Valeant announced a hostile bid for Allergan, explicitly noting its value creating strategy, with an estimated $80 billion in synergies to be achieved in the first six months.   Allergan rejected the acquisition offer by Valeant but is now implementing many of the same strategies Valeant has proposed.  Specifically, Allergan has focused heavily on research and development while Valeant has focused more on sales.  Valeant said it would cut up to 20% of Allergan employees, primarily in R&D.  Allergan rejected these initiatives but is now following a similar strategy in an attempt to pacify its shareholders.  It has announced that it will lay off about 13% of its workers.  Here are just a few of the lessons from past posts.

The Best Takeover Defense: Don't leave Money on the Table.  Anticipate value creating activities and implement them, however painful.  Continuously evaluate your firm's strategy, particularly in light of a changing environment.  Consider Are You a Takeover Target? Take the corresponding action before external markets force change upon you. Don't wait for a hostile bidder to force you into action.  Indeed, Do Unto Thyself.

Once your firm is in play, the ownership quickly shifts to arbitrageurs.  The Speculation Spread between the offered bid price and the post announcement market price reveals the market's anticipated outcome for the deal (e.g., successful or unsuccessful acquisition and whether the bid will be revised).  Once arbitrageurs are the major owners, a deal is much more likely to happen as their interest coincide with deal completion.  As we noted in April, "The market is predicting a higher, successful bid as the Allergan's stock price on Monday closed well above the $153. value offered by Valeant." Allergan's shares closed at $171.14 on Monday.

This deal is reminiscent of the numerous oil takeovers in the 1980s.  During the late 1970s, many companies began an extensive drilling program searching for more oil.  By the 1980's two factors made that strategy hugely unprofitable.  First, the price of oil fell from $40. a barrel to around $10. a barrel. Second interest rates rose from single to double digits.  Thus, in terms of the present value equation, the numerator declined while the denominator rose.  Not a good combination.  Firms that failed to adjust were subsequently taken over.  

To repeat, it is necessary to always consider if your current strategic course is the best one for maximizing value.  If you get this wrong, you are likely to find out the hard way.

All the best,

Ralph

21st Century Fox-Time Warner: Round I

FoxA made a preliminary $80B hostile Bid for TWX. The bid was rejected on pricing grounds. The deal represents a $17B - 20% - premium over the pre-announcement price and 12.6X trailing EBITDA - neither of which is particularly rich. FoxA is willing to consider a higher bid once it gets access to TWX data. The deal is 60% cash and 40% nonvoting common FoxA shares. The Murdoch’s control Fox thru the 38% family ownership of the voting shares. The deal makes strong strategic sense - especially given the consolidation taking place in the industry. Initial estimates are of $1B in common synergies with the potential for $2B+ additional synergies to be confirmed upon due diligence once access to additional TWX records is granted.

The 60% debt financed cash component of the price is initially covered by a Goldman - JP Morgan $25B bridge acquisition loan, which will be subsequently termed out with long term debt. The post close capital structure will have a FD to EBITDA multiple approaching 5X. Large diversified media can tolerate higher debt levels than other industries given the historical stability of their cash flows. Nonetheless, this multiple is reaching the upper bounds of FoxA’s current Baa1 rating. The nonvoting status of the stock consideration is raising some questions concerning its valuation and governance issues. See Damodaran for a discussion of the valuation issues with nonvoting shares.

Ordinarily, corporate acquisition funding is rather straightforward - long-term debt and common. Here, there are funding constraints giving rise to interesting structuring questions. FoxA has limited additional debt capacity assuming it wants to maintain its Baa1 rating. Issuing more stock also has issues. First, TWX shareholders may have issues about nonvoting stock given the governance concerns associated with a family controlled business run by an 83 year old man. Second, the Murdoch’s are unlikely to issue voting shares which would dilute their voting control of Fox.

What will Fox do to fund the expected higher bid for TWX given these constraints? Some possibilities include some or all of the following subject to market availability:

1)     Sacrifice the Baa1 rating-dropping to Baa2 or Baa3. Rumor has it that the Murdochs are reluctant to take this action-at least for now.

2)     Issue voting shares. Probably a deal killer for Rupert and his sons.

3)     Issue more nonvoting shares to the public to reduce initial debt levels.

4)     Additional asset sales: antitrust issues will probably require some asset sales. TWX’s CNN is a potential candidate which could bring $8-10B. This only makes sense if the assets can be sold at a price exceeding their value to Fox. This depends on market conditions. Also, the sale of non TWX assets such as FoxA’s Sky unit could be used.

5)     Joint Venture-Partial Sale licensing arrangements.

6)     An Equity Carve-Out .

7)     Issue some sort of preferred stock. The nonvoting common is similar to preferred. The dividend rate and other features - e.g. cumulative and convertibility- need to be determined.

8)     Rights offering of the voting shares allowing the Murdochs to maintain their proportionate interests - assuming they are willing to invest.

9)     Assets securitization of contract receivables. Need to consider possible negative credit implications.

10)  Board Seats: consider offering TWX shareholders board representation as per Gabelli.

There are many open issues-competing bidders, antitrust, integration, Rupert’s age, 

succession plan, and governance issues. In any event, this promises to be an interesting structuring case.

J

Valuing Synergies

It has been a banner year for mergers.  Currently, Reynolds American is seeking to acquire Lorillard, Inc.  Comcast and Time Warner are trying to combine.  Meanwhile, Time Warner is rejecting an offer from 21st Century Fox.  And, of course, we've seen a wave of Pharma mergers recently.   As we've mentioned, the maximum premium a bidder should pay for a target is the net present value of the deal. Of course if you pay this amount, you are giving away all your expected value. Bargaining is the key to the division of gains.   But today's post is not on bargaining but on synergies, generally a large component of the NPV and unfortunately, often overestimated.  Because of their importance, we have written frequently about valuing synergies (See, for example, Synergies and Anticipating the Competition).  

There are three basic types of synergies: revenue enhancement, cost reduction and financial synergies.  Revenue enhancement derives from expanded market power, the ability to expand markets, and the ability to increase prices.  Cost reductions come from economies of scale, eliminating duplicative positions, tax reductions and increased power in bargaining for supplies.  Financial synergies are controversial.  In theory, they derive as the new firm is better able to bargain for financing, reducing the cost of capital.  While this is possible, there are many dangers in estimating financial synergies. (See, PE Magic).

Here are just a few of the many things to keep in mind when estimating and valuing synergies:

1) Synergies are often over-estimated.  Ask yourself why these synergies exist and why no one else has exploited them.

2) If there is disagreement among the executive team as to the amount of synergies, consider tying compensation to their realization.  That simple technique can have a sobering impact on the magnitude of estimates.

3) Remember you are not operating in a vacuum.  Consider how the competition will react.  (See Synergies and Anticipating the Competition).

4) Value synergies at a rate commensurate with their risk.  Safer, more certain, synergies can be discounted at a lower rate.

5) Don't forget point (1) or Warren Buffet's parable of unresponsive Toads kissed by managerial princes.  (Acquisition Returns and Unresponsive Toads).

Happy Hunting,

Ralph

Hostile Takeovers: They’re Back

1H14 M&A has rebounded sharply, and along with it hostile takeover bids. This fact combined with the already robust shareholder activity present another challenge to existing firm management. This is good news to lawyers as the initial management response is to “lawyer-up”. Unfortunately, legal defenses address the symptoms not the cause of underlying performance and governance problems.

The basic problem is having survived the great recession is necessary, but not sufficient condition to performance problems. Cost cutting and share repurchases are good at preserving value, but not at growing increasing shareholder wealth. Current managers and owners may no longer be the best owners and managers of the firm’s assets. Alternative strategies and execution tactics by competitors may yield improved results in a changing market. Existing management is usually reluctant to change once successful strategies even though the market has changed. Consequently, a value gap develops between the firm’s public market and private control value, which hostile bidders will attempt to exploit. The gap needs to be significant to entice the offer given the risks involved.

Hostile activity can be viewed as a governance failure by the board to monitor and control management. Characteristics of this failure include the following:

1)     ROE lagging Ke

2)     Dividends < 50% of free cash flow resulting in a cash build

3)     Cash and marketable securities represent a significant component of overall market value

4)     The firm is under leveraged

5)     Sum of the parts is greater than the whole

Management must address the underlying performance problem or sell. Usually, the difference between a hostile and friendly deal is a higher price. In the meantime, the firm can make sure it has enough time to respond by considering the following:

	w   Tactical legal matters	w   Financial Engineering	w   Strategic Options
Proactive Measures	w   Voting provisions w   Staggered board w   Poison pill	w   Sale of block w   Joint venture w   Acquisitions w   Leveraged acq. Vehicle w   Divestitures w   Leveraged disposition	w   Monetize undervalued non-strategic assets w   Cost restructuring w   ESOP w   Spin off w   LBO w  Recapitalization –   Full or partial
Reactive Measures	w   Stock repurchase w   Block repurchase w   Voting provisions w   Poison pill	w   Divestitures w   Acquisitions w   Pac Man	w   ESOP w   LBO w   Recap w   Sale

The top portion of the above chart relates to proactive measures, while the bottom concerns reactive actions once the threat materializes. Some measures like poison pills can be used either proactively or reactively. The left column lists tactical legal matters. The middle column focuses on financial engineering, while the right pertains to strategic options. The Pac Man option was used by Men’s Warehouse to block the Jos A Bank bid. Allergan is considering a large acquisition to ward off Valeant .

The problem with defending against a hostile takeover is that you lose sight of the real objective. The key is to create shareholder value not remain independent. My concern is many management teams will lose the value creation war while winning the takeover battle. Their win will be short lived unless they add value by postponing the takeover.

There is no compelling long term defense to a well financed premium offer by a determined bidder absent real or threatened governmental interference as in AstraZeneca-Pfizer. You can buy time to improve the offer as did Jos A Bank.  Sooner or later, however, you must deal with the offer or improve performance to close the value gap.

J