Acquisition Finance in Amsterdam: October 8-10

We are about five weeks away from our next offering of Acquisition Finance in Amsterdam.  The class will be held October 8-10 at the Amsterdam Institute of Finance - a wonderful location central to all of the city.  The past year has seen a sharp rise in M&A volume, an increased interest in tax inversions, the advent of many multiple bidder transactions, an increased role of activists and even an increase in hostile deals.  All of these tops will add excitement to the regular core of material.   If your interests involve mergers and structuring the deal, I hope you will attend.  

The typical outline for the course is below.  Enrollment details can be found here.

All the best,

Ralph

Day 1Introduction to M&A Deal Design and Acquisition Finance

• M&A strategy
• Components of an M&A deal – where finance fits in optimizing M&A deal design
• Current conditions and trends in acquisition finance

Valuing the Highly Levered Transaction

• Techniques of valuing the target firm
• How financing creates – or destroys – value

Non-investment Grade Leveraged Financing

Private Equity Requirements

Framework for Analysis: the "Whole Deal" Approach

Case Analyses: Participants analyze and structure deals to better understand the interplay of capital structure, cost of capital, market products and deal design

Day 2Designing the Capital Structure

• Identifying the range of financing alternatives
• Choosing the right mix of financing
• How lenders and investors look at the mix of debt and equity

Structuring the Financing

• Designing the terms of financing instruments
• Pricing the instruments
• The syndicated loan market
  -  Covenant late
  -  Second lien

• Developing the term sheet
• Risk analysis

Fixing the Broken Deal

• Decreasing senior debt
• Adding a back ended T/L C held by the originating bank
• Additional covenants
• Increased pricing

Additional Case Analyses of the Dynamics of Acquisition Finance

Day 3Acquisition Financing in the Context of Negotiations and Auctions

• Acquisitions as bargaining outcomes; Behavioral finance
• Varieties of auctions and the incentives they create
• Hostile takeovers as settings for negotiations and auctions

How Financing Can Influence Outcomes in Negotiations and Auctions

Negotiating the Deal

• Understanding the needs of the other party
• The inter-related elements of deal design
• Bargaining on many fronts
• The ‘whole deal’ approach

Dealing with Risk in Acquisition Finance

• Earnouts – a great technique for closing the deal
• Toeholds
• Collars
• Termination Fees

Additional Case Analyses

Concluding Case in Deal Design

Leap of Faith M&A: Mind the Gap

There is an Interesting Post on the difficulty in valuing tech M&A targets highlighting the Facebook-Whatsapp acquisition. We previously discussed the Transaction offering some tentative observations. I agree trying to value or price early stage targets with no earnings is difficult. I, however, strongly disagree with the assertion that such deals cannot be analyzed and we should rely on the judgment of successful entrepreneurs like Facebook’s Zuckerberg because tech is different and not subject to the laws of economics. I am always suspicious relying upon “great men” because of the difficulty distinguishing between luck and skill. Besides, the jury is still out on how this acquisition performs. Furthermore, the “they can afford it anyway” argument made in the FT post is dangerous-I think Hewlett Packard blew itself up using such an affordability argument in its disastrous acquisition program.

The tech “is different” canard was used during the 1990s dot.com boom, and did not have a happy ending-remember EToys and Pets.com? Early start-ups without sales, let alone earnings, lack intrinsic value and are difficult to evaluate. Their price depends on what buyers are willing to pay. The absence of a valuation anchor means tech is subject to substantial mispricing risk. Option pricing methods can help analyze such situations.

Option pricing methodology is tricky and subject to misuse - akin to trying to value lottery tickets. The keys to option value include

1)     Skill: does the acquirer have the skill to develop? Many tech investors (Venture Capitalists) acquire not to develop, but to hold a portfolio of deeply out-of-the money options and hope for the best on one of the investments.

2)     Exclusivity: does the option offer exclusive rights to the acquirer e.g. R&D, patents, etc.? If not it has no value.

3)     Sustainability: how long do the benefits last - what is the “T” or product life cycle?

The keys in tech M&A, just like in regular M&A, are the ability to identify winners in advance and acquire them at a reasonable price. 

The complications in tech M&A are

1)     The story (sizzle) dominates while the numbers (performance) lags.

2)     New metrics cloud the analysis. Remember “it is the cash stupid”!

3)     Paradigm shifts occur - AKA  _hit happens.

4)     Information is lacking.

Acquirers must guard against the growth trap of assuming rich future follow-on investment opportunities that can justify anything. The problem is the future opportunities fail to deliver sufficient returns. This is especially true in the tech area with its short product life cycles.

Beware the “this time is different” justification for tech M&A. All investments, tech included, have to produce sufficient cash at some time to offset the current investment. Tech is difficult, but not impossible to evaluate given the information uncertainties and short product life cycles. Nonetheless, that does not justify taking a leap of faith. Keep in mind the difference between flying and falling - at first not much, but then a lot. The same is true for leap of faith M&A.

j

Valeant, Allergan and the Market Pricing of Proposed Acquisitions

We've written  before about the information implicit in the speculation spread, the percentage difference between an offered bid price and the post announcement stock price.  As we have said, if a stock is trading for $20, a bidder offers $30 and the post announcement price moves to $25, that represents a 16.7% speculation spread.  If you bought the stock at $25 and the deal closed at the bid price of $30, you'd earn 16.7%.  We've also noted that the market's perception of deal completion and revision are implicit in the speculation spread and in the post announcement move of the target's stock price.  In the example above (ignoring a few simplifying assumptions), the market is predicting that there is a 50% chance the deal will go through.  (The $25 post announcement price represents a weighted average of a 50% chance the price would return to $20 and a 50% chance it would rise to $30.)  If the deal was certain to be completed, the post-announcement market price would rise to approximate $30.

In our research, we found that the average speculation spread in deals is about 2%, but that the variation in this spread is large and significantly predicts deal outcomes and time till the deal closes.  Time till deal closes is important as it impacts the rate of return earned by arbitrageurs.  The fact that speculation spreads are significantly related to time to closing is testimony to the importance of this time period and to the wisdom of the market.

In our research, 23% of the speculation spreads were negative meaning that the post acquisition price exceeded the offered bid price.  (In our opening example, this would mean the price rose to more than $30.)  What is implied by a negative spread?  You guessed it - a revision in the bid price by the initial bidder or another bidder.

The Allergan saga continues to provide an interesting example of speculation spreads.  Notice the rapid increase in stock price in the chart below.  The price rises before the deal is announced, probably on speculation and dramatically when a bid is announced and Allergan adopts a defensive measure (the poison pill).

The speculation spread, shown in the chart below, is also informative.  Notice the negative spread, implying bid revision.  It continues to be negative until - the bid is revised.

Of course, the Allergan saga is not over.  Allergan management has implemented many of the ideas espoused by Valeant, yet the stock price remains below the highest offer by Valeant and the speculation spread remains positive indicating the uncertainty that a deal would close.  Meanwhile, news has surfaced that Allergan also thought about merging with Salix Pharmaceuticals in a defensive move.

It will be interesting to follow this one going forward.

All the best,

Ralph

Valuation: Tales from the Real World

The most important skill in successful M&A is valuation. Buyers cannot determine whether the target is worth the price without a valuation anchor. Many buyers are simply price takers subject to market distortions - noise. The problem with price is that it is not value. The biggest risk in M&A is paying too much relative to value received. There is a huge gap between valuation in practice and valuation in theory which complicates the situation.

Price reflects investor opinions of value - the target’s ability to deliver expected cash flows. Opinions are influenced by market behavioral finance including technical factors like mood, momentum, liquidity, and herding. Consequently, price can differ from fundamentally based value for long periods of time. As Keynes famously noted, markets can remain irrational longer than investors can remain solvent. Prices and value eventually converge, but the convergence process can be quite painful. The risk is using prices, usually expressed in market multiples for comparable transactions, to make over priced M&A purchase decisions.

Paraphrasing President Reagan, we should trust, but verify market prices. This is achieved through valuation - primarily based on discounted cash flow (DCF) models. Valuation provides the discipline necessary to control overpaying. Unfortunately, no one likes discipline. As St. Augustine put it so well - God, make me chaste, but just not yet. Keep in mind, however, everything in moderation. Do not over rely on DCF models - they are just a tool to understanding price. This is no one true fixed eternal intrinsic value - it depends on the target’s strategy and execution of that strategy.

Acting on good valuation analysis is hard in the real world. Finding that market prices exceed value estimates means telling your boss that the market is wrong. This is usually a career limiting choice for young analysts - especially when your boss wants to do the deal because all of his peers are acquiring. You cannot create acquisition opportunities when there are none, but boy it can be difficult to sit on your hands and wait.  The Rizzi motto in such a case is please 'stand and don’t do anything' - if only Hewlett Packard, TPG and others had followed that advice! Human nature seems to be buy high. For example, 2010 LBOs were priced in the 8X EBITDA range, while they are now above 10X. Are they really worth 25% more? Obviously, it depends, but the likelihood of high returns at 10X is most likely lower than at 8X.

Remember how LBOs are priced. You determine the market multiple of funded debt to EBITDA-now around 6. The current required equity percentage contribution is 35%. Then assuming a $1000 EBITDA, the affordable purchase price is 6000 in debt plus equity of around 3000 for a total of 9000.This represents a purchase price multiple of 9. If this is below the market multiple of 10, then the PE firm’s options are:

1)     Walk away

2)     Contribute more equity

3)     Increase the debt multiple

4)     Assume higher pro forma (AKA earnings without the bad stuff) EBITDA

5)     Synergies

Notice that none of this has anything to do with textbook DCF - no forecast period projections, terminal values or WACC calculations. You may see some fancy models in the offering memoranda, but they are multiple based and disguised as DCF.  This is like my Uncle Tony who used a 4 year payback rule when making capital investment decisions. When told he should switch to something more modern like a risk based discount model he said OK - I chose 25%!

Practitioners survey responses state they use DCF, but in name only. Look at the terminal value calculation in most DCF models. It compromises the majority of the value-usually > 65%. That calculation is usually based on an EBITDA multiple - usually the entry price multiple. Using price in valuation models is like a financial chain letter. The acquisition is usually taking place when markets are heating up and is inflated. How sure are you that this same multiple can be used for exit purposes?

As Yogi Berra noted- in theory there is no difference between theory and practice, but in practice there is. There is a great divide between what academics teach, practitioners say and what takes place in M&A valuation. That is what makes it so difficult to do M&A correctly.

J

Mitigating Common Deal Risks in Acquisitions

Last week we reviewed some common deal risks in acquisitions.  Today's posts deals with ways to handle these risks.  The original post is copied below along with thoughts on mitigating the risks.  We've written in more detail on many of these items in other posts but provide an overview here.

       One of the topics that draws considerable interest in our Amsterdam, acquisition finance course is mitigating deal risk in acquisitions.  In shortened version, here are some of the major risks involved in acquisitions.   

       1. The deal takes too long to settle (increasing the risk of material changes). The longer it takes to work through a deal the less likely it will be completed.  

     Some of the ways to handle this problem involve using cash (as it is faster than stock due to approvals, etc.).  Of course, deadlines help as well.  Material adverse clauses won't solve this problem but are certainly important in mitigating some consequences of lengthy transactions.

2. The cash flows don’t play out as expected.  We acquire firms assuming a set of cash flows for the future.  In many cases these cash flows don't play out.  It is also common for the seller to have more optimistic expectations about the future than the buyer.  It is necessary to bridge the gap between these expectations to complete the deal. 

       One solution to this problem is the use of contingent payouts.  Earnouts can bridge the gap between seller and buyer expectations and help in completing a deal. But earnouts are also associated with other problems and should be handled with care - especially for sellers who may be giving up control of operations and hence influence on the payouts.  

3. One party abandons the transaction.  This is particularly problematic.  For sellers, it can mean a lost opportunity to cash out.  For bidders, it can mean the loss of time, money and opportunity spent courting a target firm.  

        Termination fees are often used to reduce the pain associated with this problem.  

4. Another bidder acquires the firm.  Similar to the above, this can be problematic for bidders not only because of lost time, money and opportunity but because a rival bidder (likely a competitor) has won and is now stronger. 

       Termination fees are also useful here.  Another solution involves the use of toeholds.  If another party acquires the company, the original bidder gains on the appreciation of shares.

5. The stock price of one of the parties changes before closing.  Particularly problematic in stock deals.  You think you have a deal arranged but at the time of closing find that the share exchange ratio you agreed upon now produces less than optimal terms.  For example, a one for one deal looked fine when the bidder''s stock price was $40, but doesn't look so good at closing when that price has dropped to $30.  

       Collars are useful in protecting against this problem and can give more price assurance to both bidders and sellers.  A typical collar places a ceiling (maximum) and floor (minimum) on the price that will be paid.

         

       All the best,

       Ralph

Texas Pacific Group: The Curse of Too Much Money

Private Equity is mature, large, global multi-trillion dollar industry with over 5000 firms. It is subject to booms and busts - experiencing 4 such cycles since the appearance of the modern industry in the 1980s. The last cycle ended with financial crisis in 2008. Activity, investments, exits and fund raising, dried up, and the industry became a shadow of its former self. The post crisis Fed induced a liquidity flood that rescued the industry by inflating the prices of some, but not all, portfolio firms. Sponsors capitalized on this development to liquidate their holdings at a profit. They returned the realized gains to Limited Partners, and began new fund raising efforts. Currently, the industry has over $1.1T in dry powder - committed un-invested capital. As previously discussed this places an incentive (AKA conflict) on sponsors to invest before the investment period ends and the unused commitments expire. This provides the context for the current TPG fund raising effort. It also sets up the introduction of a structural industry change in additional to cyclicality.

TPG is a large private equity firm with over $60B in AUM. It suffered several problem investments in its $19B 2007 fund including among others, TXU, WaMu, and Harrah's. Limited partner returns suffered. They are now seeking to raise a new $10B Fund and are experiencing some difficulties with investors. TPG is seeking to allay investor concerns by stating they identified the problem with the 2007 fund investment and will not repeat the error. They claim the problem was investing in large deals. The new fund’s focus is on smaller middle market investments. TPG is a fine firm and I wish them well. Nonetheless, I think they, and possibly new investors, misunderstand the nature of the problem.

The problem, just like with banking, is one of industry overcapacity with too much capital chasing too few quality deals. Some of TPG’s competitors recognized this problem and diversified into other activities like real estate and debt products. For example, Blackstone's $266B AUM has only about $66B in is PE.

The real issue is an insufficient number of quality deals, not deal size. Middle market deals are unlikely to be any less competitive than other private equity sectors. Also, do you need a $10B fund for smaller middle market deals? What is needed is as follows:

1)     Avoid overpriced deals: my belief is that double digit purchase price multiples (greater 10X trailing EBITDA) are presumptively overpriced. 1H14 PPX are again at the 10X level.

2)     Leverage: overpriced deals require high leverage to achieve nominal return targets which leaves little room for error. 1H14 FD leverage levels are approaching 2007 6X levels.

3)     Deal types: poor quality deal types have returned. This includes sponsor-to-sponsor (e.g. pass the parcel STS) transactions. These involve one sponsor selling to another sponsor. These deals typically experience lower returns as the low hanging fruit has been picked by the original sponsor. STS have dramatically ramped up in 1H14. Another problematic deal type, public to private transactions, have yet to recover.

TPG should recognize the industry shift to overcapacity with reduced return opportunities and adapt. This implies reduced commitments to traditional private equity investments and fund raising and shifting into other areas. Real estate and debt products may already be taken by other competitors like Blackstone, so something else will be needed. Absent this, TPG and its prospective investors may want to scale back.

j

Common Deal Risks in Acquisitions

       One of the topics that draws considerable interest in our Amsterdam, acquisition finance course is mitigating deal risk in acquisitions.  In shortened version, here are some of the major risks involved in acquisitions.  We outline some of the major problems today.  Next Thursday we'll discuss some simple ways to handle these problems.  

       1. The deal takes too long to settle (increasing the risk of material changes). The longer it takes to work through a deal the less likely it will be completed.

2. The cash flows don’t play out as expected.  We acquire firms assuming a set of cash flows for the future.  In many cases these cash flows don't play out.  It is also common for the seller to have more optimistic expectations about the future than the buyer.  It is necessary to bridge the gap between these expectations to complete the deal.

3. One party abandons the transaction.  This is particularly problematic.  For sellers, it can mean a lost opportunity to cash out.  For bidders, it can mean the loss of time, money and opportunity spent courting a target firm

4. Another bidder acquires the firm.  Similar to the above, this can be problematic for bidders not only because of lost time, money and opportunity but because a rival bidder (likely a competitor) has won and is now stronger.

5. The stock price of one of the parties changes before closing.  Particularly problematic in stock deals.  You think you have a deal arranged but at the time of closing find that the share exchange ratio you agreed upon now produces less than optimal terms.  For example, a one for one deal looked fine when the bidder''s stock price was $40, but doesn't look so good at closing when that price has dropped to $30.  

         Fortunately, there are excellent ways to mitigate these risks.  We'll provide some solutions in next Thursday's post.  

All the best,

Ralph